Posted On Thursday, Apr 23, 2020
Lately, there has been a lot of talk about global central banks liquidating their flight-to-safety assets - gold reserves - in order to generate cash and save their economies from the upcoming recession. Understandably, gold investors are concerned that this large scale gold-selling will push the asset's price down.
Although central bank policies have been prone to error, we believe that this is the "misstep" they would want to avoid. So, we rightly discount this possibility. Till the latest central bank reserve statistics are not out to confirm or deny this, let's examine the factors that could limit the possibility and scale of this phenomenon for the benefit of wary investors.
After witnessing the massive bond-buying programs unleashed by global central banks as a response to the current crisis, you should be convinced that central banks can print money when they please, hence eliminating the need to sell anything for cash.
In the decade since the financial crisis, global central banks have been net purchasers of gold. This change in behavior is a clear acknowledgment of the benefits that holding gold can bring to a reserve portfolio, especially in times of economic crisis. In a 2019 survey by the WGC, over three-quarters of central banks saw gold's role as a long term store of value as relevant, while 63% highlighted its effectiveness as a portfolio diversifier as highly relevant.
The COVID-19 pandemic has heightened economic and political uncertainty and led to an increase in systemic risk. Gold, unlike the other reserve asset - US dollar, bears no political or credit risk.
Central bank portfolios are typically US dollar centric. There are concerns about the outlook for the US dollar as it faces the threat of being devalued by the extraordinary monetary policies being announced to battle the current crisis. It thus makes sense for central banks to reduce their exposure to the dollar by holding gold, which cannot be devalued or manipulated. In fact, as per a 2019 WGC survey, 13% of central banks said de-dollarization was highly or somewhat relevant to their decision to invest in the shiny metal.
Central banks manage funding strains during times of crisis without liquidating their gold reserves. They use gold swaps and gold deposits as ways to create foreign exchange liquidity.
The value of gold holdings that these central banks own is little as compared to the huge liquidity being doled out by them.
As you can see, Gold reserves are paltry in comparison to the monetary/fiscal measures committed by the country. They are expected to further keep pushing billions of dollars to support their beleaguered economies. In effect, selling gold reserves would be of no help.
Now since we've pretty much established that these speculations about central banks dumping their gold have little or no basis, let's quickly map out what would happen even if they turned out to be true. You don't know what Trump would really do, right?
For instance, the Federal Reserve decides to sell all, yes all of its 8133 tons of gold reserves to fund its current rescue package of $2.2 trillion (the gold, by the way, is valued at ~$400 billion at current prices and will fund barely 20% of the stimulus).
Of course, there will be a knee-jerk reaction in gold markets as the supply suddenly shoots up. But let's not forget that there will also be buyers to absorb the new supply and stabilize prices. Buyers with large appetites for gold,like the central banks of Russia, China or large holders of US treasuries who as we mentioned before, will be really keen to diversify their reserves away from the US dollar. This would indeed be true when the US removes one of the important pillars of strength for the US dollar that emanates from its large gold holdings. Remember, gold at the end of the day is a monetary asset and was used as money for a significantly longer time period than any other reserve currency.
Fundamentally, they have a good reason to diversify. Ballooning deficits and unsustainable debt levels of the USA are increasingly threatening the stability, reliability, and reserve currency status of the dollar making it imperative for central banks to reduce their large exposures to the currency. There will also be buyers with smaller appetites - institutions and investors which will devour the metal for its increasingly conducive fundamental and situational attributes.
To sum it up, whether these speculations are true or not, either way, the future looks bright for gold. Brace for some price volatility along the way as central banks continue to intervene in financial markets.
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