Best Of 2011: Central Banks — The Hidden Gold Demand Grows

December 27, 2011

Editor's note: This story originally ran on Nov. 21 and was the second-most-read story on HAI in 2011.




Impact of central banks buying gold becoming biggest factor behind price appreciation; more so than investor and jewelry sales.

It’s that time of the quarter when we dig deep into the demand numbers for gold provided by the World Gold Council. The headline for gold bugs is generally a good one. Even with the average price of gold more than $1,700 for the quarter, demand was up 6 percent year-over-year, with strong demand from anything related to investment.




Looked at on percentage terms, real growth of physical investment fell 10 percent from this time last year due to pullback in jewelry demand.




But that’s not the interesting story here. We all know, up until this point, that investor demand for gold and the subsequent rise in prices has been fueled by the search for safe-haven assets around the globe as uncertainty about the economy in Europe, and frankly everywhere else, inspires panic.

The really interesting story is this: Central banks remain consistent buyers of gold. But where are they on the demand chart? They aren’t. Because central banks have been net sellers of gold, for ages, they’re not even listed as a source of demand.

Here’s a bit of historical context for the “traditional” role of central banks in the supply-and-demand equation:





And here’s where they fit in the overall supply picture today:



The above charts show central banks (which are euphemistically called the “official sector” by the London-based World Gold Council) putting out a “negative supply” of some 148 tonnes. Compare that with the demand chart, and central banks’ buying has been a bigger factor for gold prices than all of the technology and industrial applications, and twice the size of healthy ETF demand for the quarter.

So what’s going on, and how did we get here?

Before 2000, the world’s central banks – dominated by Western central banks – controlled roughly one-third of the above-ground gold in the world. There was concern among economists, bankers and politicians that the actions of one central bank could cause huge swings in the price of gold, and that unchecked, this could be a bad thing. So in 1999, the first “Central Bank Gold Agreement” was signed. The agreement acted as a kind of ceiling on the amount of gold that any country that signed the agreement could sell each year.

When the first CBGA expired, a second five-year agreement was signed, and in 2009, when CBGA 2 was signed, a third one was signed. And if you look at the actual sales by these European central banks, it seems like the limit made sense once upon a time.






Where did all this gold come from?

Ultimately, it goes back to Franklin Delano Roosevelt in 1933, who criminalized the holding of gold by U.S. citizens (seriously). FDR engaged in some massive sleight of hand, buying gold en masse from the citizens of the country at roughly $20 an ounce, and then pegging the dollar to an ounce of gold at $35. After World War II, the Bretton Woods agreement and the foundation of the International Monetary Fund further entrenched central bank ownership of gold as the foundation, effectively, for the world’s currency system.

And while you’d be hard-pressed to find a central banker who’d admit to it, gold still serves as a reserve asset. Ownership of an asset that’s rising in value in its own currency gives a central bank options, more than anything else, because it self-protects against inflation. On the other hand, central banks like to buy low and sell high too.

So who’s buying now, with gold at all-time highs? The short answer is “we don’t really know.” What we do know is that the signatories to the current CBGA were not big sellers of gold (as the above charts show), and it’s unlikely, given the state of the eurozone, that they were big buyers either. Instead, the smart money is on China and Latin American countries fueling the central bank buying.

Increasing their gold reserves, particularly for China, acts as a kind of ballast that further reduces their dependence on the U.S. dollar. With China seeking to make the renminbi a reserve currency, a deep gold reserve is almost a necessity. And a high price of gold makes the U.S. seem like less of a reserve currency, and anything more tightly tied to gold, more of one.

This was all famously the subject of a diplomatic cable (exposed by WikiLeaks) back in 2009, when many suspect China began its slow accumulation of gold reserves. While conspiracy theorists went nuts, there’s much to consider in the content of the cable:

“The U.S. and Europe have always suppressed the rising price of gold. They intend to weaken gold's function as an international reserve currency. They don't want to see other countries turning to gold reserves instead of the U.S. dollar or euro. Therefore, suppressing the price of gold is very beneficial for the U.S. in maintaining the U.S. dollar's role as the international reserve currency. China's increased gold reserves will thus act as a model and lead other countries towards reserving more gold. Large gold reserves are also beneficial in promoting the internationalization of the RMB.”

Is there any story in commodities these days that doesn’t come back to China?

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