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Wednesday, April 25, 2012

Central Bank gold purchases - an assessment of the impact

After yesterday's report on the latest Central Bank gold purchases, Jeffrey Nichols analyses the impact of such buying on the global gold market and its underpinning of the gold price

Author: Jeffrey Nichols
Posted:  Wednesday , 25 Apr 2012 



NEW YORK  - 
A recent survey of central-bank reserve managers predicted that the most significant change in their official reserve holdings over the next 10 years will be their intentional accumulation of gold.

In fact, central-bank reserve managers are already moving in this direction, expanding their reported bullion reserves by 439.7 tons last year - the biggest annual increase in almost five decades . . . and this doesn't count significant purchases that remain unreported.


Central banks, taking advantage of depressed market prices, were again big buyers of gold this past March according to statistics just issued by the International Monetary Fund.  Reported official gold holdings increased by 49.8 metric tons last month and 55.1 tons during the first quarter.

However, it is quite likely that actual central bank gold reserves rose considerably more as some countries, led by China, choose not to report or otherwise publicize their gold market activities.

Among those central banks reporting to the IMF, Mexico was perhaps last month's most notable buyer, adding some 16.8 tons this past March on top of the 98.8 tons purchased in 2011.

Turkey added some 11.5 tons to official reserves, although this results from commercial bank transfers to meet domestic reserve and collateral requirements.
Russia, a fairly regular buyer in recent years, boosted its official gold reserves by some 15.6 tons last month and the country's central bank has said it bought another ton in the first three weeks of April.  Proving itself to be an astute trader, Russia's central bank was a small seller at higher prices in February.
Kazakhstan, like Russia, buying from domestic mine production, added 4.3 tons last month.  In addition, a few other countries bought smaller amounts.

Readers of my NicholsOnGold reports and followers of my more frequent Twitter posts should not be surprised by the recent news of continued significant central bank gold purchases this past March.  We have repeatedly suggested that official purchases were giving the market some downside protection with central banks buying on dips when their purchases would not be disruptive or particularly visible to other market participants and observers of the gold scene.

Central banks, like many private investors, view gold as a hedge against debasement and devaluation of their U.S. dollar- and euro-denominated currency reserves.

And, because it is the only financial asset with no counterparty risk, central banks hold gold as a safe haven free from confiscatory and political risk.  Indeed, both Iran and Venezuela last year, as a precaution against political risk in the form of economic sanctions, repatriated some of their official reserves that were previously held in Bank of England vaults.

With total reported global official gold reserves at roughly 31,000 tons (997 million ounces) compared to annual world gold mine output at 2,810 metric tons (about 90 million ounces), relatively small percentage changes in central bank holdings can have a significant influence on the metal's price.

In the two decades through 2009, net official sales added roughly 15 to 20 percent to the supply of gold entering the market each year.  One can imagine that this additional supply had a considerable negative effect on the metal's price.

Similarly, in more recent years, the effect of central banks shifting gears - becoming net buyers rather than net sellers - has had a very positive effect on the metal's price.

I believe that net official gold accumulation will not only continue but will likely expand in 2012 and for years to come.  With China and Russia leading the pack, a growing number of central banks, underweighted in gold and over-weighted in dollars and euros, will join the line to buy gold.

Importantly, the official sector will continue to underpin the price - buying on corrections when significant quantities are readily available and may be purchased discretely without disrupting the market.

Fuelling the rise in official sector interest in gold is the anticipated future depreciation of the U.S. dollar in world currency markets and the continuing erosion of its status and role as the world's key official reserve asset.

And, the dollar is not the only currency suffering a loss of respect.  A few weeks ago, an Asian-country central banker told me his country's recent gold purchases had been motivated mostly by a loss of confidence in the euro as a reliable reserve asset.

In recent years, China's central bank, the People's Bank of China, has probably been the most significant buyer.  Three years ago - in April 2009 - the PBOC revealed it had bought some 454 tons of gold over the preceding six years, an average of about 75 tons per year.

Since then there has been no hard evidence of additional buying . . . but my guess is that the PBOC continues to buy regularly from domestic mine production and scrap refinery output - perhaps as much as 50 to 100 tons or more per year.  For its part, the PBOC not long ago said it will "seek diversification in the management of reserve assets," possibly signaling their intention to accumulate gold without actually saying so.

One day in the future we should not be surprised to see by a PBOC announcement that China's actual official gold reserves are considerably higher.

Many other central banks have also taken a much more positive view of gold in recent years.   Indeed, the official sector has been a positive net buyer of gold for the past two or three years.  This follows some two decades in which the official sector was a net seller of gold to the market, reflecting mostly large-scale sales by European central banks that mistakenly thought gold was in descent as a legitimate reserve asset and sold at a mere fraction of today's price.

Following many years of net annual sales in the 400-to-500 ton range, the official sector became a net buyer of gold in 2009.  This is a "game changer" for the gold market.  Instead of supplying hundreds of tons, year in and year out, central banks are now buying at what seems to be a net rate of 400 to 500 tons per year - representing a swing in the annual supply/demand balance of 800 to 1000 tons a year.

I don't think most market observers and participants fully appreciate just how significant this has been - and will continue to be - for the world gold market.

The list of countries that have reported gold purchases to the IMF in the past few years is itself growing with new, surprising names joining the club:
  • Russia has been the most outspoken and one of biggest buyers of gold in recent years.  It has an explicitly stated policy to continue making monthly purchases from domestic sources  at a rate of about one hundred tons a year . . . and has more than doubled its gold reserves over the past four years.
  • Kazakhstan is another gold-mining country intent on buying its own mine output in order to build up its official gold reserves.  The National Bank of Kazakhstan has announced plans to purchase their nation's entire gold production during the next few years.
  • India made a strong pro-gold statement, buying 200 tons directly from the International Monetary Fund at the start of the IMF 's gold-sales program a couple of years ago.
  • South Korea last summer announced the purchase of 25 tons, its first purchase since 1998 when it collected and resold gold jewelry donated by patriotic citizens to help the country through a period of economic emergency.
  • Saudi Arabia also bought significant quantities of gold - 180 tons, in fact but did not report these purchases until last June.  It is likely that the Saudi Arabia Monetary Authority continues to buy on the sly . . . along with some of the other oil producers that, like the Saudis, are over-weighted in U.S. dollar assets and grossly underweighted in gold,
  • Mexico was one of the biggest buyers in 2011, acquiring some 100 tons.  As America's southern neighbor and close trading partner, this is yet another sign of the diminishing faith and trust in the U.S. currency.
  • In addition to Mexico, other recent Latin American buyers include Bolivia (which recently bought seven tons following a similar purchase in December 2010), Colombia, and Venezuela (which not only bought some gold last year, but also repatriated much of its gold reserves that were previously held abroad in the Bank of England vault),
  • Other names on the list of recent central-bank buyers include Thailand, Turkey, Belarus, Sri Lanka, Mauritius, and even Bangladesh.
Meanwhile, gold sales by European central banks - those that had been big sellers in the 1990s - have dwindled to practically nothing, only enough to supply their bullion and commemorative coin programs.

Keep in mind that aggregate central bank gold purchases probably exceed the official data by a wide margin.

The People's Bank of China, the Saudi Arabian Monetary Authority, and some other central banks with huge and some might say "excessive" U.S. dollar- and euro-denominated official reserve assets have an incentive to buy gold discretely and surreptitiously - simply because the announcement of their buying programs would likely boost the yellow metal's price and raise these central bank's acquisition costs.

Importantly, much of the gold bought by central banks has been bought for the long term - and will likely be held not just for a few days, weeks, months or even a few years . . . No, much of this gold will be held for decades or longer, even at much higher prices.

Central banks are now creating an upside bias to the market and are reducing the "free-float" available to meet future demand, even at much higher prices.  As a consequence, we can expect less downside volatility - and a more sustainable bull market with much higher prices in the years to come.

Jeffrey Nichols is Managing Director of American Precious Metals Advisors and Senior Economic Advisor to Rosland Capital

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