Markets & Finance

Central Bank Buying Spurs a Gold Rush


India's and Russia's central banks helped push gold to nearly $1,200 an ounce, although their buys amount to minor diversification. Is this a gold bubble?

It's typical in India for gold demand to escalate during the country's festive holiday season, which extends from September into January. But it's not only gift-givers that are scooping up the precious metal this year. India's central bank is also buying gold, a factor in the yellow metal's recent surge to nearly $1,200 an ounce. That development worries some people: Since central banks typically buy U.S. dollars to store their foreign exchange reserves, the growing taste for gold can be seen as the latest sign that the greenback's status as the world's sole reserve currency is in jeopardy. The yellow metal has been on a tear since the end of August, but the rally gained added momentum starting on Nov. 4, the day after the Reserve Bank of India announced that it had bought 200 metric tons of gold from the International Monetary Fund in October. The deal boosted the central bank's gold reserves by nearly 56%. This may sound substantial, but gold accounted for just 4% of the RBI's total foreign exchange reserves in September. Marc Chandler, chief currency strategist at Brown Brothers Harriman, calculates that the value of India's total foreign exchange reserves has grown by twice that of its gold reserves this year, so the central bank's holdings haven't diversified at all. Russia added gold from its own mines

Before buying from the IMF, India held 357.7 metric tons of gold, which was only 4% of its total bank reserves, while China's 1,054 tons of gold represented 1.9% of its total reserves, according to the World Gold Council's September count. Meanwhile, the 8,133 tons held by the Federal Reserve equaled 77.4% of its total reserves in September. The price of gold futures on the Chicago Mercantile Exchange reached $1,186 an ounce on Nov. 25 before settling at $1,192. On Nov. 23, Russia's central bank announced that it had bought 15.6 metric tons of gold in October to add to its monetary assets. But unlike its Indian counterpart, Russia's central bank bought gold produced by the country's own gold mines. The additional gold was only 2.7% of the 568.4 metric tons it owned in September, which represented 4.3% of its total reserves. Leo Larkin, equity metals analyst at Standard & Poor's, says he wouldn't be surprised to see other central banks start to show more interest in accumulating gold, and "instead of selling gold, actually start to buy it and keep it as a monetary asset, as part of their reserves." The IMF, under its program to raise money to lend to low-income countries, has another 203.3 tons of gold to sell. Oil exporters must diversify, too

In view of widespread forecasts of further declines in the dollar's value, it doesn't surprise economists and investment pros that there should be a growing desire by global central banks to diversify away from the greenback. Lower demand for dollars makes sense to central bankers in countries such as Japan, which is no longer trying to control its exchange rate vis à vis the dollar and is no longer so inclined to buy greenbacks to support the dollar's value, says Barry Bosworth, a senior fellow at the Brookings Institution in Washington. "Similarly, you'd expect oil exporters who are investing for future income to be fully diversified and want to hold less dollars," he says. But central banks' sharper focus on gold mystifies Bosworth. It would seem more rational for commodity-exporting countries to shift toward holding a basket of currencies in their reserves, including currencies of some emerging markets, which are becoming more important trading partners, he says. Given China's future prospects, it would make sense for central banks to diversify into the yuan, except that it isn't a tradable currency, he says. The choice by central banks to diversify away from the dollar by using gold rather than other currencies is partly a bet that interest rates around the world will stay low for a long time. But it also reflects central bankers' growing distrust of all paper currencies, not only the dollar, says Larkin at S&P. The growing anxiety about all paper currencies is a reaction to the enormous amounts of debt that many countries have assumed in order to recapitalize their banking systems and pull their economies out of recession, he adds. Gold is "a currency that can't default. It doesn't have any counterparty risk. It's universal money," says Larkin. Gold: a "greater fool dependence?"

But the yellow metal functions as a store of value, not an earning asset. Gold doesn't generate cash flows, in contrast to the dividends that many stocks pay and to the coupon payments generated by bonds. Gold does have what Wells Fargo Private Bank (WFC) called "greater fool dependence" in a Nov. 12 market report. "Because it has no inherent earnings power and no intrinsic value, investors in gold are hoping that other investors will come along to bid up their holdings in the future," the report said. That may be a common tactic of speculators, but it's rarely a good long-term investment strategy, the report said. Indeed, European central banks began to sell their gold reserves in the early 1990s. This reflected the greater focus among a new generation of professionally trained bankers on earning the highest possible returns by making more efficient use of bank reserves, says Chandler. He believes the surge in gold prices over the past month has been driven by the same factor that allowed asset prices in emerging markets to appreciate so much: Investors are displaying a bigger appetite for risk. In that sense, gold is late to the party, Chandler says. Even if it makes sense for central banks to use gold to diversify their reserves—at least while interest rates are low—it's less practical for individual investors. Not only does gold ownership provide no income stream, but keeping a substantial portion of your 401(k) portfolio in the metal would require you to pay for storage and insurance, the cost of which would diminish any return on your investment, says Chandler. HSBC's (HBC) decision earlier this week to ask retail investors to remove their gold from the bank's vaults suggests that storage costs are climbing, too, he adds. Investors who choose to own gold through an exchange-traded fund such as SPDR Gold Shares (GLD) pay a higher tax rate than they do on stocks and bonds because the Internal Revenue Service treats shares of ETFs backed by physical bullion as a collectible, not a security, says Chandler. Would normality pop a gold bubble?

Keeping a sense of proportion would also help would-be gold investors. Although the metal appears hot right now, it's been the worst performer of all precious metals in 2009, says Chandler. So far this year gold prices have climbed 34% vs. a 98% spike in palladium, a 63% surge in silver, and a 56% jump in platinum. The gold rally looks a bit extended, says Larkin, with the price near $1,200—a level he hadn't expected the precious metal to reach until the end of 2010. But he still sees an overall upward trend for the foreseeable future. The proliferation of gold-based ETFs has made it much easier to invest in gold because investors no longer have to buy the physical metal and deal with such issues as storage and insurance costs. And gold ETFs carry much less risk than owning shares of gold mining companies, he adds. Erik Davidson, managing director of investments at Wells Fargo Private Bank and one of the authors of its Nov. 12 report, agrees that there's enough momentum to carry prices higher. But that doesn't stop him from believing that there's a bubble in the gold market right now. As soon as there are signs of economic normalcy—which would include credit markets starting to function more smoothly, somewhat healthy economic growth, and labor markets starting to tighten—Davidson expects gold prices to come down. He sees a return to a more conventional economic environment by the third quarter of 2010, putting gold prices lower at the end of 2010 than they are now. If markets and economies around the world continue to show signs of greater stability, gold's flirtation with $1,200 may not be a lengthy one.


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