“There is an illusion in gold”, claimed this week Mr Lee Eung Baek, head Bank of Korea’s reserve management department in a statement highlighting his country’s reluctance to join the bandwagon and increase official gold holdings.  Although buried among the various Yen-related data this week, the statement is notable, as it is coming from an official of a country which only twelve years ago encouraged its housewives to punt their gold holdings.  At the nadir of the Asian crisis, the gold dis-hoarding was prompted in a dramatic move to offset a rapid decline of the Won and the deterioration in South Korea’s balance of payments.  The question arises therefore, how symptomatic Mr Lee’s announcement is of Asian “attitude” towards the role of gold in official reserves.

Twelve years is also the period separating us from the beginning of the negotiations between heads of Central Banks and gold producers.  The discussions, led in the quiet rooms of Hotel Schweizerhof in Davos, Switzerland, led to a more aligned vision among the main holders of bullion over how to treat the perceived overhang of gold holdings in the vaults of the (mostly Western) Central Banks.  As we all know, this process eventually led to the first Central Banking Gold Agreement (CBGA) in 1999, limiting official gold sales by the signatory countries to 400t per annum.  The gold market has since thrived on this predictability and the importance of the original Agreement (and its subsequent extensions) cannot be underestimated.

But what has also changed during the last twelve years is the relative wealth of nations.  Deeply scarred by the experience of the Asian crisis, the economies of the Pacific Rim have since powered on, buoyed by the twin engines of US consumerism and China’s modernization.  The current account surpluses led to accumulation of reserves, with the fastest growth registered in China, Japan, India and Taiwan.  In the last seven years, China has increased its foreign reserves tenfold, and remains the single largest holder of reserves.  Overall, Asian economies control some 80% of an estimated $6,800,000,000,000 worth of reserves.  But here’s the gold bug’s ultimate dream.  The proportion of gold held in the vaults of Asian Central banks barely exceeds a 2% mark.  Far cry from the German, French or US proportion of 69%, 70% or 77%, respectively.

It should be remembered, however, that the accumulation of the gold reserves by the Western Central Banks took place either during the periods of (pre-War) gold standard, or later, under the Bretton Woods system.  In 1933, the United States government forced its citizens to swap their private gold holdings for cash (volume equivalent to some $20bn at today’s gold prices).  France, on the other hand, accelerated their purchase of gold from around 1965, largely in reaction to the perceived debasement of the dollar.  De Gaulle even advocated return to a modernized version of the gold standard…

Asian countries’ predicament today is different.  Only in October and November, Asia’s Central Banks spent roughly $150bn to prevent their currencies from appreciating against the USD.  In the process, they have accumulated further dollar reserves despite holding a widespread, negative view of the future value of the dollar.  Although the thrust of these interventions is against the competition from the deeply undervalued Renminbi, which remains pegged to the dollar, the ubiquitous rhetoric in Asia is one of US bashing, not China bashing.  This alone showcases the expectations of the relative power shift in the Pacific basin.

But what does this accumulation of dollars mean for the gold and other currencies?  Looking at the developments in the forex markets over the last three months, there is little doubt that a significant percentage of the accumulated dollars holdings have been exchanged for Euro and Yen.  This one-way anti-dollar trip has also put a new floor under gold and commodities, whose prices are dollar-denominated.  The announcement of India purchasing 200t of gold from the IMF has also changed the sentiment surrounding the “Asian” attitude to gold reserves.  As Sri Lanka, Mauritius and Russia chimed in, the expectations have surged that further announcements are imminent.  The problem for the gold market is that the 400t available under the Central Bank Gold Agreement (CBGA) may not be sufficient to satisfy such a demand.  Should China and Japan decide to increase their gold holdings to 10% (from the current 1.9% and 2.3%, respectively), it would require the supply of no less than eight annual CBGA quotas.  The resulting pressure on the market would be such that even the combined forces of Turkish, Saudi, Indian and Hong Kong secondary market would not be in a position to provide sufficient scrap to prevent the squeeze.  What on a chart would look like a gold bug’s ultimate pipe dream could cause a lasting damage to the market.

Luckily, South Korea’s comment shows that such a golden Gottesdämmerung is unlikely.  Central Banks will continue to differ in their attitude to the respective roles of gold and paper currencies.  This variety of views is healthy for the gold market.  Whether Koreans themselves are better off this way, we shall not know until another payment crisis hits their economy.

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This week, Premier Wen Jiabao’s angry reaction to EU’s unusually public pressure to elicit a modicum of Renminbi revaluation may have been surprising in its tone, if not really in its content. China’s Prime Minister used the occasion to lash out at Europe’s “protectionist” measures, thus inadvertently admitting to the link between the two aspects of international exchanges: trade imbalances and currency misalignments. And both are relevant to understand how gold prices respond to the increasingly dysfunctional shifts global foreign exchange markets.

Almost a decade has elapsed since the last internationally coordinated intervention in the currency markets. In 2000, the fledgling Euro’s teething problems were averted by a multilateral support effort. As on several other occasions over the preceding 15 years, the leading governments and central banks of US, Europe and Japan decided to cooperate to smooth out currency adjustments, reflecting a fairly harmonious image of international economic coordination. Notably, during the 15 years separating the $10bn intervention in September 1985 (an event commonly referred to as ‘Plaza Accord’) from the $2bn worth of Euro purchase in September 2000, gold had lost 17% of its value in nominal dollars. Within two quarters following the Euro support, gold hit a long-term low of $256/oz.

But in 2000, these three, periodically cooperative economic centers represented almost 75% of the global GDP. In five years from now, they will barely constitute 50% of the global GDP (calculated at PPP). In many ways, the year 2001 was a game changer, and not only because global perception of (terrorist) risk changed forever. China’s entry into WTO sent shockwaves through the global trade system with positive – mostly disinflationary – externalities for the developed economies. The Western nations and Japan could now afford maintaining relatively low interest rates. After a three year pause, Yen carry trades resumed. The dollar began its lengthy descent. The low interest rate environment also helped feed appetite for commodities, which, in response to increased investment demand in Asia, were awakening from a multi-decade slumber. The lower interest rates also put a floor under gold, where the investment demand was at that point of no relevance.

Ten years later, China is sitting on nearly 2,400,000,000,000 dollars worth of reserves. The pace of the accumulation accelerated as the country became the pivot of the global trade. Recent experiments in international swap arrangements and bond offerings notwithstanding, China’s capital account has remained closed and the dollars earned by importers had to be sterilized locally. Current account inflows generated a surplus of dollars because so much of the global trade is denominated in this currency. In fact, the role of the dollar as a form of payment in international trade (around 70%) outstrips its role as a reserve currency. Importantly, China’s entry into WTO coincided with the slow, yet gradual loss of dollar’s importance as a reserve currency (from 72% in 2001 to 65% now). The high correlation between current account surplus-driven accumulation of dollars by China and the fluctuation of euro-dollar exchange rate could indicate that some of the sterilized dollar inflows are sold in the market and exchanged into structurally overvalued currencies of Europe and Japan. Not surprisingly, the sudden, petrifying collapse in China’s trade in the fourth quarter of 2008 coincided with a bout of dollar appreciation. This remarkable jump in the dollar, commonly associated with increased risk aversion, was also reflected in the fall of the gold price, a “currency” with long-term negative 60% correlation to trade-weighted dollar.

Yet gold is largely a passive bystander in the current bras de fer between China and its trading partners. And although Beijing’s nervous verbal reaction to external pressure does not rule out a minor adjustment of Renminbi exchange rate as heralded by the non-deliverable Renminbi forward market, it does not bode well for further international economic cooperation. China has not been known for altruistic gestures similar to Japan’s voluntary export restrictions or the bubble-inducing strengthening of the Yen in the late 1980s. Gold remains a refuge among the increasingly feisty rhetoric, creeping moves towards capital account controls (Brazil, Taiwan, India) and competitive devaluations (Vietnam). Trade protectionism could yet become a natural (if politicized) response to this crumbling confidence in multilateral cooperation. Should this happen, the global growth will suffer and the interest rates will have to be kept at historic lows for much longer than initially expected. There is very little economic upside from such a scenario, but when interest rates are at basement levels, holding non-yielding assets – including gold – could be more attractive than usual.

But this is not necessarily a reason to cheer. Last time the global economy endured widespread devaluations and trade protectionism, the world fared a lot worse than simply suffering a recession. It was in the 1930s.

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Tags: currencies, gold, international cooperation, reserves, trade