To ALL:-
Here's an essay from the ECONOMIST!
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economist.com
Losing the Midas touch
Central banks' reserves are no longer "worth their weight in gold"
FOR thousands of years gold has been viewed as one of the most precious assets on this earth. It seems to have lost its lustre. On November 14th the gold price dipped briefly below $300 an ounce, the lowest since 1985. And over the past decade, while equity and bond prices have surged, gold has yielded the worst return of any financial asset. If in 1987 you had invested $100 in the American shares tracked by the Standard & Poor's 500-stock index, you would have more than $350 today. If you had bought gold, you would have less than $70.
One reason for gold's slump is that central banks have been selling some of their reserves. They have plenty more to sell. Central banks and international financial institutions such as the IMF own more than 35,000 tonnes of the shiny metal, equivalent to 30% of all the gold ever mined and to 18 years of world mine production. Although the demand for gold is strong-the World Gold Council says demand this year to end September was 11% higher than in the same period of 1996, thanks partly to strong demand in the Middle East and India-this overhang of stocks will continue to weigh heavily on the price.
Why do central banks hold gold? There are two traditional
motives.
A monetary asset. Gold once played an important
role in the international monetary system. But the gold standard
in the 19th and early 20th centuries, under which the value of
many currencies was set in terms of gold, has long been
abandoned. Some Americans favour a return to a gold
standard to ensure price stability. No need: an independent
central bank committed to price stability can hold inflation down
while ignoring gold-witness Germany or New Zealand.
A war chest. Governments have traditionally held gold to
provide security at times of international crisis. But its role
as a store of value has been tarnished. Over the past two
decades gold has generally failed to keep pace with
inflation. The slide in the price of gold despite recent
financial turmoil in East Asia and tensions in Iraq suggest
that it is no longer seen as a safe haven. And gold is also
less liquid than foreign currency and so cannot easily be
used for foreign-exchange intervention to defend a currency
under attack.
The truth is that gold is no longer a monetary asset. It has become just another commodity. Many developed economies, including America, France and Switzerland, still hold more than 40% of their total foreign reserves in gold, and these massive reserves are keeping the price artificially high. In any other market, such huge stocks would eventually cause the price to collapse.
If central banks were now to build their reserve portfolios from scratch they would probably hold less in gold and more in interest-yielding assets. Gold brings only a modest return. Central banks can lend their gold reserves to bullion dealers who then lend them to producers to hedge future sales, but this typically yields only 1-2%, well below market interest rates. Andy Smith, an economist at UBS in London, estimates that if all central bank reserves currently invested in gold were switched into foreign- government bonds, they would earn almost $20 billion a year (see chart). In Switzerland the interest which the government forgoes by holding gold amounts to over $450 annually for each household.
In recent years, governments in Belgium, the Netherlands, Canada and Australia have sold big chunks of their gold. But if all central banks tried to sell their gold, the price
would plummet. Gold bugs have therefore consoled themselves with the argument that none of the big holders of gold (America, Germany, Switzerland and France) would
dream of dumping their reserves.
They may be disappointed. In late October, the gold price dived after a group of experts appointed by the Swiss governmentproposed that Switzerland sell up to 1,400
tonnes of gold, more than half its gold reserves. The proposal will need to be put to a referendum and so may yet be rejected. Even so, it is significant that the
third-biggest holder of gold is contemplating such a step.
Yellow peril
A provocative study* published this summer by America's
Federal Reserve also deserves attention. It concluded that
the world would be better off if central banks sold their
gold, and it offers a novel explanation why.
Keeping gold reserves off the market, argue the authors,
means that resources are wasted. Extracting new gold from
the ground, at an average cost of close to $300 an ounce, is
not necessary. If the demands of gold-using industries, from
semiconductor makers to dentists and jewellers, could be
met by running down stocks rather than mining, there would
be a considerable economic gain.
The study estimates that if all countries sold their gold, this
would result over time in a net gain in economic welfare of
$368 billion. Of this, $342 billion would go to governments,
while private-sector users of gold would be $198 billion
better off. In the loss column, private owners of gold would
be $102 billion worse off due to lower prices, and gold
producers would suffer to the tune of $70 billion.
The study has the usual disclaimer that it reflects the views of the authors and not those of the Federal Reserve. But the fact that the holder of one quarter of all official gold reserves is asking whether gold could be put to better use cannot be dismissed lightly.
The big holders of reserves among emerging economies, such as China and Taiwan, have little gold in their vaults. If the smaller central banks continue to sell gold at a modest rate, then the price may hold steady. But if the big central banks dump the metal then gold could meet the same fate as silver. In the 1870s both Germany and America stopped the regular minting of silver coins. Germany in particular began dumping silver on the market, and by the early 1900s the price had tumbled by two- thirds.For gold bugs, central banks' diminished affection for the yellow metal may not have a silver lining.
* "Can Government Gold be Put to Better Use?" By Dale
Henderson, John Irons, Stephen Salant and Sebastian Thomas.
Federal Reserve International Finance Discussion Paper no. 582.
June 1997.
c Copyright 1997 The Economist Newspaper Limited. All Rights Reserved |
