CANARC CONFERENCE CALL - Part II of III
FV: Thank you Brad. Well, it's quite a day to have a conference on this subject with gold having made a new low below the 1985 low. I know everyone wants to know why it's happened and where we're going in the short run. I must say that our perspective is a fairly long one. It's a very commodity oriented perspective and we have tried to elaborate the framework that we use and the views that we have and the forecast that we make in an extensive document that we're putting out in January. It's called the Gold Book Annual. It will be coming out every year. It's a long thing, it's about 250 pages and it has a great deal of analytical detail that supports the type of commodity framework for the gold market that we have. Now, in this framework lies a very bullish long term scenario. The short term situation is much less clear because it's been a flow of central bank gold that has been depressing the gold market and it is rather difficult to assess how that flow will go over the short run.
First, I'm going to give you a little bit of the framework so you understand what's going on. Then I'm going to talk about the short run, then I'm going to run back to that framework and draw some implications for the longer run.
First, the gold market. The gold market has about four to five thousand tonnes of demand and it has about 3,000 tonnes of mine and scrap supply and the difference is the flow of central bank gold. Some of that central bank gold flow is due to outright sales and some is due to gold
borrowings. Gold is borrowed by producers that hedge, by fabricators to finance inventories and by various kinds of speculators, the so-called shorts of the market. Both of these factors, outright sales and borrowings have been very important in this year.
We believe that the official data on the gold market is very much in error. We look at the World Gold Council which provides an alternative survey of demand to this official data on the gold market and we come up with a demand level of about 600 tonnes above what is generally accepted. We have done considerable work on the flow of borrowed gold and we think that this flow has been about 500-700 tonnes higher than what is generally accepted. Both of these findings support the other. We feel very very confident about our research on gold borrowings.
If we take this structure, we think that the gold market had a flow of official gold at $385 in prior years of in excess of 1,000 tonnes. We know how much the gold price will go down if you increase the supply. We understand the price elasticity of demand and from that we can draw certain conclusions about what the flow of central bank gold is at various price levels on the way down. It is our judgment that this year we probably have a flow of central bank gold that lies somewhere between 1,500 and 2,000 tonnes. Probably more than half of it is outright sales. Obviously with the price lower in the 2nd half of the year than the 1st half of the year, the flow has been more intense in the last 6 months, in particular in the last 3 months.
Okay, who were the sellers? What has caused the big break? Probably there is one major European Central Bank that has been the impetus behind this bear market. The dealers in the gold market have been telling all manner of participants in the market, be they speculators, producers or smaller central banks, that there would be a great deal of European Monetary Union related central bank selling this year, so this impetus, this European Central Bank selling, has created an accelerator in the form of a lot of other transactors - hedge funds, producers and smaller central banks - who are selling along with, or in front of, this well advertised central bank
selling. Our guess is that the central bank selling out of Europe is not coming from the G-7 central banks, but from the smaller central banks. Most likely it is the Dutch or the Belgians. We believe that, in the 1st half of the year, there were a couple of hundred tonnes of unrecorded central bank sales, probably Dutch in origin. We think that around May there was an agreement by the European Central Banks to cease selling. A statement to this effect was made by the 3rd ranking man in the Banque de France, a man by the name of Jean Pierre Patat, at the June FT gold conference, when gold was around $345. I want to read to you some of what he said because I think it's important in interpreting what's going on now. He said that the European Central Banks will not sell a major portion of their gold reserves and that allegations to that effect are "devoid of all substance". He also said that several central banks in Europe which had sold gold from their reserves now feel there is no longer an advantage on selling more bullion. "The reasoning now was that any advantage was outweighed by the loss on the remaining reserves from reducing the gold price." So here's the Banque de France, this past June, telling you that these two central banks, Belgium and the Netherlands, that had sold in the past, have decided, have agreed, to stop selling because the loss of the value of the reserves that are held outweighs any gain to be had by selling the gold and putting the proceeds into interest bearing securities.
It is our opinion that sometime after June, one or several European Central Banks broke rank with this consensus, failed to live up to this agreement, and began to sell again. Now, what would their motivation be? There are two possible motivations. The one you most frequently hear about is that they want to sell gold in order to raise cash to improve their fiscal and debt ratios in order to get closer to the criteria that are needed to gain acceptance into EMU. But there's another motivation. When the European Central Bank is created, very little of the reserves of the System of European Central Banks will go into the European Central Bank. The European Central Bank will be a central type of entity like the Fed Board of Governors in Washington. Then you'll have a system of country central banks, which are the central banks that now exist, very much like the regional fed banks in the United States. In the European case, however,
these country central banks will hold most of the system's reserves. Only about 15% of the reserves will be allocated to the ECB; most will reside at the country central bank level and the fiscal implications of their reserve composition, whether they earn interest or not, will be borne by the individual countries. However, once the ECB is created, the individual country central banks will lose autonomy over their reserves. The management of those reserves will be done by the European Central Bank itself and that European Central Bank will be dominated by the French and Germans. All central banks like the Dutch and the Belgians will have the management of their reserves largely dictated by the French, the Germans and the Italians.
Now the French have been very pro-gold, they have made several pro-gold statements about the role of gold as a reserve asset in the forthcoming European Central Bank. The Germans have also taken a pro-gold position in a dispute with the United States over whether the IMF should sell gold.
Also this year when Finance Minister Wiegal tried to revalue the Bundesbank gold, it created enough of a public furor that there were repeated assurances that the German government would not sell any gold. Both the German and the French people had a certain affinity for gold, unlike the
populations of the Netherlands and Belgium. So we believe that, with this on the horizon, some of the central banks, most likely the Netherlands, possibly Belgium, possibly one other, have been trying to sell as much of their gold as they can and put it into interest bearing assets before the European Central Bank is created, at which point they may no longer be allowed to do so by the French and the Germans who will dominate the ECB. Now, this is not just pure speculation on my part. Some noted economist friends of mine, like David Hale at Kemper Zurich, have talked to these central bankers and in general the attitude seems to be that in the immediate run up to EMU and in the 1st year or so after the ECB is created, the French and the Germans will not want the boat rocked with any major changes in reserve management. If someone in the system of European Central Banks is going to want to sell gold and turn it into an interest bearing portfolio position, they will have to do it before reserve management is passed to the French and Germans, who will dominate reserve management in the European Central Bank.
OK, what then would be the time table? When would they want to get that gold sold by? Well, the European Central Bank will not begin formally until the end of 1998 but the decision about the exchange rates that will be used for converting the European currencies into the Euro is to be made at the end of April or the beginning of May. It is the opinion of some analysts of the European scene that an effort will be made to freeze central bank reserve positions at that time. Also, it is the opinion of some that once these exchange rates are set there will be a testing period between the establishment of these exchange rates in the beginning of May and the conversion to the Euro late in the year. The European Central Banks will want no shocks that would create any pressures on those exchange rates. One might construe an announcement of a very large gold sale by a European Central Bank as having shock potential.
So, there is a chance that one or several European Central Banks that are trying to sell as much gold as they can prior to the setting of these exchange rates. Whether that is the end of this year or April of next year, we're not sure, but we do think that one or more European Central
Banks are running up against some kind of a time table, trying to dispose as much of their gold as they can. This whole threat of European Central Bank sales has been so well advertised that it has brought a lot of other sellers into the market. We've seen Australia, we've seen Argentina, and we believe that there are several others. Brazil is a candidate; the IMF data suggests that they've been drawing their gold reserves down. We think there may be one or two others, several smaller central banks that have been panicked by this prospect and are selling their gold. We don't know exactly who the sellers are, exactly their motivations, exactly the timing, but we do believe the impetus is European, the sale is very very large, it has created its own momentum in the form of other smaller central banks selling, producers hedging and hedge funds going short, but we believe there is some time limit on this big impetus. That doesn't mean that, when these European Central Banks, or this one European Central Bank, is done, that there will be no more central banks selling, but the odds are that there will be less central bank selling.
I really would not be at all surprised if we wake up one morning to find out that the Dutch announced that they'd sold 700 tonnes or most of the gold that they had at the beginning of this year. This kind of thing is very unlikely to be repeated. Like I say, when it comes to the big
European Central Banks I do not believe that they have been the sellers. I believe that the pro-gold positions of the Germans and the French will make any gold sales out of the European Central Banks minimal or non-existent at least for the 1st year or 2 of the European Central Bank. Now, how great could the selling of the smaller central banks be? I don't think it could
really be that great because if you look at the number of central banks outside of Europe and the United States and Japan that have hundreds of tonnes of gold, there really aren't very many. And some of those central banks are actually adding to their positions. Russia, for example is one
of the nine central banks that has more than 5 million oz. of gold and the Russians actually have been adding to their gold position and continue to do so. The same seems to be true of China. So, I think there could be quite a few smaller central banks that could be selling quantities on the order of tens of tonnes, maybe 100-200 tonnes, but it does not seem likely to me that in total this would generate net central bank selling on anything like the volume we've had this year.
In sum, the big impetus probably has been a big European sale, it is probably a sale being done against a timetable. That timetable probably ends either the end of this year or the end of April, possibly the end of 1998, but I doubt it. And so I think that we will see in 1998 a recovery in the gold price. Now, how much of a recovery will depend upon how much of a role hedge fund and computer fund short sales have had in this year's bear market. There's a great deal of dispute about this. My guess is that it's been pretty big, though I don't think that it's been the principle pressure on this market over the last couple of months. The pace of any
gold price recovery also will depend upon the behaviour of producers. My guess is that because of the shock of this year, because of the new fears of central bank selling, we will see a considerable amount of producer hedging of any rally in 1998. So I would expect that there will be constraints on any rally that develops. Nonetheless I think that once you eliminate this big central bank sale which has been the impetus behind this bear market , the market will go up and there is an outside chance that the short position in the market is so large that you could get a violent rally. I don't exclude it.
I must say that I'm a little shocked and surprised by the amount of central bank selling that's been going on. I've worked with central banks as an advisor from 1971 to 1989. Central banks tend to be very gradualist. They tend to be very cautious. They tend to work in a cooperative way. The type of selling that we have seen in the last 3 months has been none of that. Think about it. The Italians have 2500 tonnes of gold. They have it on their books at $364 an oz.. The French have 3100 tonnes of gold and they have it on their books at $340 an oz. Marking to market these reserve assets does influence their debt ratio going into EMU. Patat of the French
Central Bank made it very clear that the loss on the remaining reserves from reducing the gold price far outweighs any gain to be had from the interest earned from selling the gold, so the French and Italians must be very displeased with what is happening to the gold price. To have other central banks, particularly European Central Banks, savage the market to this degree, is really extraordinary; it represents the kind of uncooperative behaviour on the part of some central banks within the central banking community that I just find no precedent for. So we are a little uncertain about making a forecast for next year, but on balance, the odds are extremely high that the recent intense rate of selling will abate when whatever these guys are doing is completed before this EMU timetable, which, as I repeat, is probably sooner rather than later, more likely the end of this year at the latest rather than late April or the end of 1998.
OK, that's the near term, let's talk about the long term. I said to you that our views are that demand in the market has been much higher than is widely believed and the flow of central bank gold has been much larger than is widely believed. I've had this position, about the size of central bank flows, both the sales and the borrowings, for a very long time. If some of you know my work, I wrote two pieces in Forbes, back in 1995, one called "What's Holding Gold Down?" and I said "Central banks." and another one called "Brother Can You Spare an Ingot" and I talked about central bank sales and now heavy borrowing holding the price of gold down. At that time, most people thought it was far too alarmist to talk about central bank borrowing and central bank selling of those magnitudes. Now, no one doubts that in fact this is occurring, but no one's focusing on the long run significance of such large flows. I told you we feel very very comfortable with our assessments, we've documented them in great detail in this book that we're bringing out. The implications are pretty simple. If gold demand is that much higher and the deficit in the market is that much higher and the flow of central bank gold is that much higher, then two things follow: 1) the flow is likely to be unsustainable because it is so high, the rate at which bullion is leaving central banks vaults is higher than people think and therefore less sustainable than people think, and 2) if the deficit of the market is much larger than people think, when this flow abates or ends, as ultimately it must, the gold price will have to go much higher than anyone thinks in order to clear the market. The way the market clears is largely by rationing down price elastic demand to the level of mine and scrap supply. Mine supply is fairly price inelastic. We have come up with some estimates, from econometric studies done by others as well as our own analysis of past gold market data, of what the price elasticities of demand and supply are in the gold market. Applying those elasticities to the size of the gold market deficit that we believe now prevails, when this central bank flow abates you get a very high market clearing price relative not only to the current price but to the average price of $386 of the prior 3 years. So we think that, in the long run, a couple years out, you are going to see much better gold prices than most people think, as long as the biggest central banks, that is the European Central Bank (dominated by the Germans and the French) and the United States Fed don't sell gold. We think that it is highly probable that these central banks will not sell gold. The longer term, then, is actually much much more positive than anyone imagines. We've documented all of this in this book we are producing: why we believe that gold supply and demand are different than is widely believed; what the various price elasticities of the supply and demand variables are; and what kind of price results you'd get to clear the market when these central bank flows abate.
There are two other questions that I thought were important. One was "How does the financial crisis in Asia impact gold demand?" We think that the crisis in Asia has probably chopped off about 300 - 400 tonnes or close to 10% annually from last year's demand level and I would say 400 - 500 tonnes or 8% versus the type of demand levels that we would have had otherwise this year. Part of this reduction in demand in a transitory thing. A surprisingly large amount of the decline in demand in the Southeast Asian countries was due to dishoarding in Thailand. We believe that dishoarding in Thailand has now abated. There may be a new shock of a similar sort coming out of Korea because the Korean economy and currency is under a lot of pressure now. But these bouts of dishoarding tend to be quite transitory. We expect that, once they run their course, the more sustainable decline in demand will result from the depreciation of these
currencies; there devaluations raise the gold price in these currencies which rations down price elastic demands. This more sustainable decline will be more in the order of about 200 to 300 tonnes. So, we're talking about a market that's in a deficit of somewhere between 1500-1800 tonnes for 1997 overall. God knows below $300 gold it's more than that, maybe 2000+ tonnes at an annual rate. The Asian currency crisis, with these currencies at these depressed levels, probably would chop a couple hundred tonnes off of demand on a sustainable basis. This demand decline has been an important factor in this year's gold bear market but it's not the
overwhelming factor. What's really caused this bear market is central bank gold flows, not threats of central bank selling, not Swiss selling in 2001, not the Asian currency crisis, but central bank selling and borrowed gold flows that are occurring right now, that are occurring this year.
Now, the other question that was asked was "What will happen to the dollar and what is its impact on gold demand?". Well, this year we have a huge rise in the dollar against a gold demand weighted basket of currencies. What's important is not the dollar exchange rate against, let us say, the British exchange rate, because when the dollar exchange rate changes against the British Pound and influences the Pound price of gold, it doesn't effect global gold demand very much because the Brits don't buy very much gold. What's really important is the movement of the dollar against those countries that consume the most gold. That would be Southeast Asia and India.
This year we've had a tremendous rise in the dollar in the 2nd half of the year against an index of currencies weighted by gold demand - that is, in effect, one that's weighted heavily by the Far East Asian countries. My own belief is that the current break in the Southeast Asian currencies has gone much too far. Take the Korean Won. The Korean Won was 8000 in 1996, it was 9000 by the middle of this year. The current account deficit of Korea had already swung from a 4% of GDP deficit last year to a balance by November and now we've taken the Korean Won all the way down to 14,500. This degree of depreciation of these Asian currencies far overshoots
anything that's needed to get their current account and balance of payment houses in order. In fact, Far East Asia overall is a current account surplus block against the United States. China, for example, has a 5.5 billion dollar monthly per trade surplus with the United States. The
currencies of this whole Asian block over the long run are not going to be depreciated against the U.S. dollar. In my own view, if you look at the dollar against these key Asian currencies, this dollar rise looks like as much of a dollar disequilibrium as the 1984/1985 rise, and one that has the potential for an equivalent kind of reversal. In that period, as a result of the big rise in the dollar, the current account deficit of the United States went to about 3% of GDP. Prior to the rally in the dollar this year this deficit was already at 2% of GDP. With the long lags in trade, we can expect the current account deficit of the United States as a percent of GDP
to go to an all time record. Back in 1985/86 we were still a net creditor nation. Now we have a net debt equal to 12% of GDP. If you look at the United States from a balance of payments point of view, its net debt position, its current account deficit, where its current account deficit is
going to go, it looks like an incredibly vulnerable currency. So, although I think we're going to chop a couple of hundred tonnes off of demand at an annual rate now from the soaring dollar against the Far East Asian currencies, this will be more than reversed in the years to come. OK,
that's it. Thank you. |
