The key to understanding the gold market is understanding the role central banks play in prices.
This article originally appeared in the April/May 2012 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000.
Central bank purchases, particularly from the official sector in emerging economies, have been the largest single driver of higher gold prices during the past five years. This development is particularly notable because central banks have historically been net sellers of bullion since the 1980s. Central banks from emerging economies have been buying gold to diversify their foreign exchange reserves, while developed Western countries with large legacy bullion holdings now see gold as a strategic reserve asset and have accordingly halted their gold sales programs. Gold holds particular appeal for countries with large U.S. dollar holdings such as China and OPEC member nations, given gold’s historically negative correlation versus the greenback. However, central bank buying cannot maintain its current pace over the long haul, which supports Morningstar’s lower long-term gold price forecast of $1,200 per ounce. That being said, there are a number of potential scenarios regarding official sector gold demand over the next several years, some of which include accelerated central bank purchases, that could be very bullish for gold prices in the near to intermediate term.
Before 2010, central banks around the world were major suppliers of gold on a net basis, selling on average more than 400 tons of gold per year between 2000 and 2009. 2010 marked the first year in which central banks were net purchasers of gold, buying 87 tons that year, and the trend accelerated in 2011. To put this in context, global gold demand has increased from 3,800 tons in 2000 to 4,108 tons in 2010.1
The increase in gold demand that resulted from central banks switching from selling to buying bullion has been the largest component of gold demand growth over the past five years. During that period, it has outpaced demand growth from the inception of bullion-backed ETFs, which many analysts like to cite as being the primary culprit behind the recent bull market in gold. Increased central bank buying has also more than offset declining global jewelry demand.
Why Are Central Banks Buying Gold?
While countries might have different reasons for buying gold, Morningstar’s analysts believe that central banks have been purchasing bullion primarily to diversify their foreign exchange reserves. Gold holds particular appeal for countries attempting to diversify their reserves away from the U.S. dollar.
Currently, the U.S. dollar comprises the majority of global foreign exchange reserves, thanks to the United States’ dominant economic position and the dollar’s role as the currency of choice for international trade. At the end of September 2011, U.S. dollars comprised about 61.7% of total allocated central bank foreign exchange, or FX, reserves, which is by far the largest percentage for any asset or currency.2 In contrast, total official gold holdings amounted to only half as much, equal to 31.3% of global allocated FX reserves, assuming a gold price of $1,722 per ounce.
As one might expect from any money manager whose portfolio is overly tied to a single asset, central banks have been looking to diversify away from the dollar. (Why they have only realized this recently is another question, and it’s very hard to get concrete reasons for why central banks do what they do.) As a result, the greenback has been declining as a percentage of global FX reserves during the past 10 years, while other currencies, most notably the euro, have gained share. However, the euro’s share of global FX reserves has also started to decay after reaching its peak in 2009 as the ongoing European debt crisis has undermined confidence in the currency. Central banks are increasingly looking to gold rather than the euro in diversifying their FX reserves away from the U.S. dollar.
Gold is also appealing to countries with large U.S. dollar holdings because of the negative historical correlation between these asset classes. Since 1986, the correlation of returns between gold and the U.S. dollar has been negative 0.10.3 Only real estate and select baskets of commodities have featured a lower correlation with the U.S. dollar than gold among the major asset classes during this time period, and gold is a more appealing asset for central banks to hold in reserves than real estate or commodities. Compared with real estate, the gold market offers greater liquidity and the option to purchase discreetly, given the bullion market’s anonymity. In addition, gold is easier to store compared with other commodities such as petroleum, agricultural goods, or base metals.
Given gold’s reputation for being an effective hedge against the U.S. dollar, one would expect to see countries with large dollar reserves also be major gold investors. We have seen this play out to a certain extent, as China and the major oil-exporting countries4, which account for two of the five largest holders of U.S. Treasuries, have also been active players in the bullion market during the past several years. China, for example, purchased more than 450 tons of gold in 2009, while Saudi Arabia added 180 tons in 2010. Also, other countries with sizable dollar reserves, such as Mexico, Russia, and Thailand, have recently stepped up their gold purchases. But the main player to watch here is the Chinese central bank, which not only owns more than $1.1 trillion in U.S. Treasuries but also holds only 1.8% of its FX reserves in gold even after its recent purchase.5
If China wanted to raise this percentage to merely 5%, then it would have to buy an additional 1,800 tons of gold (which represents more than 40% of annual global demand). If China wanted to increase gold as a percentage of its FX reserves to the current global average of 16.7%, then it would have to purchase an additional 8,700 tons of gold. Even if such a massive purchase program was conducted over a period of two decades, it would still increase official sector demand for gold by more than 430 tons per year, which equals more than 10% of total annual gold demand. This, of course, is not including other countries that may also be looking to diversify into gold.
However, it isn’t likely that developing countries such as China will reach the global average percentage of gold holdings, for a number of reasons. For one, the global average of 16.7% is skewed upward by developed countries in North America and Europe that have the majority of their reserves in bullion as a legacy of the now-defunct gold standard. Countries operating in the current fiat currency system have no need to amass such a massive gold hoard. Also, developing countries by and large are looking to gold as a diversification tool for their reserve assets and not as a new core asset to displace their holdings of foreign currencies. And according to research from the World Gold Council, gold can effectively generate these diversification benefits within the context of a typical central bank portfolio when it comprises between 2.4% and 8.5% of total reserves, which is a percentage range not far above what many emerging countries have already attained.6 Nevertheless, many emerging countries (most notably China) still have some way to go in terms of diversifying their reserves away from the U.S. dollar, even assuming these more modest targets for gold ownership, implying that official sector demand for bullion could remain healthy over the next several years.
While emerging economies such as China, Russia, India, and Saudi Arabia have been busy purchasing bullion, developed Western economies have brought their gold sales programs to a halt over the past five years, with the last major sales occurring in 2009. We think that although the developed Western nations already have sizable gold stockpiles, they are not likely to be major sellers of gold in the near to intermediate term for a number of reasons. For one, many of these countries were badly burned by selling low on gold and failing to benefit from current high prices, and thus may be more careful about parting with their gold bars. More important, holding large amounts of gold can help bolster investor confidence in a country’s monetary system. Debating the merits of holding gold to a country’s financial system is a topic for another day, but it does seem to foster public perception of strength, which counts for something. On the other hand, the developed Western countries already own huge tonnages of gold as legacy assets, so we don’t think they are likely to be major buyers anytime soon.
Implications for Gold Prices
Central bank purchases of bullion can’t be sustained over the long run, but we see a wider range of possibilities over the near to intermediate term that could lead to divergent outcomes for gold prices. Here are four scenarios regarding near-term central bank purchases and their implications for gold demand and prices:
Scenario 1: Central banks return to their traditional role as net suppliers of gold.
This scenario assumes that Western developed countries will resume their gold sales while emerging countries stop purchasing bullion. A sharp return to central banks selling roughly 400 tons of gold per year (which is what happened between 1995 and 2005) would have a disastrous effect on near-term gold demand and prices. This scenario is not likely during the next several years because of a shift in the official sector’s view of gold as a strategic reserve asset (especially from emerging economies) and Western countries’ aversion toward further reducing their gold stakes.
Scenario 2: Central banks slow bullion purchasing but do not return to selling gold.
This scenario will be more likely to occur because of a winding down of purchase programs in certain emerging countries that are currently buying gold than because of bullion sales by Western developed economies that have decided to take advantage of higher gold prices. This is because central banks are motivated more by strategic, policy considerations than by pure economic rationale. Even a moderate slowing in the official sectors’ appetite for gold would likely prove a headwind for gold demand and prices.
Scenario 3: Central banks maintain current levels of gold purchases.
This scenario is the most likely, and it best fits with Morningstar’s gold price forecast. If central banks sustain current levels of gold purchases, then gold prices will remain around spot levels over the intermediate term, assuming other supply and demand factors hold constant. Once the big buyers stop amassing gold because they have reached their gold-percentage target, official sector demand in aggregate will ease, leading to lower gold prices over the long term.
Scenario 4: Central banks scramble to accumulate gold over the intermediate term.
This scenario is not likely, but it is certainly possible. Heightened sovereign debt concerns or an erosion of confidence in the U.S. dollar could prompt central banks to rush into gold as an alternative FX reserve asset. Such a scenario would cause an upward spike in gold demand and prices over the near to intermediate term. However, accelerated purchases of gold probably cannot be sustained for long periods of time because central banks generally accumulate gold to hedge against the U.S. dollar and other foreign currencies rather than to have bullion dominate their reserves. In fact, accelerated buying could actually pull forward the eventual decay in official sector demand for gold by allowing central banks to reach their gold-percentage targets more quickly.
While central bank purchases have undoubtedly led bullion prices higher during the past several years, this cannot continue over the long run, as gold already comprises a significant percentage of global official sector reserve assets. However, we do see the possibility of a surge in official sector purchases leading to a bullish price environment for gold over the next several years.