Should Central Banks Use Gold to Diversify Reserves?

There are many assets to choose from in the financial system, but “safe” assets are a different story. The U.S. dollar is considered to be a safe-haven due to its world-reserve currency status. It is found throughout many countries, and is backed by the world’s largest economy and military. However, central banks around the globe are making changes to their reserve portfolios.

Since 2000, official reserves for all central banks have grown from $2 trillion to more than $12 trillion. These reserves primarily consist of greenbacks and euros, but the ongoing financial crisis has caused a shift in thinking. According to the World Gold Council’s latest report, the U.S. dollar’s share of total reserves has declined from 62 percent to 54 percent. Other currencies in reserve composition have tripled in absolute terms since 2008.

The report explains, “While the dollar is still the primary global currency, its long-term supremacy is less certain.” The WGC’s manger for Government Affairs Ashish Bhatia, adds, “In response, central banks are reducing allocations to U.S. dollar and euros while increasing purchases of traditional assets such as gold and Japanese yen, and newer alternatives, including Chinese renminbi.”

Alternative reserve assets such as Chinese, Australian, and Canadian denominated instruments offer safety and diversification when compared to traditional reserve assets, but they do not have a market depth and size as large. For example, the Chinese treasury market is considered to be the largest among alternative reserve assets, but it only has a market size of $1.5 trillion. In comparison, the U.S. treasury market has a size of $10.5 trillion. Furthermore, alternative reserve assets have a positive correlation with risk assets.

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Due to the shortcomings of alternative assets, the WGC believes gold should attract more attention as a portfolio diversifier. It has a very long history as a reserve asset with central banks and the gold market is liquid with a size of nearly $3.5 trillion. Gold also has zero counter-party risk when held in bullion form. The precious metal fell out of favor with central banks during the 1990’s, but it is making a comeback.

While some central banks print money in historic amounts, others are buying gold. According to the WGC, central banks purchased 145 tonnes of gold in the fourth quarter of 2012, the highest quarterly haul since the sector became net buyers again just a few years ago. For the entire year, central bank buying surged 17 percent to 534.6 tonnes, the highest annual total since 1964. In comparison, central banks bought 456.8 tonnes in 2011.

Overall, the WGC’s study finds that central banks should diversify their reserve portfolios with alternative assets from China and Australia. However, considering that these markets need time to grow, gold “emerges as the dominant asset for diversification.” The suggested optimal allocation of gold is 8 percent in U.S. dollar terms.

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Disclosure: Long EXK, AG, HL, PHYS