The ‘official’ gold binge has legs
Emerging market central banks are still stockpiling the precious metal, despite higher interest rates curbing its investment appeal. Here are three reasons why
GEOPOLITICS tops the list. Whether it’s a trade war or an actual war, “black swan” events are not so rare anymore. Unexpected economic consequences are coming from many channels: commodity price shocks, capital flight, and lasting supply chain disruptions. We have seen it all in the last few years.
The world has become more fractious and uncertain for businesses and policymakers. The rise in geopolitical risks has in the last few years been the sharpest since 2001’s attack on New York’s World Trade Centre and the 2003 Iraq war, according to Economic Policy Uncertainty data.
Gold’s ability to hold value in the face of complex geopolitical risks makes it a favoured asset in central bank portfolios.
The second reason is the return of high inflation and the monetary policy responses that triggers. The 2022 inflation shock – the sharpest since the 1980s – marked a shift in inflation in developed markets from the low, manageable inflation that followed 2008’s global financial crisis.
As developed market central banks pushed up their policy rates, bond yields rose sharply, diminishing the value of underlying bonds. Emerging market central banks hold a large quantity of these liquid bonds in their foreign currency reserves. International Monetary Fund data show around 59 per cent of global foreign currency reserves are US dollar-denominated assets.
As the value of these bonds toppled, the net worth of foreign reserves held by emerging market central banks shrank. We estimate roughly half of 2022’s loss in Asia’s foreign currency reserves was due to these “valuation” effects. As adequate foreign currency reserves are an important marker of stability, this likely left a lasting sour taste.
It is unsurprising that emerging market central banks are diversifying their reserves away from developed market Treasury bonds. For example, the share of US Treasury (UST) bonds held as reserves by foreign central banks and governments has fallen at a discernibly sharper pace in the last two years.
The third, albeit more peripheral, reason is the depleted trust in the US fixed income assets and the rising use of other currencies. The fiscal largesse of the US government during the pandemic has come under intense scrutiny, leading to downgrades by rating agencies last year. This has perhaps hurt the appeal of UST bonds as the ultimate risk-free asset.
Turning tides
The global monetary system is evolving. Emerging markets are pushing their own currencies for international payments. China is reportedly settling trades with Russia in yuan and has made clear its intention to internationalise its currency. Other regional players, such as India, are also pushing to settle foreign trade in their domestic currency.
Global central banks (mostly emerging market) are now important drivers of gold demand. Their annual share of demand is about 25 to 30 per cent, nearly trebling from the pre-pandemic long-term average. Their gold buying spree has legs, even if it doesn’t continue at elevated levels of over 1,000 tonnes seen in 2022 and 2023.
A Bank of International Settlements study suggested a 10 per cent share of gold in central bank portfolios would be adequate from a hedging perspective.
If emerging markets collectively were to reach this benchmark by 2030 from the current 7 per cent, it could mean annual central bank gold demand of over 600 tonnes, nearly 20 per cent more than before the pandemic. This is excluding unreported purchases, which have averaged about 25 per cent of total purchases.
China’s contribution will be the most noteworthy, as gold’s share of its foreign currency reserve is low, at 4.3 per cent. With geopolitical and economic uncertainties marking the mainland’s outlook, there may be a strong impetus to increase official gold holdings.
Central bank buying will likely set a stronger base for gold demand, as it has in recent years. Despite the rapid rise in real interest rates that generally hurt gold’s appeal and weaken investment demand, gold’s price remains well supported at near-historical highs.
The writers are strategists with ANZ Research
