Currencies: G7: Gold as a Reserve Currency for Asian Central Banks?
Stephen L Jen (Brussels)
Should Asian Central Banks Consider Holding Gold?
Gold is a rather attractive reserve asset for Asian central banks, in light of the structural long-term risk to the US dollar, and other considerations. I even suspect the latest surge in gold prices may be due to new purchases of gold by several Asian central banks.
Basic Facts on Gold
1. Stocks overwhelm flows. What sets gold apart from other commodities, besides being ‘non-destructible’ and ‘homogeneous’, is the above-ground stocks are massive (153,000 tonnes as of 2004), relative to the annual newly mined supply (2,464 tonnes in 2004). This means the holders, not the producers, of gold have market power.
2. Gold has not been a good inflation hedge. The real price of gold has declined by 50% since 1983. To keep pace with inflation since 1983, gold should be trading at US$930 an ounce — about twice the current market price.
3. Gold has a low to negative correlation with stock prices, and low general correlation with the business cycle.
Gold as a Hedge against Currency Risk
Gold is not really a good inflation hedge, but a decent hedge against the business cycle. We argue gold is a good hedge, or, more precisely a ‘neutraliser’, against currency risk.
This favours central banks holding more gold in their reserves to dilute their exposure to foreign currencies. First, the USD could falter and thus erode the USD value of the Asian central banks’ foreign reserve holdings. Second, the Asian currencies could appreciate leading to a valuation loss on official reserves. Gold holdings could partly ‘neutralise’ or dilute the first risk but can do little about the latter, especially if the country in question has low gold holdings. For the same reasons, petrodollar holders should also consider buying gold.
The sensitivity (θ
of the price of gold in the base currency to a change in its exchange rate against all other currencies can be calculated. If θ is close to 1, we have a country with monopolistic power in gold. If θ is zero, we have countries with no market power in gold. We estimated θ’s 0.01 for GBP, 0.38 for EUR, 0.26 for USD, 0.02 for JPY, and 0.02 for CNY. As far as a country like China is concerned, one that holds USD, EUR, JPY, and GBP in its reserves, the following conclusions can be made:
Gold is a very good hedge against JPY and GBP, because international gold prices are not a function of these two currencies (with the θ’s close to zero).
For EUR and USD, gold is not as good a hedge as for the other two currencies, but is still a pretty good hedge (with the θ’s low). Specifically, if the USD unilaterally depreciates, the USD value of China’s gold holdings will rise by 1-θUSD = 1 - 0.3 = 0.7 of the depreciation in the USD, thereby providing some neutralising/diversifying effects.
Gold holdings do not at all provide any hedging against unilateral CNY (or AXJ) appreciation. If CNY unilaterally appreciates against all currencies, international gold prices should not be affected (with China’s θ close to zero). The value of gold should also decline, in terms of CNY, as much as USD would.
Gold is also a good neutraliser against valuation losses from a back-up in USD bond yields. If capital flight from the US triggers a sell-off in bonds, Asian central banks could suffer valuation losses on their long-term bond holdings. Gold does not neutralise that risk, but gold has no yield, either.
Official Holdings of Gold
About 20% of above-ground gold stocks are held by official entities, with the EMU the largest gold holder (US$177 billion worth), followed by the US (US$122 billion). The Asian central banks with the four largest foreign reserve holdings (Japan, China, Korea, and Taiwan) have little more than 1 percent of their reserves held in gold; the global average is 8.7%.
If these four central banks raised their gold holdings to 5%, it would be an additional US$109 billion worth of gold purchases, (about three years of global newly mined supply). This would have meaningful effects on global gold prices.
Bottom Line
Gold is a good hedge against currency risk, not inflation. This is important for the Asian central banks, which have large holdings of reserves. Gold is an excellent hedge against GBP and JPY variability, and a pretty good hedge against USD and EUR. But the big four Asian central banks have only a little more than 1% of their reserves in gold. Any increase in their gold holdings would have significant implications for world gold prices.
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