Top holders of currency reserves like China, Russia or India will likely need to increase their exposure to gold over the coming months and years as the value of fiat currency reserve holdings like the USD or the EUR comes into question. The obvious problem with Emerging Market Central Bank (EM CB) diversification is that there is simply not enough gold to go round. Official sector holdings of gold have moved from 29.1 to 28.7 thousand tons from 2004 to 2008 despite the higher prices. Net, gold held by the official sector has declined by 1.27% in the period, according to GFMS.
Gold supply trails the expansion in global nominal GDP In effect; the increase in the global stock of gold is roughly equivalent to the increased mined output every year. In 2009 and 2010 we estimate this figure to be 2,350 and 2,300 tons, or roughly 1.5% of the current global above-ground stock of gold. With governments around the world loosening up monetary policy to stimulate the economy, not enough gold is mined out of the ground relative to other goods in the economy.
The risk of waves of competitive G10 FX depreciation…
In the meantime, with G10 fiat currencies suffering from a credibility problem, a move towards hard assets like gold by investors and CBs appears likely. If the US prints money to fight off deflation and a soaring public sector deficit, Europe will have to follow or suffer from a USD competitive depreciation. Political and central bank discomfort over USD weakness is mounting within G10. Few, if any, G10 nations are willing to embrace further currency appreciation given the current valuation levels. The problem is that every country with a floating currency is in the same situation, creating a vicious cycle, where a USD competitive depreciation leads to a GBP competitive depreciation, which in turn leads to a EUR competitive depreciation and so on. Because the public finances of the US, Japan, Britain and the Euro zone are in such dire straits, it is hard to envision how these countries will return to trend economic growth without robust foreign demand, suggesting that this dynamic could go on for a while.
…is forcing EM CBs to turn to gold instead of G-7 bonds Any given EM CB cannot hedge against further USD weakness by buying EUR or GBP. This is because there is a significant probability that the ECB and the BOE will have to follow any monetary policy moves by the Fed, as it became apparent during the financial crisis. Then again, if EM CBs come to the conclusion that gold is better value than EUR, the problem of reserve diversification becomes one of game theory. In recent weeks, India made a first move by snapping up half of the IMF gold for sale in one go. With 203 tons of IMF gold still up for sale this year, every other EM central bank must be wondering who will move next and how fast . In the light of the experience of the last 10 years, more diversification out of G10 currency accumulation into gold seems like an attractive proposition.
Simply, beggar-thy-neighbor policies have natural limits… Effectively, as the USD or the GBP weaken against the AUD, the NOK, the JPY or the EUR, these currency areas also lose competitiveness against Britain and the United States. In turn, this means that the diversification benefit for a nation’s FX reserves from buying EUR or GBP rather than USD is limited. A point that we have made over and over is that monetary policy is contagious. Large economies like the Euro zone, the US or Britain may have different objectives when it comes to inflation or economic growth, but their central banks cannot operate independently of each other because their economic cycles are closely interlinked. More importantly, with the EURUSD touching 1.50 it is hard to argue for further dollar weakness against the European currency purely on fundamental grounds.
…because further USD weakness requires a CNY revaluation Because there are natural limits to floating G10 currency appreciation against the USD, our EM Fixed Income and FX Strategy team has been arguing for EM FX appreciation against G10 currencies (and against the USD). But most floating EM FX currencies have already surged tremendously in recent months. In the case of the commodity exporters, the risk of catching the “Dutch disease” is increasing very rapidly1. In our view, further weakness in the trade-weighted dollar would require a CNY revaluation. In turn, as EM CBs can not accumulate CNY, the only practical way to avoid adding EUR at these levels to EM CB portfolios is to buy gold.
The point of fiat currencies is to debase them as needed While some investors remain concerned that lax monetary policy could end up resulting in inflation sometime down the road, we would argue instead that the whole point of having a fiat currency is to be able to debase it when the economic conditions require it. As the combination of monetary and fiscal policy measures help create an upswing in economic activity over the next two years, cyclical pressures will come back into the system, likely resulting in a lot more money chasing the same oil barrels. As we expect gold to maintain its long-run relationship with other commodities, we see a third stage of gold price appreciation where prices push above $1500/oz on the back of higher oil and commodity prices.
Our view is, as always, not without risks There is a clear case to be made for stronger gold prices, but our view is not without risk. Our positive gold view could come under pressure if EM central banks decide to shun gold in favor or USD or EUR denominated bonds. A move to diversify away from all G-10 currencies at the same time would hurt the USD most given the higher USD weight in FX reserves. Meanwhile, a more aggressive shift out of fresh USD inflows into both EUR and gold by CBs could bring about the dynamic observed in recent months, but the valuation and performance of the EUR during the crisis argues against this and we believe the share of gold will likely continue to increase.
Courtesy: Metals Analysis, Merrill Lynch
