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As gold’s bull market has unfolded over the past decade or so a funny thing has happened to central bank gold sales.  They have gradually dwindled to the point where net central bank buying has outpaced selling recently.  Central bank buying has reached a blistering pace in recent years and months –so much so that in the first two months of 2013, according to figures compiled by UBS, central banks around the world purchased $3 billion worth of gold.

What’s behind the buying?

Central bankers buying gold generally cite the importance of diversifying reserves and of bolstering the credibility of a bank by adding gold to its holdings.  Another factor which may help to explain the change in the behavior of central banks when it comes to buying gold in recent years is the loose money policies of several of the world’s major central banks.

With the US Federal Reserve creating $85 billion dollars each month in an attempt to goose the economy via quantitative easing (QE), and with Japan’s central bank recently announcing its own even more ambitious (when taking the size of Japan’s economy into account) QE program, the potential for an inflationary outcome is not negligible.

Given gold’s centuries-long role as a store of value it doesn’t strain credulity to imagine that some of the world’s banks have been turning to the yellow metal as a hedge against the inflation that excessive money printing can bring.

Which central banks have been doing the buying?

Using figures calculated by UBS, in the first 2 months of 2013 Bosnia bought 1 ton, Indonesia bought 1.9 tons, Azerbaijan bought 2 tons, Kazakhstan bought 6.6 tons, Russia bought 19.2 tons, and South Korea bought 20 tons of gold.  This buying comes after a strong year of gold purchases by the world’s central banks in 2012, which saw them buy 534.6 tons of gold, the most since 1964.  Central bank buying, according to the World Gold Council, accounted for 12% of total gold demand in 2012, up from 10% of total demand the year before.

Gold’s role in the international monetary system

In 1971 the United States, under President Nixon, renounced the Bretton Woods system of dollar-gold convertibility, marking the move to a worldwide system of fiat currencies.  Such currencies, backed only by faith in the government and central bank responsible for their issuance, have been subject over the years to periodic debasement due to excessive money printing.  In some cases, for example during the French Revolution’s assignat period, or in Weimar Germany following World War I, currency debasement proceeded at such a rapid pace that hyperinflation ensued.

Given gold’s standing as an inflation hedge, it should come as no surprise that central banks around the world have affirmed its value as an important element of a country’s monetary reserves.  One sign of the value placed on the yellow metal is the recent move by Germany to repatriate a portion of its gold reserves which are held by foreign central banks.

The move has sparked much speculation as to what lies behind it, but whatever the motivation may be, the act speaks for itself in demonstrating the high value that a major central bank, namely, Germany’s Bundesbank, places on its gold reserves.

What it all means for gold

While central bank buying alone is no guarantee that gold’s bull market will continue, in my opinion it bodes well for investors in the yellow metal.  Central banks almost by definition can be considered “smart money.”  And following the smart money is often a wise thing to do.

Central banks around the world are well-positioned to observe the monetary factors which are likely to predominate in light of today’s macroeconomic trends; the fact that they are reacting to these trends by adding to their gold holdings is significant –providing ample motivation for investors wishing to follow in their footsteps to contact a gold dealer or two.

 

Japan has been locked in decades-long economic stagnation.  Its central bank has attempted to battle the slump over the years with modest amounts of quantitative easing (QE), which has involved purchasing assets such as short term Japanese government bonds, ETFs, and the like.

New leadership calls for more aggressive easing

With the return to office of Prime Minister Shinzo Abe, the Japanese central bank has been encouraged to more aggressively stimulate the economy.  Under new central bank chairman Haruhiko Kuroda, the bank has discussed ramping up its QE policies in dramatic fashion.  If this new plan of action is followed, investors in gold could benefit as the debasing of the currency of one of the world’s major economies is likely to have broad inflationary implications.

Gold’s role in inflationary times

Gold has long been considered a store of value and inflation hedge, as it tends to preserve purchasing power during inflationary times.  A major reason for this is that the yellow metal is protected by virtue of its scarcity from the rapid increase in quantity that fiat currencies such as the Japanese yen are subject to.

While central banks in the United States, or Great Britain, or Japan can and have engaged in QE programs which increase the amount of the currency in dramatic fashion by the simple expedient of printing more money (whether via the printing press or a computer), gold must be mined from the ground at not-insignificant cost to see an increase in quantity.  Given the precious metal’s rarity, this makes gold all-but-immune from a rapid increase in its quantity a la fiat currencies.

The Japanese central bank’s new plan

Chairman Kuroda, supported by new governors Kikuo Iwata and Hiroshi Nakaso,  has proclaimed that he is prepared to take whatever steps are necessary to get the Japanese inflation rate up to 2% a year.  Given that Japan is an aging society, which tends to slow economic expansion, achieving this goal is likely to require considerable effort by the central bank.  Kuroda has indicated that the bank may buy longer-term government bonds, among other assets, in its attempt to spark inflation.

If Kuroda and the new team at the Japanese central bank are serious about reversing deflation, the Japanese Yen is likely to see a decline in value as a result.  This currency debasement, in conjunction with the existing QE purchases being conducted by the US Federal Reserve, is likely to bode well for gold as a safe haven investment.

Pandora’s box and inflationary expectations

While the Japanese central bank may be successful in its plan to increase inflation, one danger to its plan is that inflation, once unleashed, can be hard to control.  This is because inflationary expectations can lead to a feedback loop whereby the citizenry, seeing inflation in the economy and expecting more to come, change their behavior as a result.

Once inflation becomes ingrained in a society, bringing it back down can be a difficult, painful task, as was seen in the US during the 70s when high inflation led to a painful adjustment period.  In the worst case, it can lead to hyperinflation if the central bank continues to inflate even in the face of rapidly rising prices, as was seen in Weimar Germany and, more recently, in Zimbabwe.

However it plays out, those who believe that the Japanese central bank will be successful in reinflating the country’s economy may want to consider adding to their gold holdings – as the implications of such a policy, combined with other QE programs such as that in the US, are likely to be good for gold.

The answer to the question posed above may be “not much” in the short run, but longer term, the troubling case of the Cyprus “bailout” could actually mean a great deal to gold and its investors.  Before I delve into why this may be, a summary of the Cyprus situation is in order.

Events in Cyprus

After joining the EU in 2008, hot money flowed into Cyprus banks to take advantage of the high interest rates and EU access they offered.  However, with the collapse of Greek bonds in the aftermath of the crisis there, much of the funds invested by some of the largest Cypriot banks were severely impaired.

Bailout gone bad

The initial attempt at bailing out Cyprus was bungled badly by the Eurogroup, in that it aimed at “taxing” supposedly insured deposits of bank accounts (those below 100,000 euros in value), as well as higher uninsured deposits.  Even though the resulting hue and cry eventually led to this idea being abandoned, the fact the Eurozone had signed off on such a measure sets an ominous precedent.

After the Cypriot parliament voted down the initial proposal, another one was devised following more traditional precepts for dealing with bank failures by creating good and bad bank entities while protecting all insured depositors of under 100,000 euros.

What it all means

Whatever the final result of the Cyprus situation, the fact that the Eurozone was willing to allow Cyprus at one point to take supposedly insured bank deposits to help fund the bailout deals a blow to the supposed safety and sanctity of bank deposits throughout the Eurozone in general.  After all, if they were prepared to do it once, why not again at some later time if they felt it was called for under the circumstances?

What heretofore were considered absolutely safe and secure bank deposits may now not be so highly thought of.

 

 

 

Gold’s position in the monetary system

When it comes to gold, one advantage it has over other forms of currency is that it does not require a counterparty to validate its value.  That is to say that while currency of the fiat variety depends upon the full faith and credit of the country backing that currency to retain value, in the case of gold no such need applies.

As the case of Cyprus shows, it is not only the strength of the country backing a currency but the strength, or lack thereof, of the bank where one’s money is deposited which must be considered as well.  Whereas for holders of gold this concern is not as acute, as gold has demonstrated its ability to hold its value through all types of currency regimes, bank failures, as well as the failures of even nations themselves.

The aftermath

After the shenanigans in Cyprus, it may appear to some that “money in the bank” has lost a bit of its luster.  Recent events have demonstrated the forgotten truth that money placed in a bank is in fact a loan to that bank.  Government guarantees have made such loans appear to be risk free for all intents and purposes –but now that the Eurogroup has shown that what can be given can also be taken away it remains to be seen whether bank deposits in the weaker Eurozone countries will suffer as a result.

Gold’s recent multi-year bull market has been powered largely by the deluge of money creation central banks worldwide have turned to in an attempt to fight off the ill effects of the great financial crisis which began in 2008.  Now that the Eurozone has tipped its hand and shown a willingness to take or “tax” so-called insured bank deposits to deal with the crisis a new front has been opened in the war for financial solvency.

It would not be surprising to see some individuals react to this behavior by moving assets to one of the few monetary assets which does not require a counterparty of some sort to back it.  As a result gold coin dealers and other sellers of bullion may be the ultimate beneficiaries of the events