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By
Oleg V. Mozhaiskov
Deputy Chairman, Bank of Russia
The London Bullion Market Association Bullion Market Forum
Baltschug Kempinsky Hotel, Moscow
June 3-4, 2004
I would like to thank
the conference organizers for this opportunity to share my thoughts on such a
complex, even mythical subject as gold and the prospects for the near and
medium-term. I assume that the request was made for one simple reason: that
I, as a senior executive of the Bank of Russia, should know more than other
ordinary mortals.
In general, this logic
is flawed, although there is sense to it: It is necessary to understand the
central bank's perspective regarding this precious metal, particularly given
that it does have approximately 500 tonnes of the metal in its vaults.
It is from this
perspective, that of central bank, that I intend to base my presentation. I
hope you can understand that it is quite a specific topic, management of gold
reserves. This is distinct from the views adopted by gold prospectors,
industrialists, investors, speculators, and ordinary purchasers of jewellery.
For the central bank,
the gold stock is the international payment reserve for the whole country --
for the state authorities, private companies and corporations, as well as
individual citizens. Like any reserve, it needs to be conserved, in terms of
both actual physical form and its value. To a lesser extent, we need to be
concerned about its liquidity, or more precisely, market price developments.
The central
bank’s duties in managing gold reserves may therefore not seem
particularly onerous to a commercial trader, who has to close dozens of
transactions daily to achieve results by the end of the day.
In this there is a
grain of truth. The central bank’s specialists do not have to follow
real-time price movements every day and every minute, or react
instantaneously to every little twist and turn in the market. We are
concerned with other, less immediate problems regarding gold. In a figurative
sense the central bank’s attitude can be compared with that to a
giraffe. I have in mind an image of an animal that suggests certain
ambiguity, at least in the Russian language.
On the one hand, when
Russians say that someone is reacting like a giraffe, they are highlighting
that person’s slow reaction. It even suggests a degree of
slow-wittedness. On the other hand, the evident magnificence of the animal
commands respect. "The giraffe is tall, and he sees all" -- the
words of the Russian bard Vladimir Vysotskii are well known throughout
Russia.
With this allegory in
mind, I would like to mention the issues concerning gold which fall within
the "giraffe category" -- or more formally, present concerns of a
central bank.
These are several: the
volume of actual precious metal stock, both in absolute and relative terms
(essentially, the optimum component of the metal in total monetary reserves);
methods of controlling the stock; ensuring both security and availability for
liquidity purposes and at the same time optimizing income-earning potential.
All these issues reflect very practical concerns.
It may seem strange
but all bear direct relation to a problem that is often considered purely
theoretical: What is gold currently, and what will it be tomorrow? Real money
with intrinsic value? A raw material? A cash commodity that has lost some of
its monetary functions? If so, what are the prospects -- complete loss of
gold’s role or a restoration of lost functions, in one form or another?
There is a wide circle
of leading financiers who believe that pondering on these themes is a
fruitless academic exercise. They are convinced that the heads of the
world’s richest countries, who once agreed to abolish exchange of
national currencies for gold at a fixed rate, have in fact demonetized gold
altogether. In their eyes, the existence of official gold reserves is simply
a remnant of the past, a financial monument to the gold and gold-currency
standards, which will ultimately be absorbed by the global gold market. This
market has properly organized infrastructure, products, rules, and
procedures, and central banks are merely one of its clientele. For them, this
is the only reality to be reckoned with.
Is this a true picture
for gold in the modern world?
Many people do not
think like this; the reality is more complicated. The contemporary gold
market has emerged as a byproduct of a series of agreements between
governments, initiated by the United States and supported by the other major
powers, in whose possession the bulk of all gold ever extracted lies.
These agreements (the
most important of which were the Jamaica Agreements of 1976) created ideal
conditions for stimulating international trade by means of expanding credit
facilities in national currencies. The obligations on debtor countries to pay
off the trade deficits with gold (upon demand of the creditor countries)
severely limited the exporter countries’ opportunities for trade
expansion. The importer countries were made to live within their means, predicated
by their gold reserves. Gold was therefore considered by a number of
economists and policy makers as an instrument guaranteeing order and justice
in international economic relations, while others remained convinced that it
hindered international economic progress and development.
The latter, as you
know, secured the upper hand.
That brief look back
into the past was necessary to make the following conclusion: The present
state of the gold market and its future cannot be analyzed in isolation from the
problems of the international monetary system.
Some people may
question this conclusion because of the incompatibility of the present
volumes in the respective gold and foreign currency markets. I would suggest
that the volumes do not matter for this particular purpose. The modern
monetary system, although undoubtedly robust and long-standing, in fact has a
number of flaws and weaknesses. These, like the birth of the new, can cause
health problems to the participants of the system.
This disconcerting phenomenon
occurs because, by taking gold out of international payments turnover, people
are undermining payment discipline. The discipline I have in mind is at a
macro-level; that is, the discipline of rich industrial countries whose
convertible currencies have taken the role of an international trade medium
by virtue of their economic strength and have been accepted by the world
community as reserve units of payment.
Although there are
several reserve currencies, the blatant lack of discipline is demonstrated by
the U.S. dollar. I am leaving aside the main aspects of this problem, such as
the social and economic injustice of a world order that allows the richest
country in the world to live in debt, undermining the vital interests of
other countries and peoples. What is important for us today is another
aspect, which is connected with the responsibility of the state issuing the
reserve currency and for the international community preserving that
currency’s buying power.
Given the actual
behavior of the dollar on the foreign exchange markets, the problem could be
more accurately termed the irresponsibility of the U.S. government in
relation to the market valuation of its currency in international
circulation.
Today the net debt
owed by the United States to the outside world (the so-called
"international investment position") is in the region of $3
trillion. To understand the scale of this figure, let me remind you that it exceeds
the total official currency reserves in all the world’s countries
(including the United States itself). According to the International Monetary
Fund statistics at last year-end, the world pool of foreign currency reserves
totaled Special Drawing Rights 2,013 billion, or about $2,800 billion. The
volume of cash only ("greenback" banknotes) available outside the
United States totals about $400 billion.
The world has come to
a paradoxical situation in which the creditor countries are more concerned
with the fate of the dollar than the U.S. authorities themselves are.
Thus, the evolution of
the U.S. dollar's reserve role in recent years has given ground to some quite
pessimistic forecasts, based on rational economic theory. No wonder that the
number of people who have held assets in dollars and now wish to diversify
them partly into gold -- the traditional shelter from inflation and political
adversity -- is steadily growing.
The statistical
correlation between the market prices of dollar and gold is obvious. For the
problem we discuss today it means specifically that gold, in addition to its
unique physical and chemical properties used in industry, has retained its
particular monetary attractiveness for cautious financial investors, and its
market price is still heavily influenced by the state of the international
monetary system.
This dualism in gold
price formation distinguishes it from other commodities and makes the
movements in the price sometimes so enigmatic that market analysts need to
invent fantastic intrigues to explain price dynamics. Many have heard of the
group of economists who came together in the society known as the Gold
Anti-Trust Action Committee and started a number of lawsuits against the U.S.
government, accusing it of organizing an anti-gold conspiracy. They believe
that with the assistance of a number of major financial institutions (they
mention in particular the Bank for International Settlements, J.P. Morgan
Chase, Citigroup, Deutsche Bank, and others), some senior officials have been
manipulating the market since 1994. As a result, the price dropped below $300
an ounce at a time when it should, if it had kept pace with inflation, have
reached $740-760.
I prefer not to
comment on this information but dare assume that the specific facts included
in the lawsuits might have given ground to suspicion that the real forces
acting on the gold market are far from those of classic textbooks that
explain to students how prices are born in a free market.
So even those who
stick to traditional economic theory in analyzing and projecting gold market
developments should admit that various factors that influence gold price
interact between themselves in a constantly changing manner, sometimes in a
very odd way. Here, as in nuclear physics, some factors briefly disappear or
cease to act, and in their place comes a new dominant market factor. This
causes confusion for the forecasters in their efforts to build a logically
balanced model for the metal price movements.
So I do not even dare
shed light on the methodology of gold price forecasting, but would like to
risk outlining basic factors, which are permanently (and I stress permanently)
acting on the market. There are four of them -- two relating to the raw
material properties of gold and two to its monetary qualities.
As an economist
educated in the Marxist school, I believe that the base for gold prices is
rooted in the sphere of the real economy. Like any mineral raw material,
mined gold has its intrinsic value. This value fluctuates quite significantly
depending on the location, time, and technology of extraction. The market
averages out the individual expenses, optimizing them at a level that is
acceptable to the industry that uses the metal in its production. The
absolute values in monetary terms for this factor fluctuate, although they
are the least mobile element of the price.
The production cost
category has its own "floor and ceiling." The technological
particularities of gold extraction determine the minimum price level at which
production is economically feasible in the industry as a whole. We think that
the worldwide level is currently about $200 per ounce. This is the minimum
price limit. With lower prices the industry will plunge into a zone of
catastrophe. So the average costs of gold production in volumes sufficient to
satisfy expected market demand (over the past 15 years this has averaged
2,500 tonnes with the upward trend) are the first factor.
The second factor is
the real volumes of demand generated by the consuming industries for physical
gold. The behavior of industrialists (jewellery is playing the most important
role) is mainly caused by factors connected with an economic activity cycle.
During the 1990s there was a significant but uneven rise of demand for
jewellery: from 2,200 tonnes in 1990 to 3,200 tonnes by the end of the
decade, with a peak of 3,350 tonnes in 1997. The first three years of the new
millennium saw a decline of demand from jewelers; the volume of metal
purchased by the industry dropped down to 2,550 tonnes in 2003. The
fundamental correlation between gold prices and the volume of demand from
industry is normally linear in character. This correlation cannot be the sole
cause behind the dramatic falls in prices, but can show a vector for price
movement, which can be enhanced or indeed maximized through the efforts of
speculators.
However, even when
speculative activity is relatively quiet, this vector is not always clear.
There are "anti-phases" in economic activity in various parts of
the world, and on top of these, various national traditions in demand for the
metal.
A recent example of
this occurred at the turn of the century. After prices reached a 20-year low
of $252 in May 1999, demand for physical metal increased and pushed the price
temporarily to a new "equilibrium level" of $300 by the end of the
year. The concept of "equilibrium" reflects the situation on the
market when its participants believe that they are aware of a balance between
supply and demand. It brings a measure of price stability to the market.
Such a situation
appeared to take place following the central banks' Washington Agreement on
Gold.
However, as soon as
demand started to shrink again and a danger of excess supply arose, prices
went down. This was the beginning of a two-year market stagnation, with the
price waving within a range of $270-290. It was not sufficient for the metal
producers, but they were unable to control the situation. It was investors
who made the weather on the market.
Now the time has come
to admit that investment demand was, and still is, the main driving force
behind price fluctuations on the gold market. The changing character of
demand heavily depends on what is going on in the international foreign
currency and financial markets.
The investors pay
continuous attention first to the dollar rate of exchange and second to the
level of interest rates for financial assets. The volatility of these
indicators directly influences the investors' interest in gold. Since this
interest is realized not through operations with physical metal but through
deals with gold derivatives on stock-exchange and non-stock-exchange markets
(where gold is mentioned only as a base asset), the volume of these deals can
exceed the volume of trade in physical metal dozens of times. Last year turnover
with gold derivatives was about 4,000 million ounces (or 129,000 tonnes), but
physical metal actually sold totaled 120 million ounces or some 3,860 tonnes.
As it is said: Feel the difference!
It is true that the
markets for derivatives linked to other raw materials also usually exceed the
operations with base assets. The difference in volumes are incomparably less
(five to 10 times). At the same time the markets for derivatives with foreign
currencies and prime securities as base assets are developing every bit as
rapidly as the gold derivatives.
What can we infer from
that?
One conclusion, at
least, is clear: Gold is predominantly a financial asset, not merely a
precious metal.
In this capacity gold
is competing with other financial assets on a variety of parameters. Being
inferior in terms of returns, it is far more reliable than anything else for
protection against war-related, political, financial, economic, and credit
risks, and provides a high level of liquidity and lower management costs.
However, since the rate of return is the main measure of success for
financial institutions under normal conditions, investment-related decisions
depend directly on the stability of the international monetary system,
strength (or weakness) of the dollar, and the level of interest rates on
financial markets.
This dependence is not
linear in nature. Correlation factors change from time to time because
decisions are taken by investors individually on the basis of their market
expectations. As a result, investors' reaction may race ahead or lag behind
developments on the forex and financial markets. If we examine gold price
movements over the last 10-12 years, it becomes clear that during the first
half of the 1990s the dominant factor was the weak dollar and the market was
still living in hope of a recurrence of the 1980s "gold fever."
From 1997 onward, as the dollar strengthened, these hopes were dispelled,
investors turned around, and price fell to the level of support on the
physical market. It seems to us that the depth and duration of this depressed
phase of gold prices were to a considerable extent caused by the wide use of
gold derivatives by investors. Insofar as these instruments are intended for
protecting banks and their customers against unwanted and unexpected changes
in price dynamics, they can provoke massive closing of the existing position
at a specific moment. This process may take the form of a chain reaction. As
a result, the price falls below the level dictated by the sensible interests
of investors.
I would also like to
note that recently the central banks have been playing a significant role in
the gold market. Low interest rates in the money markets and revaluation of
gold reserves in line with lower market prices have exacerbated the problem
of the financial efficiency of gold stock management. To earn some income on
the stock and compensate for "book losses" caused by its
revaluation, a number of central banks have started to place a part of their
reserves into deposits with commercial institutions -- leasing operations.
Data available to me
suggest that these banks deposited about 1,000 tonnes in 1991, and 10 years
later the volume of the deposits reached 4,800 tonnes. Naturally, the central
banks' activity increased market liquidity and thus also put downward
pressure on the gold price. The influence of these operations, however, must
not be exaggerated. It is even incomparable with the pressure that was
exerted on the market of gold derivatives.
The same conclusion
can be made about the central banks' sale of some of their gold reserves. All
market participants have been paying particular attention to these operations
since September 1999, when 15 European central banks agreed in Washington on
the orderly sale of 2,000 tonnes of gold from their official reserves over
the next five years.
One month ago the
agreement was extended for a further five years (to September 2009), setting
the total sale limit at 2,500 tonnes or 500 tonnes per year. One may wonder
if these agreements and sales indirectly indicate that these countries have
embarked on a long-term gold demonetization program and if their statement
that "gold will remain an important element of global monetary
reserves" is nothing but a sort of soothing therapy for the market. Such
opinions exist, although they do not prevail.
I think that the
agreements do not give ground for this view.
First, the
participating countries own between them 12,300 tonnes of gold. The share of
the metal in their official monetary reserves has reached 36 percent. This is
significantly higher than the average for all the world's countries (10-12
percent). So the sales can be seen as optimization of the reserves structure.
Secondly, the
countries making the sales (France, Germany, and some others) are enduring
budget deficits exceeding the limits laid down by the Maastricht Treaty.
Hence, this may explain the temptation to solve their budgetary problems
without reducing expenditure or raising taxes.
The current decisions
by the monetary authorities in European countries could therefore be
considered sensible, like the actions of certain Asiatic states that in recent
years increased the gold portion within their monetary reserves. The internal
imperfections of the international monetary system (which I spoke about
earlier) have already led to a number of regional financial crises and still
carry the danger of larger upheavals. Under these conditions, the growing
interest of investors in real assets, gold in particular, is more than
justified.
And on that optimistic
note, I would like to end my presentation.
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