The main fundamental drivers of the gold price are central bank buying by the emerging nations together with Chinese and Indian retail demand. The motives behind this buying are very different from what we see in the developed world, with the exception of buying into gold Exchange Traded Funds. But buying gold for monetary reasons is a concept that usually doesn’t come into the consideration of gold investors.

Monetary gold buying has a certain mystery about it, which needs to be understood well, in order to understand what lies ahead for gold. Many have a preconceived view of the use of gold to be the same as used by central banks in the past, but global financial conditions have changed radically since then, as has the acceptable ways in which gold can be used in today’s global monetary system. We look at the difference between the private retail uses of gold and set it against the background of monetary gold to highlight the differences.

Developed World Retail Gold Buying

When a man in the U.S., Europe, or the United Kingdom goes out to buy gold, it’s usually for a special present for his wife or girlfriend and he rarely thinks of gold jewelry as part of his financial assets that could be sold in an emergency. Sometimes, usually if he is a coin collector, he will buy a gold coin for safekeeping at home as an investment for the worst of times. Rarely does he plan a ‘practical’ actual use for it, depending only on the vague assumption that it will be useful when hard times hit.

Developed World Retail Investment Buying

For the much richer buyer, buying gold as an investment comes in the form of a bar of gold bought for investment and stored in his safe deposit box or to be held in an unallocated account in the vaults of his bank. The quickest and cheapest way he would buy to hold gold long-term is through the shares of a gold Exchange Traded Fund. Please note that in these two examples banks are tied into the transaction one way or another. This strikes emerging market buyers as strange because banks may prove to be the problem when push comes to shove. Holding it at home appears far safer and out of official sight.

Commercial Banks Holding Gold?

Despite proposals that will lead to Commercial banks buying gold as a Tier I asset, at the moment Commercial Banks do not hold gold to satisfy banking capital adequacy ratios because only 50% of its value is deemed of value in those terms.

So we turn to what we believe will be the main driver of the gold price in the years to come, which will be of such power that it will sideline private demand completely…

Global Central Bank Buying

Reserve Asset

Central Banks hold gold as an important reserve asset. This immediately separates them from private investors. The term ‘reserve asset’ somehow fails to convey either its value or its strategic nature. A previous Banque de France President (M. Noyer) put gold in national vaults this way saying, ‘selling central bank gold reserves is like selling the family jewels.’ It’s a last resort, when all else has failed. Its overwhelming importance lies in the fact that it’s what keeps international trade going when confidence in the country has gone.

Ask yourself, ‘Why do central banks hold any reserves?’ Central Bank reserves in essence are held to ensure that a nation can continue to trade internationally when all sources of funds have been exhausted. With the ease that a nation’s central bank can issue new local currency, this seems strange. But then one has to reflect that a nation’s currency is only as valuable as the foreign exchange markets think it is. National currencies have varying levels of liquidity and convertibility, but most importantly different levels of confidence, internationally.

Confidence Key

It’s the level of international confidence in a nation, its economy, and its money that give rise to holding reserves ‘just in case’. Right now the relatively new euro, now only 12 years old, is the subject of fears that it will not survive. The prospect of Greece returning to the Drachma is now a serious probability. The currency will garner no international confidence if it comes to that. Who would accept the currency outside Greece, once it has gone bankrupt? Even retaining the euro as its currency, it would need to impose Capital Controls to keep capital in that land because of the total collapse of confidence in the nation’s economy relative to its indebtedness. It would be far better for continued convertibility for Greece to go bankrupt and keep the euro then start again with a clean slate, but with zero international trust. Its 111 tonnes of gold will go as this is already pledged against its repayment of debt (an unlikely prospect).

Take a look at any banknote in your possession and look at what it says. In most nations it says something like “I promise to pay the bearer one hundred dollars….” What does this mean? It means that you can take your $100 note into the central bank and cash it in for another $100 note. It can be exchanged for nothing else. It’s actually only as valuable as the confidence it inspires. In these days of so much financial uncertainty, huge national indebtedness and dwindling economic growth, confidence in all the developed world nation’s currencies is dwindling at an accelerating pace.

Confidence in Gold

This is where gold comes in. Gold is internationally respected and valued. It is acceptable as money to all nations. It will be accepted as payment when currencies fail. There is no ‘I promise to pay the bearer…” on it. Whoever holds it and has control over it owns it. The only exception is where another central bank holds it, on behalf of another nation. This does imply risk because the holding bank is responsible to its government and could be instructed to take possession of it. That’s why Venezuela repatriated its gold back to Venezuela.

Gold’s New Virtues

But gold has gained another huge function that goes to the heart of the continuation of the global monetary system as we know it. On the back of the qualities of gold we have just described it has facilitated leverage in the form of a ‘guarantee’ function. Gold’s lack of credit or counterparty risk, coupled with the deterioration of sovereign credit, has encouraged investors and global exchanges to increasingly use gold as a source of high quality collateral. Governments have done this too. In previous articles we have described how gold/currency swaps were used to facilitate loans between nations (via the B.I.S.) and to ensure that they were much cheaper than if the loan was not backed by such side transactions. The value that gold in this role has is considerably more than the dollar price of gold at the time.

This is why the central banks buying gold now are price insensitive. They are only interested in acquiring tonnages of gold. Whether they pay $1,000 per ounce or $1,500 an ounce makes no difference. It is the number of ounces a central bank holds that counts!

Now take this concept forward to the future. As the emerging world becomes more and more independent of the developed world and as emerging world currencies become reserve currencies themselves, the competition between currencies will undermine confidence more and more. The need for gold in facilitating loans and lowering interest rates will rise in line with this. It’s more and more likely that central banks and governments feel they need more gold in their reserves. But there is nowhere near enough gold available in the markets to increase gold reserves significantly.

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