Box 121 Gold as a reserve asset

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Foreign exchange reserves are supposed to be held in forms which are safe, that is, on which large capital losses will not be taken. This raises a question as to the desirability of gold in such reserves. Gold was a strong investment from 1971 to 1980, increasing in price from $35 to $850, which produced enormous capital gains for central banks that held it in large volumes. Since then, however, things have been different. At the time of this writing gold was selling for $350 per ounce, which represents a 59 percent loss from its 1980 high. Allowing for the fact that gold earns no interest, while exchange reserves in the form of dollars or DM earn market interest rates in the United States or Germany, the losses incurred by holding gold over the two decades since 1980 have been even larger. Some central banks have been quiet but sizable sellers. The Dutch sold 9.6 million ounces in 1997, which brought in about $3.4 billion at the $350 price prevailing then, and the Belgians have reportedly sold 15 million ounces in recent years.

Countries holding really large amounts of gold, such as the United States, Germany, Switzerland, and France, have been discouraged from selling by the fear that they will push the price down even further. If the Dutch and Belgians quietly sell a few million ounces, the market may be unaffected, but if Germany, which holds almost 100 million ounces, sold off its holding, the price could collapse. The United States, with about 260 million ounces, would have an even larger problem if it decided to sell.

Gold's value as an investment is only as a hedge against inflation. It has done well precisely in periods such as the 1970s when inflation was severe. Since the central banks of the major industrialized countries have apparently concluded that serious inflation really is a thing of the past, they look for additional opportunities to sell.

The Bank of England announced on 9 May 1999 that it intends to sell 58 percent of its gold holdings, or 415 tons, during the next few years. This announcement drove the price of gold down by almost $7 to about $283. Another report suggests that Switzerland, which has enormous holdings, also intends to sell. Gold may be in the process of becoming just another commodity.

Source: Adapted from the Financial Times, January 21, 1997, p. 14, and the New York Times, May 8, 1999, p. B-1.

held in the form of foreign exchange, 11 percent was gold, and the remainder was IMF-related assets, meaning Special Drawing Rights (SDRs) and countries reserve position within their IMF quotas. These reserves had grown by 42 percent in the 1996-2002 period, with virtually all of the growth being in foreign exchange. The value of reserve holding of gold actually declined slightly during these 6 years. Almost 70 percent of the world's holdings of reserves in the form of foreign exchange represented US dollars, with most of the remainder being euros, followed by smaller holdings of sterling, yen, and Swiss francs.

It was originally thought that SDR allocations would be the major source of reserve growth, but there have been only six SDR allocations, totaling 21.4 billion SDRs, with the last allocation being made in the early 1980s. SDRs now constitute only 1.4 percent of the world reserves.

As was suggested above, the foreign currency part of a country's reserves are normally held in the form of a deposit at a foreign central bank or as short-term securities issued by a foreign government (such as US Treasury bills), with a clear emphasis on the avoidance of risk. Occasionally, however, central banks will take large risks while seeking higher returns, frequently with unhappy results. It was reported in late 1998, for example, that the Bank of Italy invested $250 million of that country's reserves in a US hedge fund, Long Term Capital Management, a large part of which was lost when that fund almost went bankrupt.

Data on a country's foreign exchange reserves are sometimes less than fully accurate because governments and central banks find ways of making their reserves appear to be larger or smaller than they are. If a developing country wishes to inflate the size of its reserves, it might have a state-owned firm borrow large sums in New York and then sell the dollars to the central bank. A forward contract would be used to protect the firm from possible losses if the exchange rate moves before its loan must be repaid. The central bank adds the dollars to its reserve assets, but does not have to enter the forward contract on its balance sheet. If, on the other hand a central bank wishes to conceal the fact that its reserves have increased, perhaps because it is maintaining a managed floating exchange rate which it is holding down for mercantilist purposes, it might instruct domestic commercial banks to buy the dollars from it and invest them in New York, and then offer those banks slightly better than market forward contracts to get them back into the local currency in 90 or 180 days. It is widely thought that the Bank of Japan has used such techniques to disguise the extent to which it is holding the yen down to encourage a large trade account surplus. Some care and a bit of cynicism are sometimes necessary in interpreting a country's published foreign exchange reserve position.

Foreign exchange reserves are analogous to an individual's holdings of cash: they increase when the individual has a surplus in his or her other transactions, and they decrease when he or she has a deficit. If a country's foreign exchange reserves rise, that transaction has a minus in that country's payments accounts because money is being sent out of the country to purchase a foreign financial asset. If, for example, British holdings of such reserves in the form of Swiss francs increased, the Bank of England would purchase those francs in the London foreign exchange market, and then send them to Switzerland in exchange for a financial claim on the Swiss government or central bank. Money would leave Britain, and the ownership of a financial claim on foreigners would return in exchange.

Many foreign governments and central banks hold their reserves in the form of dollar claims on the US Treasury or the New York Federal Reserve Bank. If Canada reduces its holdings of such dollars, thereby reducing US official reserve liabilities to foreigners, that transaction is a minus for the United States and a plus for Canada, because funds flow out of the United States. Counter-intuitive as it seems, increases in a country's reserve assets or reductions in its reserve liabilities are a minus, whereas reductions in its assets or increases in its liabilities are a plus.

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