Turning the corner? — Central banks see the light

Good news has come so rarely to the gold market in the past six years that any good news is big. And the news from the recent meetings of the International Monetary Fund is unquestionably good for gold.

The European Central Bank, the continental agency that oversees the monetary policy of 11 European countries, announced that its members and three other central banks seen as potential gold sellers — the Swiss National Bank, the Riksbank of Sweden and the Bank of England — had agreed to a cap on official gold sales. For five years, the gold market can expect no more than 400 tonnes per year from some of the largest official-sector gold stocks in the world.

A source of supply that had been seen as at best unpredictable — and at worst a waiting deluge — is now governed by a production ceiling: OPEC couldn’t have done better.

The restriction on sales is smart business, for several reasons. First, gold is good for you. Some modern bankers may have convinced themselves that currency crises only happen in outbacks like Southeast Asia or Latin America, that the world’s primary reserve currencies, backed by the strong economies of the major industrial countries, are safe; but a little historical perspective shows that that view is a little naive. In 1997, the Japanese yen was saved through timely intervention by the Bank of Japan and its G7 allies; and it is only two decades ago that central bankers worried out loud about the U.S. dollar itself, and gold touched US$800. “Hard” assets, like gold, can provide the international monetary system with a redoubt if things get really dark.

Second, the sales served the interests of the central banks only in the short term. Swamping the market with gold effectively devalued the holdings the banks had built up. Some banks incurred paper losses. Others relied on conservative valuation policies — some banks even carried gold at early-70s price tags — to keep the loss off the books.

Third, gold matters. It doesn’t command the massive market capitalizations of Internet or hi-tech companies, but it employs more people and earns foreign exchange for some pretty desperate Third World economies. No industry is entitled to think the world owes it a revenue stream, but the gold industry was being throttled by deliberate acts of policy, to the detriment of ordinary people from Ghana to Great Slave Lake. Central banks don’t exist to do that sort of thing.

The new announcement makes it clear that for now, at least, some significant official-sector sources have recognized the warts on their policy of uncontrolled gold sales and have (belatedly) seen that the market is not an ordinary one where producers move the supply curves and consumers move the demand curves. Clearer vision can only help the bankers do their real work: safeguarding the value of national currency reserves, in whatever form.

At the same time, the International Monetary Fund has come out with a modified proposal to use its gold assets to fund debt relief for Third World countries with large foreign obligations. Because the Fund values its gold below market, sales of gold to member countries generate a paper profit. Then, the Fund takes back the gold at market price — making the transaction a wash for the member country — and applies it to the member’s IMF obligations. The difference between the old figure for the gold’s value and the new figure goes to an account where it will be invested to pay for the IMF’s debt-relief programs.

The plan means that no gold goes on the physical market, lifting more shadowy fears that had chilled gold’s flame. The result was plain to see in the days following the two announcements.

More important over the long term, gold lease rates have shot up to around 4%. The low lease rates of recent years — 1% to 1.5% — were the foundation of the bullion banks’ money-making strategy, allowing them to sell leased gold and invest the proceeds in short-term debt above the lease rate. The locked-in profit from gold leasing drew more and more gold into the market.

Higher lease rates change all that. With gold lease rates closing on the yields of U.S. Treasury bills, there are at last better things to do with your money than lease gold, and better things to do with your gold than sell it now before the price slides further.

We doubt there was ever any conspiracy to drive down the gold price. The choices of hedging, leasing and shorting were all economically rational ones. When every measure of economic advantage weighed against gold, a conspiracy to bring the price down was unnecessary.

Still, there can be little doubt that most central bankers harbour a general distaste for J.M. Keynes’s “barbaric relic” and repose their trust in government paper. This predisposition reinforced the market’s signals and (as Pierre Lassonde of Franco-Nevada Mining argued in this newspaper last July) led the major central banks to destroy the market value of their own old holdings through leasing and gold sales.

Gold bugs and their conspiracy-theorist friends may say what they like about the central banks, but anyone that has tried to cut the interest coupons off a good-delivery bar can’t blame the central banks for trying to find ways to make money on their assets. They will not be looking to increase their gold holdings, nor is there an ironclad argument that they should. But staying their hand in the gold market is the next best thing for an industry that has had enough of these artificial hard times.