Gold retains its global trading popularity

Gold lost its pivotal position in the international monetary system in August, 1971, when the U.S. formally suspended the dollars convertibility into gold. But even though it has lost its significance as a monetary anchor, gold has not lost its lustre.

According to Gary OCallaghan, author of IMF Occasional Paper No. 105, titled The structure and operation of the world gold market, since 1971 a global market for gold as an asset in its own right has developed, remaining open around the clock and using a full range of derivative instruments. Moreover, although the international monetary system is no longer attached to a golden anchor, almost one-third of the worlds monetary reserves were still being held in the form of gold in 1991.

The nature of gold has given rise to certain features peculiar to the gold market. Gold is a durable good which is never consumed. Most gold that has ever been brought above ground, according to OCallaghan, has remained there. Most of it can be accounted for.

Gold is thus highly attractive as a store of wealth, and large stocks, held for investment purposes, can influence prices substantially more than simple additions to the annual supply from new production. Therefore, any consideration of the structure of the gold market has to look beyond the current supply of new gold.

The gold market could not function without the assurance of confidentiality to both sellers and buyers. This guarantee of confidentiality has produced gaps in the existing knowledge of the structure and operation of the market, making it difficult to calculate annual supply and demand.

Theoretically, the annual supply of bullion should equal turnover and demand. In practice, it is impossible to estimate turnover and equally impossible to estimate all sources of annual supply to the markets. Therefore, according to OCallaghan, analysts have confined themselves to estimating sources of supply of new gold and have augmented this figure with estimates of major changes in the composition of existing gold stocks.

Market analysts estimate an average net bullion supply to the private sector of 2,530 tons a year during 1985-91. South Africa continued to be the dominant producer, accounting for about one-third of the total, followed by the former Soviet Union, which supplied 15%, and the U.S., which supplied 10.3%.

Net market demand is also difficult to estimate because of a dearth of information on hoarding. Estimates must rely on cross-border movements, says OCallaghan, but even these are generally not available for Europe and North America, and market stocks in London and Zurich are not revealed. An estimated 2,350 tons (roughly 93%) were absorbed annually over 1985-91 for fabrication of jewelry and ornaments, implying net private bar hoarding of about 180 tons (7%).

Existing gold stocks have a significant influence on annual market supply and prices. According to OCallaghan, at the end of 1991, estimated cumulative gold production was over 100,000 tons, and the gold stock . . . was almost 60 times the annual supply of new gold from mines.

Central banks and official monetary institutions hold about one-third of these stocks, which, valued at a market price of US$350 per oz., would be worth US$330 billion. Therefore, despite their passive role in the gold market, central banks maintain considerable influence.

The breakup of the former Soviet Union has given rise to considerable speculation about the size of its gold reserves and past levels of production and exports. Although it is estimated to be the worlds second-largest producer of gold, the former U.S.S.R., states OCallaghan, has long maintained absolute secrecy regarding its annual gold production, stocks and sales to the West. The industry consensus before 1991 was that Soviet reserves totaled about 2,000 tons at the end of 1989, but according to information recently made available to the IMF, the figure could be as low as 290 tons.

Since 1968, Gold Fields Mineral Services (GFMS) has been estimating bar hoarding, but because the figures for North America and Europe are derived from the yearly residual demand, they are probably not too accurate. Based on these rough estimates, about 25% of accumulated gold is thought to be in private stocks, and, according to OCallaghan, at least theoretically, available to enter the market in response to price changes. It is difficult to track the flows of gold which move through the markets each year. To preserve the anonymity of individual customers and the confidentiality of their transactions, organizers of the physical gold markets do not reveal information on turnover or volume.

OCallaghan adopts a market-centred approach to estimate yearly flows through primary and secondary gold markets. This approach, he says, forces one to think in terms of where the flows of bullion must have been derived and sent.

By combining the available information on gold flows (largely from GFMS), OCallaghan estimates that the combined market supply of gold was 3,225 tons in 1992, with Zurich accounting for almost 30% of the total (912 tons), followed by London (511 tons), New York (443 tons), Hong Kong (396 tons), Singapore (215 tons) and the rest divided up among a number of other regional markets.

The gold market operates from three major locations, each one serving a particular function: the London market determines spot prices of gold, the New York futures market speculates on the spot prices and physical gold is shipped largely through Zurich.

Before the gold market came into its own in the 1970s, London was the centre for the market. Before the First World War, the market operated through five bullion houses which channeled gold from suppliers (mainly South Africa) and fixed a daily price. The South African Reserve Bank (SARB) took over the marketing of South African gold in the 1920s, but the fixing continued to be (and still is) conducted by representatives of the five original bullion houses.

The London market closed in 1939 with the outbreak of the Second World War and did not reopen until 1954, several years after the Bretton Woods system had been in operation. The Bank of England, acting as agent for the SARB, was able to maintain the price of gold at 12.5 per oz. (equivalent to US$35) until March 15, 1968, when pressures to increase the price beyond US$35 forced the market to close.

When the market reopened two weeks later, according to OCallaghan, it found a changed world of gold. Under the newly instituted two-tier market, private individuals were permitted to trade freely, but central banks could trade only with each other and only at the official price.

Because the London fix was now free of intervention by the Bank of England, OCallaghan says, an afternoon fixing was introduced to attract investors from the U.S.

In the two weeks that the London market was closed, however, the newly formed Zurich Gold Pool, comprising the three major Swiss banks, had persuaded the SARB to market its gold through it.

Since 1968, Zurich has become the largest entrepot for new gold and the worlds largest storage centre for new gold. According to OCallaghan, the Zurich Gold Pool is still thought to handle most new gold sold on the world market from South Africa and the former U.S.S.R.

Switzerlands dominance in physical gold trading depends on the specialized banking and ancillary gold services it provides in an essentially unregulated and confidential environment, he says.

Despite the growing prominence of Zurich as a trading centre, however, London is, according to OCallaghan, still considered to be the most liquid and influential in determining the spot gold price because of its twice-daily fixings.

The London fixing, he says, allows the rest of the world to absorb any net supply (or demand) and is regarded as the true market price by virtue of its market-clearing mechanism.

Over recent years, in addition to the continuing demand for physical stocks of gold, markets have been developing for derivative physical instruments, including loans and swaps and forward sales, as well a
s for paper instruments. From a recent issue of IMF Survey, an International Monetary Fund publication.