Central banks have started to reduce reserve portfolio allocations to US dollars and euros in favour of alter- native reserve assets, the World Gold Council (WGC) states in its ‘Central bank diversification strategies: Rebalancing from the dollar and euro’ report, released last month.
According to the council, a portfolio optimisation analysis, also in the report, concludes that gold, with its lack of credit risk and its deep and liquid market, is one of the most attractive alternatives in this diversification process.
“Accordingly, building gold reserves in tandem with new alternatives is an optimal strategy, as these markets need time to develop and allocations to gold remain largely below optimal levels.”
While the dollar is still the primary global currency, its long-term supremacy is uncertain, and, as such, central banks are actively considering the diversification of their reserve portfolios and, specifically, the reduction of allocations to US dollars and euros, the WGC states.
The report states that the signs of diversification are already apparent.
“Between 2000 and 2012, global central banks shifted away from US-dollar-denominated assets as the US dollar’s share of total reserves declined from 62% to 54%. “Some of this shift has been into euro- denominated assets; however, anecdotal evidence suggests that euro allocations may have plateaued as a result of the European sovereign debt crisis.
“With incremental euro allocations falling out of favour, central banks have been exploring various other assets, such as the Canadian dollar, the Australian dollar, the Swiss franc, the Danish kroner and the Chinese renminbi. “In addition, in line with this diversification trend, central banks have also become net buyers of gold, from 2010, after a period of nearly two decades of net sales,” the WGC says.
Renewed Relevance of Gold
Gold has a long history as a reserve asset for central banks. During the time of the gold standard, it was the reserve asset backing a nation’s fiat currency. Since the end of the classical gold standard and the subsequent gold-exchange standard, gold has remained an important part of reserve portfolios for central banks. It quietly fell out of favour, however, as interest-bearing sovereign debt in the US and Europe took on greater importance in the 1990s and 2000s, the WGC report states.
More recently, however, central banks have once again become net buyers of gold.
According to the council, central banks have turned to gold in reserve portfolios for various reasons.
Gold is statistically not correlated with traditional reserve assets, such as the US dollar, the euro, the British pound and Japanese-yen-denominated assets, and alter- native reserve assets such as Australian-, Canadian-, Chinese-, Danish- and Swiss-denominated instruments, which allows it to provide significant diversity to a portfolio.
“This is the primary reason why gold is one of the most important assets that central banks should consider when diversifying away from the US dollar and the euro,” states the WGC.
The council’s report also illustrates that, owing to the large size of the gold market – about $3.2-trillion – central banks have sufficient access to gold for large investments.
The WGC states that its study did, however, not factor in several important qualities of gold, namely its lack of credit risk and its liquidity as measured by trading volume. While reserve assets tend to be of high credit quality, they still represent an obligation of a sovereign and carry some measurable level of default risk.
As central banks have long-term investment horizons, the marginal sovereign default risk that emerges over time is relevant for them; however, gold has no credit risk when held in an allocated bank account or in physical form in a central bank vault.
Further, with regard to liquidity, gold’s average daily trading volume is estimated at $240-billion, as measured by a dealer survey conducted by the London Bullion Market Association in 2011. Compared with other large assets and currencies, gold emerges as one of the most frequently traded, trailing only major currency pairs, US Treasuries and Japanese government bonds.
When measured against the size of its market, gold’s liquidity is even more robust, with a turnover of about 7%, which exceeds all other reserve assets. Gold’s deep liquidity is attributed to its global nature and its role as a currency and an asset with multiple uses.
Therefore, the WGC concludes that, as central banks aim to reduce dollar and euro exposure, traditional reserve assets, such as gold, can play an important role alongside alternative assets such as Chinese-, Canadian-, Australian-, Swiss- and Danish-denominated assets.
Edited by: Martin Zhuwakinyu
Creamer Media Senior Deputy Editor
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