Precious preserve

Feature | 1 July 2016

Natixis' Bernard Dahdah and Alogmir Miah forecast that central bank demand for gold will remain weak, and the direction the price of the metal will take depends heavily on the speed and size of rate hikes from the Federal Reserve

Over the decades, central bank attitudes towards owning gold have changed several times. Much of these changes in attitude have come from important transformations in the world's monetary system.

Holdings of gold moved from being compulsory, to ensure the convertibility of currency when the latter was backed by gold (gold standard and Bretton Woods system), to being largely sold off in the years after the collapse of the system.

On 15 August 1971, the United States ended the convertibility of the US$ to gold, turning the dollar into a fiat currency. In the years following that event, gold was seen as an expensive asset to hold (weak returns, high cost of storage) especially as other assets were more attractive.

The role of gold in central banks

As part of a diversified foreign exchange (FX) portfolio, there are several reasons why a central bank would want to hold gold.

  • Gold is the ultimate asset to hold in an emergency;

  • It has often appreciated in times of financial uncertainty;

  • Store of value argument;

  • Always accepted as a medium of exchange between countries;

  • No default risk; and

  • Gold can't be printed or produced in unlimited amounts. Thus, it is a way to avoid being under the "mercy" of decisions by foreign central bank as is the case when holding sovereign assets.

That said, there are also reasons why not to hold gold, especially when it constitutes a large part of FX reserves.

  • Gold isn't free to hold. There are costs of storage involved.

  • Unless the metal is placed in London, New York or Zurich, it is hard for the central bank to lease the metal and make a profit out of it. The lease rate will also be dependent on the location.



Gold as protection against a currency debasement

Given the historically negative correlation between gold and the US dollar, this is especially important for central banks that have large holdings of US-denominated assets. At the start of the financial crisis, a fear of a US currency debasement struck the market.

Countries with a large share of US denominated assets found themselves with a rapidly depreciating currency. As such, we have seen several central banks diversify away from the dollar and into gold. Most of these banks were from emerging countries, particularly Asian banks that had preciously increased their share of dollar assets during the Asian currency crisis.

The Central Bank Gold Agreement (CBGA)

In the decades before the start of the financial crisis, central banks were typically sellers of gold. In the period between 1990 and 2008, central banks sold 5,600 tonnes of gold. This strong outflow put pressure on the price and central banks were perceived as suppliers of the metal.

The final straw came when the bank of England announced it would be selling half of its reserves in 1999. As a result of this move, the CBGA was introduced in a bid to limit sales and ease pressure on the price of gold. There were 15 signatories of the first CBGA, of which 11 were eurozone countries along with the ECB, Sweden, Switzerland and the UK. The signatories decided to limit sales to 2,000 tonnes over the following five years, or around 400 tonnes a year.

They also stated that gold would remain an important part of their reserves and that the amount of leased gold would not increase over that five year period. The announcement was positively received by the market and indirectly helped increase prices over the next year.

Between 2008 and 2012
As the financial crisis kicked-in, central banks from developed countries stopped selling gold. Since 2009, only 209 tonnes of gold have been sold under the CBGA agreement, this is far lower than the historic average of 400 tonnes a year. The majority of these 209 tonnes were sold by the IMF, which according to their official statement, was seeking "to boost the fund's capacity to provide concessional loans to low income countries".

The fear of a global economic meltdown and a US currency collapse meant that gold rediscovered its role as a safe haven asset. Not only central banks from developed countries stopped selling gold, but central banks from emerging countries, especially ones with high US dollar denominated assets, sought to diversify away from the currency into gold.

As such, since 2009, central bank net additions have been of 2,811 tonnes of gold.

The countries that were adding gold were seeking to increase the percentage share of gold out of their total foreign exchange reserves at the expense of US denominated assets. Much of these additions occurred in the period between 2009 and late 2012, when 2,100 tonnes of gold were added (including China). Almost all additions came from emerging countries.

The fundamentals of the gold market

Since the financial crisis kicked in, we have seen important changes in both the supply and demand side of the gold market.

From the supply side, we saw a boom and bust in investments by gold producers. On the demand side, the increasing importance of investors was most obvious through the rise in popularity of physically backed exchange traded funds. Quantitative easing was the main driver behind the rapid increase in the price of gold and tapering behind the collapse. With prices rapidly increasing since 2008, gold mined output was ramped up. GFMS figures indicate that between 2008 and 2014, gold mined output rose by 28% to 3,114 tonnes.

Scrap supply of gold also witnessed a boom in the period between 2008 and the end of 2012. With gold being highly price elastic, the collapse in the price of the metal led to a rapid decline. Since the 2013 collapse in the price of gold, producers have been actively seeking to cut costs. Much of these cuts have come in the form of a reduction in CAPEX and to a lesser extent, the mothballing of high cost mines. The net effect has been a reduction in cash costs and all-in sustaining cash costs of production.

Central banks

As previously mentioned, the financial crisis meant that central banks, which were historically sellers of gold, not only stopped selling the metal but also started adding it. Additions by central banks have slowed down. From the central banks that have continued adding gold, almost all of them have been located in gold producing countries.



China and India

Consumer demand from China and India accounts to around 45% of the world's demand for gold. In 2009, the Chinese government went on an unprecedented campaign to encourage local citizens to purchase gold. Previously, private citizens were not allowed to purchase the metal, but the country took to the media to encourage purchases and allowed banks to sell the metal.

Whereas western investors typically seek a safe haven refuge in gold, Chinese gold investors tend to have a more opportunistic outlook and enter the market when sharp movements in the price of gold occur.

For example, in 2013, China emerged as a market of last resort. China was absorbing outflows of gold from western physically backed exchange traded funds. As prices stabilised, so the appetite for the metal cooled down. China is still the largest producer of the metal and its second largest consumer. In 2015, net imports of gold from Hong Kong were up by 3.1% from the previous year and totalled 774 tonnes (the slowest growth in at least five years). China consumes all of its local production.

As for India, figures compiled by Natixis indicate that in 2015, total imports of the metal were 567 tonnes. This was an 8% increase from the previous year. Despite this improvement, 2014 and 2015 were the weakest import levels in at least five years.

Demand for gold in India is closely linked to GDP growth in the country. Given the cultural affinity that the country has, higher disposable income means additional purchases of gold. Since Modi reached power, the economy has picked up again and in the third quarter of 2015, GDP grew by 7.4%. Lower local gold prices also tend to prop up demand for the metal. Last year, the local price of gold averaged INR74 - this was the lowest price since 2011.

Since the start of the current year we have seen a considerable slowdown. The gold jeweller's strike, higher gold prices and taxes have hit imports. In an effort to control both the current account deficit and the weakness of the rupee, the Indian government introduced measures in 2012 to reduce imports of gold, imposing an import tariff of 4%. This tariff was raised to 6% at the start of 2013, to 8% in June 2013 and to 10% in August 2013, with other restrictions imposed as well, eg the requirement to re-export 20% of all imports. In September 2013, import tariffs on gold jewellery rose from 10% to 15%.

Gold lease rate outlook

The gold lease rate is the rate at which market participants can borrow (or lend) gold on an unsecured basis. Expectations of a December rate hike last year led to a rapid increase in the gold lease rate. Soon after, the rapid increase in the price of gold led to higher forward rates which drove lease rates lower.

As the financial crisis unravelled, Fed rates close to zero and a sharp increase in prices drove lease rates into negative territory. As prices came off over the past few years, forward rates dropped. Typically lower prices will increase physical demand and increase the number of market players who have to borrow to cover their shorts. More recently, as a result of the Fed rate hike, LIBOR increased, which lifted gold lease rates.

The most important element that will help support gold lease rates is the Fed rate hike. Natixis expects the next rate hike to take place this year. Rates are expected to rise by around 50bps this year. On a longer term perspective, the gradual implementation of the net stable funding ratio should increase the cost of funding for banks. This should also be positive for lease rates. One can also add that the nature of the gold market has fundamentally changed and is more accommodating for higher rates.

Price outlook

For the remainder of this year, we believe that the price of gold will remain heavily dependent on the decision by the Fed to raise the interest rate or not. As discussed in the introduction, gold prices are especially sensitive to the opportunity cost of holding the metal. Higher interest rates increase the opportunity cost of holding the metal.

Figures over the past few months suggest that the economic situation in the US is gradually improving and that the worst is behind us. Indeed several indicators lead us to believe this is the case including private consumption, job creation and the ISM composite.

Looking at other sources of demand for gold, central bank additions of the metal is expected
to remain weak, compared with the early years
of the financial crisis. In the first two months
of this year, holdings rose by only 20 tonnes.
In our view, most additions will come from gold producing countries.

As for China, the collapse in the stock market has provided support for the metal, especially earlier this year. Since then the government has been able to stabilise the situation and the new five year plan is providing optimism. The Chinese economy tends to perform strongly in the first year of a five year plan.

On a more supportive note, we are expecting to see a rebound in Indian demand for the metal from the lows we have currently been seeing in the import figures. Indian demand for gold is positively correlated to higher GDP, spending power and the monsoon. Under Modi, India is witnessing growth and is expected to outstrip its counterparts. Being a net importer of oil, the country has benefited from the price drop. The "Make in India" campaign has also been quite successful.



Alternative scenarios

In our downside scenario, we take into account larger-than-expected interest rate hikes in the US and an improvement in the EU. We would also not be surprised if in that case, gold prices dropped below US$1,000/oz. especially in 2017. Our biggest concern comes from physically backed exchange traded funds which in 2013, showed us that investors can quickly turn from a source of demand for the metal, to a source of supply. At current levels, there is the equivalent of 57% of 2015's mine production held in physically backed exchange traded funds.

Hedging by producers is another threat to the price of the metal as this creates supply in the market. For this year we could see prices averaging a low of US$1,100/oz. and in 2017, a low of US$980/oz. Our upside scenario takes into account an economic deterioration in Europe. Back in 2010, we saw how a fear of a collapse in Europe can lift the international price of gold. Negative interest rates are another aspect that could give further support to the metal.

The situation in China is not optimistic and should a considerable slowdown take place or another collapse in the stock exchange occur, this could affect the decision by the US to raise rates. Finally, in the event that the Indian government lifts import tariffs on gold (or reduces it) then prices could benefit from the expected increase in demand. The trade deficit has improved since the oil prices dropped.


Bernard Dahdah is a metals analyst at Natxis
and Alogmir Miah is a metals analyst within
the commodities research team

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