As Good as Gold?

In the summer of 2008, the US dollar had experienced a serious depreciation against other global currencies.  It took two dollars to buy a British pound and $1.60 to buy a euro.  Partly reflecting this dollar weakness, oil had surged to $147 a barrel.  The global economic crisis, the accompanying steep decline in global stock markets and the flight to safety of investors around the world gave the dollar something of an Indian summer as demand for the greenback soared and it strengthened across the board against the pound, euro, yen and other national currencies.  However, as the crisis begins to recede and the American policy solution to the crisis—massive fiscal stimulus to the tune of $1.4 trillion in borrowed funds—begins to assert itself, economic fundamentals will begin to re-assert themselves and the dollar will start heading back in the direction of its relative value in more normal times.  Already the euro has clawed back much of the value it lost in the winter of 2008-9. 

While plummeting dollar values will help American exports and stimulate the American recovery, they promise substantial losses for foreign holders of dollar assets.  Foreign central banks in China and the Persian Gulf with large dollar reserves will be particularly vulnerable to these developments and concerns about diversification of reserve portfolios.   Increasing their stocks of the world’s most traditional monetary asset, gold, would provide an avenue of relief from these quandaries for many dollar-centric economies.

Table 1. Major central bank holders of gold, 2001 and 2009

Sources: IMF; World Gold Council .

But why hold gold?  First, gold is no country’s liability.  Unlike the dollar, no country can simply put unlimited amounts of gold out into international markets.  Second, the amount of gold in the world is relatively fixed.  Approximately 160,000 tonnes have been mined in human history and the World Gold Council anticipates that only 2,400 tonnes will be mined annually for the foreseeable future.  Central banks hold 20,000 tonnes, around one-eighth of this gold.  It is not often appreciated how little gold there actually is – all the gold in the world would fit into the bottom third of the Washington Monument.   Consequently, gold is a good long-term store of value.  Furthermore, gold also can readily be tapped either as collateral for international loans or sold outright in a time of crisis.  India used its gold reserves in 1991 as collateral for an international loan and Switzerland targets a gold cover of 40% of its reserves in order to promote confidence in the Swiss franc and the Swiss financial system.

Table 2. Gold as a proportion of reserves, 2009, selected countries

Sources: IMF, World Gold Council, calculations from press releases of national central banks.

There are signs that countries are beginning to take notice of gold’s valuable role in portfolio diversification.  While the developed world is divesting itself of gold, developing countries are adding to their portfolios.  European countries hold nearly 60% of their reserves in gold but are steadily reducing this amount.  The European Central Bank has targeted 15% as an appropriate figure for gold as a share of its reserves.  Meanwhile, the Chinese have expanded their gold holdings from 395 tonnes in 2001 to over 1,000 tonnes in 2009 (see attached chart).  While this is barely more than 1% of their total foreign reserves, it is enough to make them the world’s sixth largest holder of gold.  China has concentrated on purchasing domestically-produced gold.  If it continues with that strategy it will rapidly surpass all European holders of gold within five years.  If it commits just a small portion of its over $200 billion trade surplus to purchasing gold instead of dollar assets it would rapidly close the gap on the United States, the world’s largest holder of gold.  India recently bought 200 tonnes from the IMF and appears to have plans to add to this total.  Most Gulf states, including Saudi Arabia, Qatar, Kuwait and the U.A.E. are seriously under-exposed to gold and over-exposed to the US dollar.  As oil exporters whose primary product is priced in oil, their vulnerability to dollar devaluation is both real and exacerbated. 

The recent crisis with declining oil prices followed by a return to dollar depreciation promises to put the finances of many Gulf states under increasing financial pressure.  Having a hedge against further declines in the dollar makes a great deal of sense for countries that are so closely tied to the United States.  Had Dubai and the U.A.E. followed the Swiss model of holding a large portion of their foreign reserves in gold, the current concerns over the fate of Dubai World would be causing a lot less anxiety in financial markets.  It is something for dollar-exposed central banks to consider.

The views expressed in this paper are those of the author and not necessarily those of the U.S. Air War College or the Department of Defense.

Dr. Mark Duckenfield - Professor of International Political Economy at US Air War College, Maxwell Air Force Base