(By
Joung Park) Central
bank purchases, particularly from the official sector in emerging
economies, have been the largest single driver of higher gold prices
during the past five years. This development is particularly notable as
central banks had been net sellers of bullion since the 1980s. We
believe central banks from emerging economies have been buying gold to
diversify their foreign exchange reserves, while developed Western
countries with large legacy bullion holdings now see gold as a strategic
reserve asset and have accordingly halted their gold sales programs. We
think gold holds particular appeal for countries with large U.S. dollar
holdings, such as China and OPEC member nations, given gold's
historically negative correlation to the greenback. We do not believe
central bank buying can maintain its current pace over the long haul,
which supports our lower long-term gold price forecast of $1,200 per
ounce. Still, we see a number of potential scenarios regarding official
sector gold demand over the next several years, some of which
contemplate accelerated central bank purchases, that could be very
bullish for gold prices in the near to intermediate term.
While the spectacular rise in gold prices over the past decade was
aided by many forces, we think the biggest single driver has been
increased central bank purchases. Before 2010, central banks were major
suppliers of gold on a net basis, selling on average more than 400 tons
of gold per year between 2000 and 2009. But 2010 marked the first year
in which central banks around the world were net purchasers of gold,
buying 87 tons of gold that year, and the trend accelerated in 2011 with
official sector demand climbing to 440 tons. Global gold demand
increased from 3,800 tons in 2000 to 4,067 tons in 2011.
The increase in gold demand from central banks switching from selling
to buying bullion has been the largest component of gold demand growth
over the past five years. Indeed, it has outpaced demand growth from the
inception of bullion-backed exchange-traded funds during the same
period, which many like to cite as being the primary culprit behind the
recent bull market in gold. Increased central bank buying has also more
than offset declining global jewelry demand.
Central banks, particularly in developed Western economies, hold
large stockpiles of gold as legacy assets from prior gold-backed
currency regimes, which have since been largely replaced by fiat
currencies (monies that are only backed by the promise of the government
to honor them). The reign of gold-backed currencies unofficially ended
in 1971 when President Nixon discontinued the convertibility between
gold and dollar at a fixed rate of $35 per gold ounce. This essentially
severed gold's pegging to the dollar (and vice versa), and given the
dominance of the U.S. dollar as the global reserve currency, countries
with large gold stockpiles saw little reason to continue hoarding the
yellow metal. Central banks consistently sold gold between 1995 and 2005
at an average rate of 400-500 tons annually, with much of these sales
stemming from the U.S. and European countries (which owned the most gold
to start with).
However, since 2006, we have seen gold sales from developed countries
slow to a trickle. Meanwhile, central banks of emerging economies such
as Russia, China, and Thailand have stepped up their bullion purchases
in a big way. Not only has the magnitude of gold purchases by central
banks increased, but also the participation level has risen, as
countries that historically avoided the gold market, such as Mexico and
South Korea, made major bullion purchases in 2011.
Why Are Central Banks Buying Gold?
We believe central banks have been purchasing bullion primarily to
diversify their foreign exchange reserves. We think gold holds
particular appeal for countries attempting to diversify their reserves
away from the U.S. dollar, given the negative correlation between the
returns for the dollar and gold, as well as the yellow metal's other
virtues such as anonymity, ease of storage, and the deep liquidity of
the bullion market. Indeed, we have seen many of the countries with the
largest holdings of U.S. dollars in their foreign exchange reserves
leading the charge in purchasing gold. We think the recent sovereign
debt crisis in Europe has only whetted the official sector's appetite
for gold as a diversification asset.
We believe gold and the U.S. dollar are negatively correlated for
three main reasons: Gold is priced in dollars on the global market,
which means that a weaker dollar causes the yellow metal to be cheaper
for foreign buyers; the dollar tends to weaken when U.S.