gold investing

Gold-backed Bonds: WGC Supportive, But Issues Warning

Sep. 05, 2012 04:30AM PST

The World Gold Council believes gold-backed bonds can play a positive role in the EU crisis, but raises matters of serious consideration, including market risks.

One of the reasons people buy gold is that it can be used as an insurance policy in times of crisis. And now is that time, according to a World Gold Council (WGC) video that expresses support for gold-backed stability bonds. This German-crafted solution, formally known as the Redemption Fund, is an attractive alternative to the originally proposed — and much less popular — stability bonds.

The European debt crisis has been aggravated by the fact that the nations with the most pressing financial needs, such as Italy and Spain, need to tap the markets for cash, which to date they have done by issuing bonds. However, access to that funding comes at the cost of crushingly high interest rates.

Stability bonds, which would allow nations to borrow collectively and share revenues, debt-servicing costs and credit risk, are not a new concept. According to an EU green paper, discussions date back to the 1990s. At that time the idea was tossed around as a means to enhance market efficiency. Now, with the region’s crisis deepening and the future of the bloc at risk, the option has reemerged and is seen as a potential means of salvation.

Opposition an issue

The needy nations tend to support the idea of stability bonds. They believe that with the more financially-sound nations backing their borrowing, creditors will be more open to lending and to doing so at lower rates.

Some nations without pressing financial problems, such as Austria, Finland and the Netherlands, are sharply opposed to stability bonds.

A common argument against these bonds is that nations with reckless spending habits will learn little, if anything, about the consequences of their actions. Furthermore, the bonds might allow them to continue spending and digging themselves deeper in debt at even cheaper rates, leaving their responsible co-signers stuck with the bill.

In addition, once hitched together, the co-signers would sacrifice their low borrowing costs for higher interest rates, like a tax by association.

Germany, which has also staunchly opposed stability bonds, claims that its constitution does not allow this type of liability. In response, the German Council of Economic Experts (GCEE) developed the Redemption Fund, which provides a way to sidestep the nation’s constitutional issues.

Enter the Redemption Fund

Under the GCEE scheme, nations would transfer excess debt — amounts greater than 60 percent of GDP — to the redemption fund, which in turn would issue joint bonds. As a means of protection, each nation would be required provide 20 percent of the value of its debt as collateral. Nations unable to meet the requirement with cash would be allowed to use their gold reserves. Should a nation fail to make the required payments, its collateral would be taken.

The WGC describes gold-backed bonds as “a credible and attractive proposal.”

No credit risk, a uniquely diverse demand base and counter-cyclical tendencies are some of the advantages the organization outlines in its support of the idea.

“Due to gold’s high quality and liquidity as a financial asset, it is frequently used as collateral to secure global funding at minimal costs and is often the most advantageous of all collateral types during crisis periods,” the WGC stated.

However, after seeking a legal opinion on the matter, the organization does not believe EU member nations can pledge their gold as collateral under current circumstances.

In the EU, gold is managed by central banks. Under the law, central banks are supposed to be independent of the government and are prohibited from providing nations with financing.

The WGC states that “gold would need to be removed from the balance sheet [of each central bank] so as not to breach the prohibition on direct government financing.”

Then, the law “would require the Governing Council of the ECB to independently arrive at a decision to mobilize the region’s gold reserve to collateralize a new stability bond.”

Like central banks, the ECB is also supposed to be independent and largely faces the same restrictions. Its primary purpose is to help ensure price stability, or to keep inflation in check, not to bail out indebted nations. But the WGC points to the ECB’s secondary objective, which is to support financial stability and general economic policies.

The WGC is under the impression that “if the ECB were to independently come to a decision that using gold as collateral was in the general interest of the region and would contribute to the stability of the financial system,” that would fall within the scope of the secondary objective.

German Chancellor Angela Merkel, who is well-known for her distaste for joint bonds, is said to be under increasing pressure to endorse the Redemption Fund.

Consequences must be considered

The outcome of this proposed solution remains to be seen. But it raises the question of what will happen if one or more nations defaults on a gold-backed stability bond and has its gold taken to cover the losses.

If massive quantities of gold were sold to hustle up cash to cover defaults on stability bond payments, there could be severely adverse and widespread consequences that could extend to gold investors, gold-exporting nations and even to other central banks that hold gold on their balance sheets.

Such considerations may not have occurred to gold investors, but the WGC certainly thought of them. The organization calls to attention the obligations that central banks bear under the Central Bank Gold Agreements.

The WGC warns that central banks should be mindful of the significant market disruptions they could cause and also emphasizes that responsibility should be exercised with any deployments of gold.

The ECB and European System of Central Banks have an obligation to limit such disruption even in the event of a default, the organization states.

 

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