Why Do Central Banks Buy Gold?

- November 12th, 2020

In 2010, global central banks switched from being net sellers of gold to net buyers, amassing more than 30,000 tonnes of the yellow metal.

Global central banks hold more than 30,000 tonnes of gold in their reserves. Most of that supply has been amassed since 2010, when central bankers commenced a gold-buying spree.

Central banks were net sellers of gold before that time, selling roughly 4,426 tonnes of gold between 2000 and 2009. But for the last decade they’ve been net buyers, adding 5,015 tonnes to their reserves.

In 2019, approximately 650 tonnes were added to the vaults of national financial institutions, the second highest amount in 50 years. Despite the record-setting total, it was a slight decrease year-over-year. In 2018, the 50 year bar was set with 656 tonnes of gold purchased.

2020 will mark a second year of declines, with additions for the first seven months of the year falling significantly short compared to the same period in 2019. Between January and August of this year, 8.4 million ounces of gold were purchased; the same period in 2019 saw 15.8 million ounces acquired.

The drop off is related to a rapidly rising gold price, which breached its previous all-time high in August, when values rose to US$2,063 per ounce. The price of spot gold had been holding in the US$1,500 range off of geopolitical tensions, but that changed when COVID-19 hit in earnest in March.

Widespread market volatility paired with a declining US dollar added to gold’s safe haven asset status, driving the metal’s value higher following a dramatic market decline.

It’s worth noting that even though purchases have dipped in 2020, central banks are forecast to continue being net buyers of the precious metal over the next 18 months.

As the Dutch central bank notes, “A bar of gold always keeps its value. Crisis or not. That gives a safe feeling. The gold holdings of a central bank are therefore a beacon of confidence.”

Central banks serve a few primary functions, including setting interest rates, regulating monetary policy and controlling the printing and circulation of coins and bills.

However, their most important task is to provide price stability to their national currency while preventing banking system collapse. This is achieved through controlling inflation — although COVID-19 has shown, sometimes the fate of a country’s currency may be difficult for a national bank to control. This risk is part of the reason central bank gold buying has increased in the last decade.

Why central banks purchase gold

There are three primary reasons why gold is the reserve commodity of choice for national banks.

1. To mitigate risk

Gold is a well-known safe haven investment prone to acting positively in times of uncertainty and market volatility. It is viewed as an asset that holds no liability, adding to its ability to mitigate risk.

American banker and financier JP Morgan is famously quoted as saying: “Gold is money. Everything else is credit,” highlighting another intrinsic benefit of gold, which is its sustained purchasing power.

Central banks look to purchase gold as a hedge against a weakening dollar or any other fiat currency.

Gold’s role as a portfolio or investment diversifier also aids in its ability to mitigate risk.

“Central banks such as DNB (Dutch National Bank) have therefore traditionally had a lot of gold in stock. After all, gold is the ultimate nest egg: the trust anchor for the financial system,” reads the Dutch central bank report. “If the entire system collapses, the gold supply provides collateral to start over. Gold gives confidence in the strength of the central bank’s balance sheet. That gives a safe feeling.”

2. To hedge against inflation

Hedging against the effects of inflation is another reason why central banks buy gold. In its simplest terms, inflation is the rise in price of a basket of goods.

In order for inflation to not dramatically impact a country’s economy, the nation requires investments that are not tied to the dollar. Enter gold and the other precious metals.

Many view gold as a barometer of the value of foreign exchange instruments. Gold’s rising value is viewed as evidence that currencies are becoming devalued.

3. To facilitate stability and growth

The primary function of central banks is to promote stability and foster economic growth. As currencies become increasingly devalued, banks must ensure their respective economies don’t flounder. As such, gold is used to control the size and speed of market growth.

Using Chinese and Russian central bank gold buying as an example, a Global Bullion report explains that emerging economies are especially exposed to free market excesses and use gold to offset the risk.

“Owning gold prevents these excesses from utterly driving currency and damaging industry,” it reads.

Which banks hold the most gold?

The US Federal Reserve tops the list of central bank gold buyers. The US holds 8,134 tonnes of the yellow metal, almost doubling second place Germany’s number of 3,364 tonnes.

Italy, France and Russia take the third, fourth and fifth spots, banking 2,452, 2,436 and 2,300 tonnes. respectively. China and Switzerland hold the sixth and seventh positions with 1,948 and 1,040 tonnes.

Down the list with less than 1,000 tonnes each are Japan (765), India (658) and the Netherlands (613).

Other nations have also increased their gold-buying efforts. In 2019, more than a dozen banks made net purchases of a tonne or more. The top gold-buying nation of the year was Turkey at 159 tonnes.

Where is central bank gold stored?

Most banks opt to store gold in their subterranean vaults, although some banks keep their physical gold in foreign reserves.

For example, of its 600 tonnes, the Dutch central bank has 15,000 gold bars, or 31 percent, of its gold stock on hand; 31 percent is held in New York’s Federal Reserve bank. The remaining 38 percent of the Dutch gold stock is kept in the Canadian and English central banks.

Central bank gold agreements

With stores exceeding 30,000 tonnes, central banks own one-fifth of all the gold ever mined (197,576 tonnes). In an effort to prevent a single bank from impacting the price of gold with a massive sell off, the Central Bank Gold Agreements were drafted.

The pact, which was signed in 1999 between major European central banks, caps the amount of gold any one bank can sell in a year. The first Central Bank Gold Agreement lasted five years and has been reaffirmed three times since then in 2004, 2009 and 2014.

Are central banks being priced out?

Since central banks became net buyers of gold a decade ago, the price has increased 88 percent. In 2010, the price of an ounce of gold was US$1,096. At its peak in 2020, gold was selling for US$2,063.

After making the second largest net gold purchase (25 tonnes) by a central bank in Q1 of this year, the Russian central bank suspended new gold purchases. Demand for gold by the Russian bank had been steady since 2006. Weakening oil prices, rising bullion prices and the country’s already robust gold reserves are likely the reasons behind the buying moratorium.

While its new stance could be indicative of the position of larger central banks around the globe, CPM Group states that buying by India and Turkey’s central banks is likely to continue.

Turkey made the largest net purchase of gold in 2020, acquiring 198 tonnes.

“One of the primary reasons these two central banks (Turkey and India) have been adding gold to their holdings is the weakness in their domestic currencies, which they seek to hedge by purchasing dollar denominated gold,” notes CPM Group.

If the gold price continues riding high, central bank buying is likely to remain muted in North America and parts of Europe into 2021. Of course, the need to counterbalance COVID-19 debt could result in increased gold demand and heightened central bank purchases moving forward.

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Securities Disclosure: I, Georgia Williams, hold no direct investment interest in any company mentioned in this article.

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