A Game Changer

By Christopher K. Potter    Nov 4 2009 11:57AM

The announcement yesterday that the Reserve Bank of India (RBI) purchased 200 tons of gold from the International Monetary Fund (IMF) puts to the test the central argument of the bears’ thesis on gold. 

For decades, gold bears have warned that central bank gold is a massive source of supply that is capable of overwhelming any conceivable demand scenario. After all, these banks currently hold approximately 30,000 tons (1 billion ounces) of gold, representing 20% of all the gold ever mined or 12 years of global production at the current rate of 80 million ounces a year.  When you layer onto this bearish outlook the incorrect but widely held belief that central banks no longer want their gold and are looking for ways to monetize their holdings, you end up with a fairly convincing argument for not owning gold. 

Unfortunately for the bears, their theories are unsupported by the actions of the world’s central banks. While yesterday’s announcement from the RBI took the markets by surprise, it is clear to careful observers that central banks have been reluctant sellers of gold for many years. Since Nixon closed the gold window in 1971 and ended the world’s last semblance of a gold standard, global central banks have sold less than 20% of their holdings and the majority of those sales came from just a handful of countries, arguably the weaker hands. The United States, by far the largest holder of gold has sold less than 5% of its gold since 1973 and has sold none of its gold in the last decade. Since 1999, the 14 signatories of the Washington Agreement have consistently sold less than their quota. All of this took place in the context of a 38 year period where central banks were unencumbered by a gold standard and therefore had no obligation to maintain gold reserves. Furthermore, there were two significant bull markets in gold during that period (1971 – 1980 & 1999 – Today), allowing ample opportunity to sell at “high” prices.

Today, the markets woke up to the idea that central banks, instead of being potential sellers of gold, might represent a new, very large source of demand. For years there has been scattered evidence that this was starting to occur. The Chinese central bank bought 99 tons of gold in 2002. Argentina, no stranger to the consequences of un-sound money, bought 55 tons of gold in 2004. Russia and South Africa have talked about increasing their gold reserves on a number of occasions.  However, all of this was peanuts relative to the RBI’s announcement last night. This was a game changer for several reasons. First, the purchase was unusually large (200 tons).  Second, the transactions were done at market prices, signaling that the RBI was a motivated buyer.  Finally, the identity of the purchaser was unexpected. There was speculation that China was a potential buyer but the revelation that it was the RBI introduced the concept that there are multiple central banks interested in increasing their gold reserves.

Why should any of this be surprising? Even a casual student of the workings of a fiat currency system should understand the logic of a central bank buying one of the world’s scarcest resources (gold) with money that it (the central bank) can create at virtually no cost. Essentially, it is turning paper into gold. Today the media made much of the fact that the RBI is diversifying away from the US dollar. However the real message of the RBI gold purchase is that the cornerstone of the bears’ thesis on gold has been removed – central banks are not sellers. In fact, they are buyers! The central bank printing press is a costless mechanism for acquiring the world’s scarcest monetary metal and the market is beginning to understand that any central bank, not just the RBI, can utilize this model. 

Christopher K. Potter

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This article is not intended to provide investment advice and should not be relied on to do so.  You should consult with your own investment advisor before deciding to follow any investment strategy or purchase any investment interests. Northern Border Capital Management LLC and its affiliates may own, purchase and/or sell certain of the investment interests described in this paper on behalf of themselves and their respective clients.