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. interest rates are low; and a weaker dollar causes gold production costs overseas to increase, setting a higher floor under gold prices.
Given gold's reputation for being an effective hedge against the U.S. dollar, one would expect to see countries with large dollar reserves also to be major investors in the yellow metal. We have seen this play out to a certain extent, as China and the major oil exporting countries, which are two of the five largest holders of U.S. Treasuries, have also been active players in the bullion market during the past several years. China purchased more than 450 tons of gold in 2009, while Saudi Arabia added 180 tons in 2010. Also, other countries with sizable dollar reserves such as Mexico, Russia, and Thailand have recently stepped up their gold purchases. We think Japan, as the second-largest holder of U.S. Treasuries behind China, could be contemplating buying bullion. But the main player to watch here is the Chinese central bank, which not only owns more than $1.1 trillion in U.S. Treasuries, but also holds only 1.8% of its foreign exchange reserves in gold even after its recent purchase.
While emerging, non-Western economies like China, Russia, India, and Saudi Arabia have been busy purchasing bullion, developed Western economies have brought their gold sales programs to a halt, with the last major sales occurring in 2009. We think that although the developed Western nations already have sizable gold stockpiles, they are not likely to be major sellers of gold in the near to intermediate term for a number of reasons. For one, many of these countries were badly burned by selling low on gold and failing to benefit from current high prices, and thus may be more careful about parting with their gold bars. More important, holding large amounts of gold can help bolster investor confidence in a country's monetary system. On the other hand, the developed Western countries already own huge tonnages of gold as legacy assets, so we don't think they are likely to be major buyers anytime soon.
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