Since we’ve moved into the brave new world of modern day finance, gold has tended to be viewed as something akin to nuclear waste from a previous era. Only the wildest gold bugs continued to harbour hopes and dreams that the metal would be remonetised again.
But with the recent discussion by the BIS in its progress report on Basel III implementation:, there has been discussion about reclassifying gold from a Tier 3 asset to a Tier 1 asset, at least as far as commercial banks go:
“At national discretion, gold bullion held in own vaults or on an allocated basis to the extent backed by bullion liabilities can be treated as cash and therefore risk-weighted at 0%.”
For the BIS to do this now reveals an extraordinary reassessment of the status of gold. Though this proposed change by the BIS impacts commercial and not central banks directly, its implication for official institution attitudes toward gold as a reserve asset is a very big deal. So if the central banks are becoming more gold friendly again, and more inclined to look at it as a preferable asset to hold in their reserve assets, the amount that they hold is a much more germane question.
According to the BIS, the value of spec holdings of gold derivatives became gigantic in the 2000s. How is that possible? Who took the other side? Mostly likely, it was official institutions which took the other side, given their huge above-ground stockpiles.
But are the stated positions in the balance sheets the real ones? One must remember that central banks routinely take hedge positions against their underlying reserve assets. They never, ever report the derivative overlay. Hence, if a European national central bank with 2000 tonnes of gold in its vault sells forward against that position, basically thereby eliminating it, it doesn’t report the corresponding forward position.
Consequently, it may be that the official institutions do not have net/net the gold they purport to hold on their balance sheets.. Now, in the old days this just didn’t matter. The fraud in the reporting of reserve positions could go on and no one would notice or care. But in light of the BIS proposals (also backed by the Fed, the OCC, and the FDIC), now the gold at these higher prices is regarded as an important asset.
Consider the case of the ECB. It has a net capital of 84 billion euros, which could be wiped out easily given its exposure to the PIIGS. But everyone now says that with the gold the ECB has a capital of 484 billion euros if the bullion is marked to market. But is that true? How much has been hedged at $400 or $500 or even $1000 an ounce? It could be a lot. Nobody knows. The ECB is remarkable for its lack of transparency on anything, as the recent bank run travails illustrate.
It is this consideration that makes the notion of the official sector becoming a net buyer of gold a much more plausible consideration. This process may well have begun (see here – http://ftalphaville.ft.com/blog/2012/07/10/1077461/propping-up-the-gold-price/)
Now it’s also the case that the net spec long position is still very high and this could well be one of the reasons why the gold price has not taken off, despite the favourable macro backdrop. Even if so, it appeasr that the official sector could well mitigate the extent of the fall, given that central banks and other official institutions will likely stop selling and may become huge buyers.