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Crescenzi: Central Banks and Gold

Thursday, 16 Sep 2010 | 9:53 AM ET

An article published in the Financial Times Wednesday discusses a forecast by GFMS, a consultancy, which believes that the world’s central banks will purchase 15 tonnes of gold on a net basis this year, the first net purchase since 1988, according to GFMS. Central banks for a number of years have been liquidating their gold stockpiles in favor of holding paper currencies such as the U.S. dollar.

Now, the tide may be turning, the article posits. If so, it would fit the idea that central banks wish to decrease their holdings of the U.S. dollar as a percentage of their so-called reserve assets, which totaled roughly $8.6 trillion at the end of August, according to data from the International Monetary Fund. China holds around $2.5 trillion of that total, mostly in U.S. dollars, which were built up from the very large trade surplus that China has with the United States.

Gold
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Gold

Central banks have been diversifying their reserve assets for many years, making any foray into goldconsistent with the effort.

The diversification theme is evident in a data comparison between 2002 and the present, which shows that in 2002 the U.S. dollar represented about 70 percent of the world's reserve assets.

Today, the tally is 63 percent.

In other words, central banks have reduced their exposure to dollars in favor of other currencies. (The Euro has been the largest beneficiary by far, with it accounting for about 27 percent of world reserve assets compared to 20 percent in 2002). Any movement into gold is likely to be small: this is still a fiat-currency world.

For those that believe gold is a better alternative, keep in mind a few ideas:

* The U.S. dollar may be a paper currency but it is backed by the hegemony of the United States, which remains the world’s biggest power politically, economically, and militarily.

* Gold is not a liquid instrument; U.S. Treasuries trade near $500 billion per day. Liquidity is an important risk factor of great importance to the world’s central banks.

* No alternative to the U.S. dollar is waiting in the wings; China does not have a bond market largest enough to house the world’s reserve assets and Europe’s isn’t as liquid.

* All of the gold that has ever been mined fits into about three Olympic-sized swimming pools. Who out there believes that nations would prefer to put their sovereign money in those pools of gold rather than in the paper currency of the United States, which is backed by its full faith and credit, its people, and its land? (Scarlet O’Hara said it best when she said, “Land: It’s the only thing that lasts!”)

Diversification into gold? It fits the diversification pattern of the past decade. A replacement for fiat currencies? Extremely unlikely.

Tony Crescenzi is Senior VP, Strategist, Portfolio Manager Pimco. Crescenzi makes regular appearances on financial television stations such as CNBC and Bloomberg, and is frequently quoted across the news media. He is also the author of "Investing from the Top Down," "The Strategic Bond Investor," and co-author of the 1200-page book "The Money Market."

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