Going for Gold: Why the RBA Should Buy Bullion

Going for Gold: Why the RBA Should Buy Bullion

It can’t be easy being a central banker.

Even at the best of times, it’s hard to come up with interest rate settings that can foster economic growth and employment…

All the while controlling inflation, ensuring it doesn’t run too far beyond the target band, and monitoring overall financial stability.

In today’s post-GFC world, the job of central bankers has become even harder.

In the last decade, they’ve had to almost single-handedly prop up the global economy, as well provide ongoing support to financial markets.

It’s some task.

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And in fairness to the RBA, while Australia has been incredibly lucky this past decade due to the growth of China, they’ve done a good job in managing the Australian economy through a tumultuous global environment.

But when it comes to our foreign exchange assets, the RBA should be looking to restock Australia’s physical gold reserve.

The 1996 memo was correct in stating that gold could no longer be regarded as something ‘special’. And even that it should be managed as just another component of official reserve assets.

Today, our gold holdings are dangerously low.

Despite the strong rally in gold prices since the turn of the century, physical gold currently makes up less than 5% of our foreign reserve assets and barely 2% of the total assets the RBA holds.

That’s according to data in both the RBA’s 2017 annual report and analysis from the World Gold Council, which uses IMF data for foreign exchange reserve analysis.

This number is alarmingly low when compared to the holdings of other developed nations.

The following chart compares Australia’s position to other economies:

As you can see, on a percentage basis, our holdings are barely 1/10th the size of many of our developed market counterparts.

In our view, that is well short of the appropriate amount given the economic environment we’re in.

Adding further weight to the argument that our national gold reserve needs to be rebuilt is the lack of income being generated on our portfolio of foreign exchange assets.

This is of course a function of the record low-yield environment that central banks the world over have created in the post-GFC environment.

It’s also a function of our foreign reserve assets. These assets are managed against an internally set RBA benchmark foreign currency portfolio.

We’ve tabled it below, alongside the net foreign currency assets reported by the RBA in their 2017 annual report.

The return on this portfolio is so-so, something the RBA itself has been warning about for years. In its 2014 annual report, the RBA noted: ‘…the running yield on the benchmark portfolio was only 0.2 per cent, compared with over 4 per cent prior to the financial crisis.

Things have picked up slightly in the last couple of years. But the yield on the benchmark portfolio is still sitting at just 0.80% according to the 2017 RBA annual report.

The latest annual report also includes the following chart:

It highlights the up-to-90% decline in yield earned on foreign currency securities held by the RBA (based on the benchmark portfolio) in the years following the onset of the GFC. As you can see, for almost 10 years, we’ve been earning less than 1% on these assets.

While it is not their only consideration, the yield generated on these foreign reserve assets, which doesn’t even match current inflation rates, is hardly high enough to act as a deterrent that should cause the RBA to resist the argument against a higher level of physical gold holdings.

After all, the opportunity cost in terms of income foregone is, in real terms, almost nil. Especially given that the RBA actually earns roughly 0.20% on its gold loans.

While the yellow metal has significantly lower inflation risk over the medium-to-long run, it also offers a much greater chance of capital appreciation compared to short-term government debt.

You can understand then why a central bank or investor might look to trim their gold holdings if they could earn close to 4–5% in ‘real’ terms investing in low-risk, low-volatility financial assets.

But we are not operating in that kind of environment today, and likely won’t be for years to come.

Adding weight to the argument that now is the time for the RBA to go for gold is the fact that the balance sheets of all the sovereigns we lend to have deteriorated significantly since 1997, when the RBA sold off the majority of its gold, and in particular since the onset of the GFC.

This is made clear in the following table. It highlights government debt-to-GDP ratios in the US and a handful of European nations in 1997, 2007 and again in 2016.

As you can see, there is no country that has managed to avoid a significant build-up in its government debt levels relative to their economic output.

Debt-to-GDP ratios for these countries as a whole have risen by over 45% in the past two decades. Most of the damage has been done since the GFC hit.

Today, while growth rates across the world have increased, the financial systems of all these countries are still precariously positioned. So much so that they’ve either had to engage in or continue to engage in historically unprecedented quantitative easing (money printing).

That’s in addition to other monetary and fiscal stimulus measures.

Worse still is the challenge of ageing populations only beginning to extract its pound of flesh from national treasuries…

The balance sheets of these sovereigns will only deteriorate in the coming years. Something that Australia is not immune to.

The end result of these trends will almost certainly be higher inflation in the coming years.

As such, while loans to sovereigns are supposedly without risk in terms of the nominal servicing of coupons and repayment of principal upon maturity, the purchasing power of US dollars, euros, yen, sterling, won and yuan that the RBA will receive in the years to come is almost certain to deteriorate.

These loans to sovereigns still offer liquidity but, in their own way, are now a source of return-free risk, rather than risk-free return!

In the face of such challenges, prudent risk management demands robust diversification of reserve assets. Rather than maintaining such a large percentage of our foreign exchange reserves in increasingly risky developed market bonds, the RBA would benefit by topping up our physical gold reserves.

But, as we’ll explore in the final part of this special series on gold tomorrow, the RBA isn’t the only central bank that would benefit from doing so. In fact, many central banks have long been doing just that…

Stay tuned.


Jordan Eliseo,
Chief Economist, ABC Bullion
For The Daily Reckoning Australia