Make Australia Gold Again!
It’s impossible to get anyone excited by gold these days.
Even though it’s now back above $1,700 an ounce…
Even though it’s the best performing asset since the turn of the century…
But if that’s the case now, imagine how it was viewed in the late 1990s…
After a double-decade bear market, gold languished below $500.
It wasn’t only investors that were ‘bored’ with gold.
Central banks the world over were net-sellers.
Indeed, from the late 1980s right through to the 2008 Global Financial Crisis, central banks offloaded close to 6,000 tonnes of the metal.
In 1997, the Reserve Bank of Australia played its part…
It sold off roughly two-thirds of Australia’s national gold reserves.
Under Ian Macfarlane, the RBA sold 167 tonnes of the metal.
It netted AU$2.4 billion from the sale.
But at what cost?
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Today, at the 21st anniversary of those gold sales — sales that reduced our national physical gold reserves to a paltry 80 tonnes of metal — we answer this question.
You may not like our answer.
It may worry you.
My hope is that it will spur you into action…
What was the RBA thinking?
The rationale for the gold sale was perhaps best summed up in a confidential memorandum presented to the RBA.
This memo noted a couple of key things:
- The RBA’s gold holdings represented some 20% of official foreign exchange reserve assets;
- The total tonnage held had remained unchanged since the late 1970;
- There was considerable cost in holding such a large physical gold reserve, especially in terms of interest income foregone — difference between actual earnings and those that could’ve been obtained;
- That gold is the only reserve asset that is not a claim on some other government, international institution or bank.
Despite these positives, the memo stated: ‘…over the past two or three decades, the world has experienced a number of economic “crises”, but gold played no part in coping with them.’
When looking at the outlook for gold, the memo suggested the gold price was likely to stay low. This was due to improving gold production techniques. As well as the expansion of the gold lending market, something the RBA participated in.
The bottom line: There would be no major increase in the gold price… And there would be a significant opportunity cost in holding gold.
The memo also included a somewhat questionable piece of analysis. You can see this in the table below. It shows the returns on physical gold versus US Treasuries from 1900 to 1970.
Compound annual returns (percentage)
This analysis was partly used as justification for the gold sale. The memo stated:
‘The value of $100 invested in US Treasuries in 1900 would now be about $3,700 (assuming all coupons were reinvested), which is about twice the value of a similar investment in gold.’
It also noted that in the previous financial year, gold lending had generated just over $20 million in income. Meanwhile, interest foregone on the RBA’s gold holdings would have amounted to roughly $190 million.
While the data in the above table is accurate, the insight drawn from it is questionable. As the memo acknowledges: ‘…from 1900 to the early 1970’s, the price of gold was officially fixed, increasing only once (from US $21 per ounce to US $35) during 1933.’
Had those preparing this memo stripped out the 70-year period where gold prices were fixed (and where gold and money were essentially interchangeable), the returns on gold versus US Treasuries would have come out in a much better light.
But it wasn’t the return on US Treasuries that doubled the return on gold, as the memo claimed.
An analysis of the returns data from the 1970s onward — when the price for both physical gold and treasuries were largely determined by market forces, not governments — shows the opposite. It highlights the fact that it was the performance of physical gold that more than doubled the performance of US Treasuries.
Regardless, the memo would have made a lot of sense at the time. You can understand why the RBA was keen to minimise its gold holdings.
They weren’t the only ones.
Many other central banks were doing the same thing. After all, it was impossible to predict the NASDAQ crash, September 11, the War on Terror, the Global Financial Crisis and the European debt crisis at the time.
Impact of the physical gold sale
In total, the RBA reduced its gold holding from 247 tonnes to 80 tonnes, with those sales occurring in the first six months of 1997.
The RBA received AU$2.4 billion for the sale of this gold, which works out at just under AU$450 per ounce.
Had the RBA held on to this gold, those 167 tonnes would be worth closer to AU$9.4 billion today. That’s calculated using gold at today’s approximate AU$1,750 level. And it amounts to roughly AU$1,300 per ounce higher than in 1997.
The decision to sell all that physical gold at an almost double-decade low means Australians have missed out on some AU$7 billion in capital gains in the past 17 years.
In fairness to the RBA, it’s not enough to just look at that AU$7 billion we’ve missed out on.
We must also account for what happened with the $2.4 billion they received for the physical gold sale.
This money was obviously invested in other assets.
The RBA’s 1997 annual report stated that ‘two-thirds of the Bank’s gold holdings were sold in the second half of 1996/97, and the proceeds invested in foreign government securities.’
That money went into assets denominated in US dollars, Japanese yen and German marks.
While it’s impossible to measure a specific return on those investments, the money will certainly have grown.
Had the money been invested in long-term government bonds, the growth would have been spectacular. Between March 1997 and March 2018, the return on global government bonds hedged into Australian dollars was an incredible 7.21% per annum. This figure is based on the World Government Bond Index.
Theoretically, the RBA could’ve invested the proceeds of the physical gold sale in line with that index. It wouldn’t have been any different to a superannuation fund with a strategic allocation to global government bonds doing something similar.
Had that happened, the RBA’s AU$2.4 billion investment would be worth around AU$10.3 billion today. That number is actually about $1 billion more than the gold holdings they sold would be worth.
In reality, the RBA would have earned significantly less than 7.21% per annum on the AU$2.4 billion received from the gold sale. That’s because the bulk of the RBA’s foreign reserve portfolio is invested in assets with a significantly shorter duration than an index of global government bonds.
In 1997, the RBA’s benchmark portfolio for foreign currency assets had a duration target of just 30 months. This number has fallen in the years since. Especially as the RBA shortened the maturity profile of its foreign currency assets.
According to the 2017 RBA annual report, over 60% of the foreign currency investments held by the RBA mature in less than three months. Another 20% have a maturity of somewhere between three and 12 months.
Given this, we’ve estimated the return on these investments by looking at the return on two-year US Treasuries between March 1997 and March 2018.
The return on two-year US Treasuries of 2.54%, compounded over 21 years, suggests the AU$2.4 billion the RBA received from its gold sale would have grown in value to some AU$4.07 billion by now.
Compare this figure with the current market value of gold…and the decision by the RBA to sell its gold has likely set the nation back closer to AU$5.3 billion in the years since.
But we can’t go back in time. And, as mentioned earlier, the RBA had many good reasons to reduce their gold holdings in the late 1990s.
The most important thing to focus on is what they should be doing now. And that’s what we’ll be focusing on in the second part of our series on gold in tomorrow’s Daily Reckoning.
Chief Economist, ABC Bullion
For The Daily Reckoning Australia