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Front-Running the Central Banks

How the intentions of the world’s largest gold players have probably switched to the buy-side

John Maynard Keynes once described speculation as a beauty time their intention to sell. The Bank of England, for instance,
contest in which contestants were asked to choose faces from preannounced a 415 tonne gold sale in 1999. Speculators drove
hundreds of photographs, the eventual winner being the person the gold price down some 10% before the transaction went
whose choices most nearly corresponded to the average opinion of all through. All of these “frictions” make it that much easier for
competitors. “It is not,” Keynes wrote, “a case of choosing those speculators to front-run central bank gold trades.
which, to the best of one’s judgment, are really the prettiest, nor
There seems to have been a switch in the intentions of central
even those which average opinion genuinely thinks the prettiest.
banks. According to World Gold Council (WGC) data, 2009 was
We have reached the third degree where we devote our intelli-
the first year since 1988 that the world’s central banks
gences to anticipating what average opinion expects the average
(including the IMF and World Bank) added to their gold re-
opinion to be.”
serves. If 2009 was a fluke, 2010’s jump in gold reserves seems
Keynes’s example, a paradox, was designed to make markets to imply that a fundamental shift has occurred in central bank
seem silly – after all, Keynes believed that markets were destabi- gold intentions. After all, the last time central banks added to
lizing. In the real world, predicting average opinion (and average their gold reserves two years in a row was back in the 1960s.
opinion of average opinion) is common practice. Take the beauty Given this switch, the side from which to front-run central
contest that is today’s gold market. Like the contestants who try bank gold trades seems to have inverted to the buy-side.
to estimate what the average opinion of beauty will be, gold
Two types of central banks are responsible for the change. Ac-
speculators try to get into the head of other market participants
cording to WGC data, the European ones, huge sellers since
to determine if these players will be future gold buyers or sellers.
1965, have sold insignificant amounts in the latter half of 2009
If the speculator determines these participants will become buy-
and 2010. Non-western central banks, neither buyers nor sell-
ers, a position is built up ahead of time in order to sell to these
ers through most of the 2000s, began to add to their positions
soon-to-be purchasers, preferably at a higher price. Vice versa if
in earnest in 2008 and 2009, and continued to do so in 2010.
they are to be sellers. This sort of speculation is something like
educated front-running. [Ed. note: By front-running, the PollittBuro Why the turn in tide? Central banks often hold significant
means the practice of buying something while taking advantage of ad- stocks of foreign assets, mostly in the form of foreign govern-
vance knowledge of pending buy orders.] ment debt (the most typical investment being US Treasury
Bonds). For political reasons these central banks want to diver-
If every participant was playing this head game, and all were
sify away from such assets as they provide an implicit subsidy to
equally good at it, the result would be Keynes’s paradox. Luckily
the debtor nation (mostly the U.S. Treasury). And for eco-
for gold speculators, not every participant in the gold market
nomic reasons, holding too much of one asset-type, govern-
speculates, nor are they all driven by concerns for the bottom
ment bonds, is a dangerous proposition – especially when so
line. Enter central banks.
many nations are 1. trying their darndest to weaken their cur-
The largest players in the gold market are those huge lumbering rencies, never a good scenario for fixed income investments
beasts of the financial world, central banks. Unlike a small inves- and 2. showing incredibly large deficits, bringing worries about
tor, who can turn on a dime, your average central bank is
weighed down by a large bureaucracy tied down to musty theo-
ries and practices. Once they pick a path, they follow it relent-
lessly. Observe Figure 1, for instance, which shows total central
bank holdings of gold since 1950. For the last forty years or so,
the world’s central bankers have been constant net sellers of the
metal. And all the way down everyone knew they were sellers.
Whereas a hedge fund manager can hide his tracks, central banks
(especially the western ones) must conform to some basic level
of transparency, although the use of gold derivatives certainly
clouds matters. Quarter by quarter, it has been possible to track
their selling in the official data. Central banks have sometimes
made their intentions even more obvious by announcing ahead of

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(Continued from page 1) at around $350 billion, or about 16% of total Fed assets. The
Swiss National Bank (SNB) keeps around 23% of its assets in
credit quality to the fore. One way to protect a portfolio from the metal, and the Euro Area as a whole still holds some 20%
currency devaluation and sovereign credit risk is to buy equities, of central bank assets in gold (see table, opposite).
not bonds. But central banking law usually prevents central bank-
On the other hand, the central banks of Brazil and China hold a
ers from purchasing equity. Even when they are so permitted, the
meagre 0.5% and 1.4% of their assets in gold. Averaging the
nations in which said central banker looks for equity will rarely
world’s 18 largest central banks together (these account for
look kindly on the practice.
80% of official gold reserve holdings) about 6.6% of their as-
With equity markets effectively shut off, that leaves central banks sets tend to be held in gold. Of those, the largest non-Western
with few options other than gold in which to diversify. Which is central banks hold only 3% of their assets in gold.
why we think it very possible that central banks’ attitude to gold
A simple model we have built shows what would happen if the
has turned and, like a herd of elephants trumpeting down a new
Euro Area, Switzerland, Canada, UK, Australia, Sweden, and
trail, it is unlikely to veer back the way it came anytime soon.
the U.S. were to keep their gold holdings steady for the next
The question is: how much gold might central bankers conceiva-
few years, neither buying nor selling, while the remaining 11
bly buy, and what sort of pressures might this put on the gold
central banks in our sample grow their gold holdings up to an
market for the next few years?
even 6% of total assets. We assume that South Africa, India and
The answer depends on the quantity of gold as a proportion of Russia, already at 12%, 8% and 7% respectively, do not reduce
total assets that the typical central bank wants to hold. For in- their holdings to 6%. This leaves 9 banks in our sample.
stance, in the old gold standard days, around 36% of the Bank of
There are two ways for gold to grow to 6% of total assets:
England’s assets were held in gold. By the end of the Bretton
through increases in quantity or increases in price. Starting
Woods days, the Federal Reserve held some 25% of its assets in
with quantity, our rough estimates show that the 9 remaining
gold certificates. We estimate today’s value of official U.S. gold
central banks must purchase about 5,800 tonnes of gold to
Gold Holdings of the World's Largest Central Banks reach the 6% level. Given world gold stocks of 150,000 ton-
Total CB As- Gold Value (local nes, this buying would account for roughly 3.9% of the world’s
Gold as %
Central Bank
Gold held sets (local currency, trillion,
of CB
supply. If the 6% level were to be attained entirely by gold
(tonnes) currency, tril- 2010 year end
price increases, a gold price of $1680 would do the trick.
lion) price)
Switzerland 1,040 0.21 0.049 23.6% Browsing through our 10 possible gold buyers, the Japanese
Euro Area 10,793 1.98 0.402 20.3% and Chinese account for very large chunks. But even if we re-
U.S. 8,134 2.43 0.387 15.9% move the Japanese, our 9 remaining banks still need to buy
South Africa 125 0.34 0.041 12.3% about 4,500 tonnes, or 3% of world supply, to reach the 6%.
India 558 15.53 1.235 8.0%
Along with China, the central banks of South Korea, Brazil,
Russia 775 16.08 1.168 7.3%
Sweden 125 0.71 0.004 5.9%
Turkey, and Saudi Arabia would all be significant buyers.
Turkey 116 0.17 0.009 5.1% The assumptions of our model, including the 6% level, are
Australia 80 0.08 0.004 4.9% open to debate, but we think that number is conservative. In
U.K. 310 0.30 0.010 3.3%
conclusion, it’s probably a fair speculation to assume that one
Saudi Arabia 323 1.66 0.059 3.5%
can step in line ahead of the world’s central banks as they pur-
Indonesia 73 915.88 32.168 3.5%
Japan 765 129.63 3.130 2.4%
chase gold, effectively front-running their trades. They will
China 1,054 25.37 0.343 1.4%
probably be active bidders supporting the market on declines,
Brazil 34 0.60 0.003 0.5% and helping it along on rises, for several years to come. Of
Mexico 8 1.55 0.005 0.3% course, this doesn’t solve the larger puzzle. For while we’ve
Canada 3 0.06 0.000 0.3% peered into the minds of the world’s central bankers as best we
South Korea 14 312.34 0.808 0.3% can, that leaves a significant chunk of motivations unanalyzed:
Source: Central Bank Annual Reports average 6.6% those of hedge funds, jewellery buyers, gold ETF purchasers,
World Gold Council non-Western 3.0% and the proverbial man on the street.

John Paul Koning Toronto, Ontario January 31, 2011

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