Time For Eurozone To Reach For The Gold Reserves?

Time for Eurozone to Reach for the Gold Reserves? (Financial Times, Aug 31, 2012):

Is it time for some eurozone governments to start selling that metaphorical family silver? Or, more specifically look at their all-too-real gold reserves, to find a solution to Europe’s crisis?

That is a question which has recently been buzzing around in some policy making and investing circles. For as autumn looms, it is clear that the eurozone remains under profound stress. However, it is also unclear whether the European Central Bank – let alone the eurozone politicians – will really be able to do anything soon to ease market fears and lower those borrowing costs.

Thus, as unease builds, the World Gold Council – or the body that represents the gold industry – has recently lobbed a new idea into the fray: it thinks it is time for eurozone governments to start using gold in a creative manner, particularly in places such as Italy, to cut those interest rates.

The issue at stake revolves around the estimated 10,000 tonnes of gold reserves that are currently held by eurozone governments. According to the Council, “it is well known that some of the countries most affected by the crisis, including Portugal and Italy, are responsible for a significant proportion of these assets.”

Unsurprisingly, this situation has prompted some to suggest that governments should sell some of that gold. The value of gold has soared in the last few years, and if there were ever a time that eurozone countries needed an unexpected windfall – say, to pay interest on bonds – it would be now.

But the Gold Council, for its part, insists this would be a mistake. For quite apart from the fact that a massive dump of gold would dampen the price, eurozone debt woes are now so large that gold sales would only scratch the surface of the problem. Or as it notes: “The gold holdings of the crisis-hit eurozone countries (Portugal, Spain, Greece, Ireland and Italy) represent only 3.3 per cent of the combined outstanding debt of their central governments.”

Thus it favours an alternative idea: instead eurozone countries should essentially securitise part of that gold, by issuing government bonds that are backed by gold. This could be done in a simple manner; or it could be structured to include tranches of different risks. Either way, the key point is that gold would be used to provide additional security for bonds – and thus reassure investors who do not trust eurozone government balance sheets anymore.

“Using only a portion of those gold reserves as collateral could significantly reduce the rate at which each of these [periphery] countries could issue debt,” the Council argues, pointing out that this scheme has been employed on a few occasions in history before. In the 1970s, for example, Italy and Portugal used their gold reserves as collateral to get loans from the Bundesbank, the Bank for International Settlements and other creditors. More recently, India raised a loan from Japan, which it backed with gold.

So is there any chance this idea could fly? Don’t hold your breath, or not soon. Personally – and leaving aside the Gold Council’s self serving interest in pushing the scheme – I think that the concept of gold-backed bonds certainly is worth debating. While gold-backed bonds would not be a full-blown solution, it could help in some respects.

But there is little sign that the idea has garnered any serious support from policy makers thus far. Even if eurozone leaders embraced the idea, there would be some big legal obstacles; most notably, much of the gold is held by central banks, not treasuries.

Nevertheless, if nothing else, investors should take note of the debate as an interesting straw in the wind. A decade ago, it seemed utterly old-fashioned to ever suggest that any investor – or institution – would post gold as a collateral; in the era of cyber finance, securities such as treasury bonds, tended to rule. But in recent months groups such as a LCH.Clearnet, Intercontinental Exchange and the Chicago Mercantile Exchange have increasingly started to accept gold as collateral for margin requirements for derivatives trades. And earlier this summer the Basel Committee on Banking Supervision issued a discussion paper which suggested that gold should be one of six items used as collateral for margin requirements for non-centrally cleared derivatives trades, alongside items such as treasury bonds.

This does not add up to a revolution; let alone the type of step towards gold-backed finance – or a gold standard – that gold bugs (and some American Republican Party members) would love to see. But it does suggest that a slow evolution of attitudes is underway – not so much in terms of the desirability of gold per se, but the increasingly undesirability and riskiness of other supposedly “safe” assets, such as government bonds. That pattern is unlikely to change soon; especially as markets wait to see what the ECB might unveil on September 6.

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