o3 BLOG | Investing

Gold Reserves — The Importance of Gold in Central Bank Reserves

November 1, 2021

O3 Mining

Gold reserves have been an essential component of central bank holdings for decades, and their appeal shows no signs of slowing down. Globally, central banks are set to be the highest net purchasers of gold this year. Currently, central banks own almost 35,000 metric tonnes of gold, accounting for about one-fifth of all gold ever mined. But, what is it in gold that has kept it so valued for so long?

One of gold’s most important roles for central banks is to diversify their reserves. Banks control their respective countries’ currencies, which can fluctuate in value depending on the perceived strength or weakness of the underlying economy. Because interest rates, the conventional monetary management tool, have been locked near zero for more than a decade, banks may have to resort to printing more money in times of need. This increase in the money supply may be necessary to minimize economic disruption, but it will devalue the currency. On the other hand, gold is a finite physical commodity with a limited quantity. As a result, it serves as a natural inflation hedge. Because gold has no credit or counter-party concerns, it works as a source of trust in a country and all economic circumstances, gold reserves along with government bonds, are one of the world’s most important reserve assets.

Gold’s inverse relationship with the US dollar, another significant reserve asset, adds to its attraction. When the dollar’s value falls, gold often rises in value, helping central banks secure their holdings during periods of market volatility.

The most active central banks’ profiles have evolved, with traditional economic powerhouses such as the United States, Germany, France, and Italy no longer contributing to their considerable gold reserves. With almost 8,100 tonnes of gold, the United States owns the most, accounting for more than 78% of its total foreign funds. That is more than double Germany’s stockpile of over 3,300 tonnes, putting it second on the list and accounting for over 74% of the country’s reserves.

Emerging economies such as Russia, China, Turkey, and India have stepped in to take their place as gold buyers. Despite large gold purchases over the preceding decade or two, the four countries continue to lag behind their Western counterparts, with gold reserves accounting for only 22% of Russia’s overall holdings and China’s gold reserves of just under 2,000 tonnes accounting for only 3%.

Poland and Hungary, both European Union members, have recently increased their reserve holdings. The statement issued by Hungary’s central bank at the time of its March purchase, which brought the country’s overall gold holdings to 94.5 tonnes, provided insight into the asset’s modern-day value as well as its long-term power. The bank stated that navigating risks induced by the pandemic was a key factor in its decision. The appearance of global spikes in government debts or inflation concerns further increased the importance of gold in national strategy as a safe-haven asset and store value. While central banks buying gold has changed throughout time, the reasons for keeping the asset have not.

When China’s economy is towards the top of the global rankings, it’s worth doing some research to figure out what’s causing it. Governments, like us, have been exploring why central banks buy gold. Government banks, such as the People’s Bank of China, have increased their gold purchases for years. In reality, these were significant purchases. According to Haywood Cheung of the Hong Kong Gold Exchange, China will acquire over 1,000 metric tonnes this year — but why? What is their end game, and why such significant expenditure on one asset?

So, what drives a central bank to buy gold? Gold reserves are highly liquid assets and contribute to the value of their holdings.

According to Reuters, China has the world’s largest foreign exchange reserve, yet only 1.8% of it is in gold. What makes something so eye-catching? Compare this to gold, which accounts for 73% of America’s foreign reserves. China will need to buy a lot of gold if it wants to keep up — which may come as a surprise to economists who recall Nixon cutting gold’s direct relationship to the US dollar over five decades ago. So, why do central banks around the world possess 20% of all gold ever mined?

Management and Mitigation of Risks

In general, central banks buy gold and other precious metals to protect themselves against currency risks. This is a tried-and-true procedure comparable to how precious metals are obtained. This is exactly what a normal person would do. “The absence of any credit risk is a basic attribute of gold,” says Herve Hannoun, Manager of the Banque de France. J.P. Morgan was also well-known for making remarks along these lines. Simply put, the purchasing power of gold functions as a hedge against a sinking dollar or other fiat currencies.

To ensure long-term growth and stability.

Central banks buy gold because it is their primary responsibility to maintain stable economic growth. Because market excesses are possible, central banks must establish monetary policies to keep markets strong but not unduly powerful. The ability to buy and sell gold enables central banks to restrict market expansion. This explains why the governments of China and Russia have made considerable investments in the metal. Their developing economies are especially prone to free-market excesses. Owning gold prevents these excesses from destabilizing the currency and damaging business.

The Dollar vs. Gold

Fiat currency movements have been dramatic since the end of the gold standard. Investing in non-dollar assets is one of the best ways for governments to protect themselves against inflation. Precious metals, particularly gold, are the most popular investment option for institutional investors. They can now effectively support the dollar because they have reduced risks and ensured stability.

There is a clear reason why Central Banks are increasing their gold reserves. To learn more about how gold can add long-term value to your investment strategy, contact our investor relations team today.

To learn how O3 Mining can add long-term value to your portfolio, contact us today.

Contact us