Why central banks across the world are buying more gold for reserves

Till 2008, they were paring gold reserves. Today they see it playing a new role in changing financial systems; share of the metal in RBI's total forex reserves rose to 5.9% in November 2018

Gold is playing a new role in the changing international financial environment. Central banks the world over see the global financial system moving from being unipolar, or dollar dependent, to multipolar, with gold serving as a better component of foreign exchange reserves as a hedge against the greenback. Many, including the Reserve Bank of India (RBI), are aggressively adding gold to their currency reserves. As a matter of fact, this shift from unipolar to multi polar was attempted by the Euro zone a decade ago, and by China later. 

The share of the precious metal in RBI’s total forex reserves rose to 5.9 per cent, taking total gold holding at 592 tonnes in November. Globally, central banks added net 480 tonnes to reserves (the highest in the past three years) in the first 11 months of 2018, compared to 373 tonnes earlier. The trend seems to be continuing.

The preference for gold began after the 2008 financial crisis and in 2013, central banks’ addition to reserves increased to 625 tonnes. However, with gold prices falling despite quantitative easing of monitory policy, gold buying also moderated. But now it is picking up again, after bottoming out last year when total purchases fell to 371.4 tonnes. Prior to 2009, global central banks were selling gold.

Natalie Dempster, Managing Director, Central Banks and Public Policy, World Gold Council, says, “Central bank purchases have strengthened recently and appear to be accelerating further. The motivation for buying gold differs between countries. Central banks have three main objectives while considering reserve assets: safetu, liquidity and generation of returns. Gold helps meet all three policy objectives.”

Over a decade ago, the Euro had emerged as a strong contender to dollar in central banks’ foreign exchange reserve basket, and several banks started adding Euro to their reserves. However, that situation didn't last long. Over the past few years, China’s Yuan has also emerged as a viable alternative.

Dempster adds, “At the moment, a lot of these purchases may be driven by the growing recognition among central banks that the world is changing and that, over the long run, the international monetary system is likely to shift from a unipolar reserve currency system based on the dolla, to a multipolar one. That will see currencies like the China’s RMB play a much greater role in reserve portfolios. However, the exact path that the world takes in getting to the new system is highly unclear. It could very well see bouts of currency instability, as large changes are made in reserve asset composition, even as speculation about prospective changes ebbs and flows. Gold’s role as a traditional hedge against uncertainty and risk could prove very valuable to central banks during this transition period."

Following the trend set by global central banks, RBI has also started adding gold to its reserves and in little under a year, has added nearly 40 tonnes to its reserves maintained as part of forex reserves.

The metal's share in RBI’s reserves also rose from 5.5 per cent a year ago to 5.9 per cent in November 2018, when the holding stood at 592 tonnes. This is because gold prices are generally firm and forex reserves are falling due to rupee volatility.

Sources tracking bullion movement estimate that by now, India’s official gold holding would have crossed 600 tonnes, or 6 per cent of total reserves.

According to the WGC report, the National Bank of Hungary also cited gold’s role as a hedge against future structural changes in the international financial system, when it announced a ten-fold increase in gold reserves in October. In September 2018, its gold holding was 3.1 tonnes which has increased to 31.5 tonnes, or from 0.4 per cent to 4.4 per cent.