The recent decline in gold prices and the drain from physical ETFs have been interpreted by the media as signaling the end of the gold bull market. However, our analysis of the supply and demand dynamics underlying the gold market does not support this thesis.
For example, Non-Western Central Banks have been increasing their holdings of gold at a very rapid pace, going from 6,300 tonnes in Q1 2009 to more than 8,200 tonnes at the end of Q1 2013 (Figure 1a) while physical inventories are declining (Figure 1b) (or being raided, as we argued in the May 2013 Markets at a Glance)1 and physical demand from large (Figure 1c) and small (Figure 1d) scale buyers remains solid.
Source: World Gold Council, Bloomberg, Hong Kong Census and Statistics Department
Average premium calculated as the average premium for the following 1oz. coins, as reported by the Certified Coin Exchange (CCEX): American Eagle, Maple Leaf, Krugerrand, Philharmonic, Panda, Isle of Man and Kangaroo.
In previous articles we have argued that Western Central Banks have been filling the supply gap to satisfy the demand for physical gold.2 As shown in Figure 1a above, the official amount of gold held in the Western Central Banks and international institutions like the IMF has been steadily declining since 2000, only to stabilize at around 23,500 tonnes since 2008. Officially, this gold has primarily been sold by continental European Central Banks under what is known as the “Central Bank Gold Agreements” (CBGA) (also known as the Washington Agreement on Gold).3 Under this agreement (which expires after five years and has been repeatedly renewed since 1999), the “undersigned institutions will not enter the market as sellers, with the exception of “already decided sales” and “The signatories to this agreement have agreed not to expand their gold leasings and their use of gold futures and options over this period”. Sales under the CBGA are shown in Figure 2 below.
Source: World Gold Council4
The two points referenced above are particularly interesting because gold leasing (or swaps) has been the primary instrument used by central banks and bullion dealers to suppress the price of gold over time (Alan Greenspan testified, on 24 July 1998, to the House of Representatives that “central banks stand ready to lease gold in increasing quantities should the price rise”).5
It is important to remember that bullion banks (members of the London Bullion Market Association, or LBMA) hold gold in their vaults for their clients.6 Most of those clients, according to the LBMA, deposit their gold (or purchase gold) through an LBMA bank, for example ScotiaMocatta, in what is called an unallocated account. “This is an account where specific bars are not set aside and the customer has a general entitlement to the metal. It is the most convenient, cheapest and most commonly used method of holding metal.”7 However, what the LBMA doesn’t say is that, just like regular fractional banking, the bullion bank does not need to keep the whole value of the gold deposit in gold, but only keeps a fraction of it in its vaults, hoping that not all depositors will request their gold at once. This creates a potential shortage of physical (and an increasing supply of paper) gold and is one reason why bullion banks sometimes need to lease gold from central banks. Leasing gold is analogous to a swap or a collateralized loan, where a Central Bank gets cash in exchange for gold as collateral, and pays an interest rate on the cash loan.
The gold leasing mechanism works in the following way (also shown in Schema 1 below):8
A Central Bank leases its gold to a bullion bank for a pre-specified period (say 1 month). In exchange, the Central Bank receives cash for the value of the gold and has to pay the Gold Forward Offered Rates (GOFO) to the bullion bank. Then, the Central Bank lends the cash on the market and receives LIBOR for 1 month, with net proceeds of LIBOR minus the GOFO, which is called the lease rate. If the lease rate is positive (and it usually is), then it is profitable for the Central Bank to lease its gold. A high lease rate increases the incentive for Central Banks to lease their gold.