Monday, 26 April 2004

Why Is Europe Now Breaking Into Its Gold Vaults?

Gold has always attracted its fair share of eccentrics. More than any other commodity in the financial markets, it has provided a haven for oddballs and conspiracy theorists.

Right now, they can have a field day. Something strange has been happening in the gold market. Europe looks to be bailing out of the metal as gold prices soar and politicians squabble with central bankers over how to make use of the proceeds.

In France, the new finance minister, Nicolas Sarkozy, is arguing for the Bank of France to sell some of its gold.

A hundred metric tons of gold is worth about 1 billion euros ($1.2 billion), which would yield from 35 million to 40 million euros a year if the proceeds from the gold’s sale were invested in assets earning interest, Sarkozy told lawmakers in France’s lower house of parliament last week.

The bank’s governor, Christian Noyer, has already said he will decide before October whether to start selling as much as 100 tons of gold annually, and invest the money instead in assets yielding interest, according to the French newspaper Le Parisien.

It sounds like Sarkozy has already made up his mind.

In Germany, Ernst Welteke resigned as Bundesbank president on Friday after being embroiled in a row over a hotel bill in Berlin. Behind that may be a disagreement about Germany’s gold reserves. Welteke’s son, Hans, has claimed his father argued with German Finance Minister Hans Eichel over how to use the money raised from selling some of the country’s gold reserves.

This year, Welteke said he won an option to sell 600 tons of gold or as much as 20 percent of the country’s reserves over five years. The Bundesbank has disposed of only 29 tons of gold coins since 1999.

Gold Sale

Welteke’s option to sell more gold was part of an accord between the euro-region’s national central banks, the Swiss National Bank, Sweden’s Riksbank and the European Central Bank last month. Under the agreement, the main European central banks may sell as much as 500 tons of gold between them each year — an increase on the annual limit of 400 tons agreed to in 1999.

With so much gold coming into the market, N.M. Rothschild & Sons Ltd., the world’s second-largest closely held investment bank, may even regret the decision announced last week to pull out of commodities trading and withdraw from the London gold fix, the price-setting institution it hosted for 84 years.

If both France and Germany start selling gold, it may have a big impact on the market. According to World Gold Council figures, both countries are among the largest holders of gold in the world. Country Rankings

The U.S. is the largest, with more than 8,000 tons. Germany comes next, with about 3,400 tons, followed by the International Monetary Fund with more than 3,200 tons. The French have about 3,000 tons. The next largest holders are also European: The Italians have 2,451 tons, and the Swiss 1,592.

The Swiss have been selling some of their gold. The Italians may have to do the same. Given the size of that country’s budget deficit, and Prime Minister Silvio Berlusconi’s determination to push through tax cuts, all that shiny metal must be looking very tempting.

The gold holdings of the big European countries have been remarkably stable over the past 30 years. Take a look at the French and German figures. According to the World Gold Council, the French held 3,139 tons in 1974 and Germany had 3,658 tons.

Since they’ve kept it for so long, why are European countries looking to get rid of their gold now? Would it be wise?

Three Obvious Reasons

There are three obvious reasons why Europe is thinking hard about emptying its gold vaults right now. And one subtle one.

Let’s start with the obvious.

One, the gold price is high. At more than $400 an ounce, the precious metal is at its highest in years. Back in 1999, gold went as low as $252 an ounce. UBS AG predicts it could reach $480 an ounce within a year. Two, unless you melt it down for rings, it’s useless. Gold no longer has any formal role in the monetary system. And, unlike some other assets, it doesn’t really pay much in the way of dividends. Instead you have to pay guards to look after it.

Three, some EU countries need the money. France and Germany, and most of the other European nations, are running big budget deficits. Economies are weak. There is no scope for tax increases. Why not sell some of that gold?

All three of those are good reasons for running down central bank holdings of gold. Indeed, the British have already acted on precisely that basis. Under a 1999 agreement, the Bank of England disposed of 395 tons of gold in 17 separate auctions completed in March 2002, unfortunately before the steep price increase.

Euro’s Role

There is another more subtle reason: the euro.

Rationally, there is no special reason to have vaults full of gold, certainly not to the extent the European national central banks still do. Gold represents 46.5 percent of Germany’s total foreign reserves, and more than half of France’s, according to the World Gold Council.

Why so much? The Swedes have only 11 percent of their reserves in gold, and the Irish just 1.7 percent — and both have strong economies. When euro-region countries had their own national currencies, there was a temptation to keep some gold in reserve. It was a financial security blanket. You never know when the world might be plunged into chaos. You might need that gold to support your currency.

The euro has changed that. France and Germany, and the rest of the euro nations, no longer have to defend a currency on their own.

And if the euro were to collapse during a crisis, a few thousand tons of gold here or there probably wouldn’t make much difference.

The creation of the euro has severed the emotional ties between Europe’s central banks and their gold vaults. They probably can’t be restored now — and the market should expect to see a lot more of the metal sold under future accords.

Matthew Lynn

April 19 (Bloomberg)