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Emerging markets should shift from dollars into gold.

Summary: Managers of the world's $10tn or so foreign exchange reserves are in a bind.

Managers of the world's $10tn or so foreign exchange reserves are in a bind. More and more of the global government bond market shows a negative yield. If held to maturity, such bonds will inflict a certain loss. Those bonds that do offer a positive yield are horribly overvalued by historic standards. If held to maturity, they will show a profit. But the capital value of these so-called safe assets is vulnerable to a spike in yields, which is bad news if central banks need to liquidate them to cope with a currency crisis or fiscal disaster.A further problem is that central banks' reserve portfolios tend to be relatively undiversified. Only US Treasuries offer the depth of liquidity that is essential for reserves to perform their safety-net function in a crisis. Nearly two-thirds of global reserves are invested in dollar-denominated assets. How interesting, then, that Kenneth Rogoff, the Harvard economist, has been arguing that emerging markets should shift a chunk of their official reserves away from dollars into gold.

His reasoning is that emerging markets as a group are competing for rich-country bonds, which is driving the interest rates they receive exceptionally low. At the same time, rich-country governments are so heavily indebted they cannot increase the supply of IOUs significantly. So bond prices cannot be expected to appreciate much further. Gold, despite being in close-to fixed supply, does not suffer from this problem, because there is no upper limit on its price. Mr Rogoff also believes a case can be made that gold is "an extremely low-risk asset" with average real returns comparable to very short-term debt.

Emerging markets are, in fact, already beginning to take the message. Since 2010, central banks have been net buyers of gold. This reflects both a slowdown in sales by European central banks - which, incidentally, suggests a striking lack of confidence in their own monetary policies - and large purchases by emerging markets.

From a systemic point of view, this is good news. It can help mitigate the squeeze arising from the global shortage of safe assets. The emerging markets' diversification problem should lessen, because gold has a strong negative correlation with the dollar. And the appreciation of the gold price that would result from EM buying would also benefit many advanced countries because developed-world central-bank gold holdings are high.

The US keeps nearly 75 per cent of its reserves in gold, while the proportion for Germany, France and Italy is between 60 and 70 per cent. By contrast, only 2.2 per cent of China's reserves are in gold, while the comparable figure for India is 6.3 per cent.

For individual emerging markets, the case is anything but cut and dried, not least because Mr Rogoff's suggestion that gold is an extremely low-risk asset is highly contentious. The yellow metal may satisfy central banks' requirement for liquidity, but it yields no dividends or interest. It is thus an entirely speculative asset and highly volatile as a consequence. Its dominant position in the portfolios of developed-world central banks is essentially a hangover from the time of the Bretton Woods semi-fixed exchange rate system that came to an end in 1971.

The capriciousness of gold is evident if you look at what happened to anyone who bought at the peak of the 1971-81 bull market in the metal. Over the next 20 years they saw a loss on their investment of 80 per cent in real terms. It can be a losing proposition over much longer periods too. Market strategist Dylan Grice, while at Societe Generale, calculated that a 15th-century gold bug who stored all his wealth in bullion, bequeathed it to his children and required them to do the same would have guaranteed his lineage a near-90 per cent decline in real wealth over the next 500 years.

This does not invalidate the case for gold in official reserves. The diversification benefit is real and the opportunity cost of holding a non-income bearing asset has never been lower in the light of negative interest rates in a growing number of economies. And the fact that "safe" assets have become so unsafe means that the risk of holding gold relative to the risk in bonds is probably less than at any time in history. It is important, though, that emerging markets do not raise their bullion holdings to developed-world levels, because their greater vulnerability to crises makes them less able to cope with volatility.

Among the lessons here are that safe assets are a figment of the academic economist's imagination and gold has been a bubble for millennia. That said, for ordinary investors, bullion can be a better bet than government IOUs in a period of monetary dislocation. In small doses, it makes for useful portfolio insurance.

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Publication:The Daily Star (Beirut, Lebanon)
Date:May 30, 2016
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