How Gold Can Help Stabilize The Balance Sheets Of Central Banks

 |  Includes: GDX, GDXJ, GLD
by: Investment Biker

Since the onset of the crisis, the world's monetary authorities have been forced to ditch their inherent conservatism and embrace extreme measures on an unprecedented scale to stave off financial and economic collapse. Central banks have repeatedly been called on to step in, providing exceptional levels of support to the financial system, when governments have been unable or unwilling to act. Along the way, central bankers - traditionally seen as a reserved and cerebral bunch - have assumed the role of fire fighting saviors.

Central banks across the developed countries have deployed their balance sheets in unprecedented ways. Total debt levels in the developed countries remain at elevated levels, post the credit bubble burst in 2008 leading to deflation risk. Consumers, banks and governments are trying to deleverage as debt has overwhelmed the economy's debt-servicing capacity. This mounting government debt poses a painful choice for developed countries that would lead to slower growth as record levels of borrowing curtail economic activity.

(click to enlarge)Click to enlarge

During debt crisis, bad debt ends in the books of central bank through Quantitative Easing. Many consider purchase of bad debt by central bank as the ultimate solution, as central bank is bestowed with the power to print unlimited amount of money into the system. Post credit crisis, there has been a great swap of debt from the private to the public sector, with consumers and corporates in the US reducing debt while the public sector has taken on more leverage.

Click to enlarge

Central bank can create only excess liquidity and not wealth

In the initial stages, the losses eat into the equity and accumulated profits. Any losses beyond this absorption capacity lead to inflation. The fiscal deficits of the developed countries are monetized by the central banks. Countries running deficits for longer periods of time would face lengthier monetization process, which leads to explosion of their balance sheet, finally resulting in inflation. Governments whose debt is monetized by central bank with insufficient asset base leads to hyper inflation. The entire process of monetizing government debt takes place in the name of stimulating the economy, new jobs and weaker currency that would keep borrowing rates low.

Now let us look into what happens when bad debt exceeds the loss-absorption capacity? In the event of extreme losses, central bank would be unable to withdraw the excess liquidity created during its asset-purchase programs. The quantity of amount it cannot withdraw due to a lack of assets determines the amount of inflation that will follow. There are 3 ways for central banks to withdraw excess liquidity which has its own drawbacks.



1. Sell assets

Wholesale selling of assets could depress their price

2. Issuing bills

Need for high interest rate to induce banks to park funds

3. Increase minimum reserve requirements

Holding more reserves could prove costly

Click to enlarge

Quasi-bankrupt government coupled with debt monetization by its central bank without sufficient assets could lead to hyperinflation. Currently the balance sheet of major central banks remains bloated.

Click to enlarge

Only a Central with large net wealth and sufficient asset base could stop hyperinflation. However, if the government is broke as well, it cannot recapitalize the central bank. Now let us look for alternative ways to create new wealth for balancing the central bank's assets and liabilities and avoid that dreadful choice? According to an recent article by Caesar Lack of UBS

It turns out that there is - by revaluing gold. Both the US and Europe own significant gold reserves. Contrary to that of all other commodities, the price of gold is primarily determined not by industrial demand or mining costs but by investors. Gold is worth as much as investors believe it is. If central banks can succeed in convincing investors that the value of gold is greater than today's prices, then it is, and new net wealth has been created.

It turns out they can. One can always weaken one's own currency against another currency, and gold can be considered a currency.

SNB proved the same last year when it weakened the Swiss franc by declaring its intention to sell unlimited amounts of Swiss francs. The process which the central bank has to follow is:

  • Set a minimum price for gold.
  • Declare that the central bank would buy unlimited amounts of it at that minimum price.
  • Central banks have the privilege of printing money at will and can never run out of their own currency to buy the gold. This factor adds to its credibility.
  • If the public does not believe in the sustainability of the new price and sells its gold, the central bank purchases all gold offered at the minimum price by printing money, until it has weakened its currency to such a degree that the gold price rises above the minimum threshold.

According to the article, the new minimum gold price must be set such that the revaluation gains balance the combined assets and liabilities of the government, the financial system, and the central bank. The following sensitivity chart gives the factor by which gold prices have to rise for stabilizing the balance sheet. Assume a country gold reserve holding at 5% of GDP and its central bank with a negative net worth at 25% of GDP. This implies that gold prices have to rise by a factor of 25 to bring the balance sheet into balance.

Initially, buying gold by printing new money will be inflationary and weaken the currency further. However, once the new equilibrium gold price is exceeded, the currency can be stabilized. The central bank is solvent again and can stabilize its currency by reducing excess liquidity and raising rates. Note that only central banks of large currency areas, such as the ECB or the US Fed, can revalue gold. If a small central bank tried to do so, it would devalue its own currency rather than revalue gold, and thus inflame inflation in its currency area.

Investment Implications: Readers can refer to my previous article "3 Reasons To Be Bullish On Gold", where I have written about why Gold is gaining importance as a reserve asset and a FX hedge against global currency war. Investors can get exposure to gold using the following ETFs: SPDR Gold Shares (NYSEARCA:GLD), Market Vectors Gold Miners ETF (NYSEARCA:GDX) and Market Vectors Junior Gold Miners ETF (NYSEARCA:GDXJ)

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.