I recently wrote an article detailing why foreign central bank buying of gold would ultimately be bad for gold prices. The theory is simply that foreign central banks are buying gold as part of its monetary policy, not for investments. By buying gold, central banks can inject currency into the economy without distorting the relative valuation of its currency with others. If a foreign bank uses forex instead of gold, the impact is skewed towards the currency it is selling. Gold is a great way to manage a money supply without dramatically impacting relative exchange rates. It is a rather benign tool, and impacts all currencies relatively equally. It is also a great way to accumulate US dollars in an emergency.
I recently wrote an article detailing an investment thesis that central bank, especially the Chinese central bank or PBOC, buying of gold will likely turn out bad for gold prices. The article got the expected negative comments, but the theory I outlined was and is solid. The theory is simply that central banks don't buy gold as an investment, they buy it as part of a broader monetary policy. Central banks aren't into commodity speculation, they are into maintaining stable growth, full employment and price stability. The decision to buy or sell gold by a central bank isn't influenced by the price of gold, or at least it shouldn't be. Central banks will sell gold when they have to in order to curb inflation and slow growth, or buy gold in order to weaken its currency and stimulate economic growth. Central banks don't have a profit motive, they get to print money, so gains made on gold are irrelevant to the implementation of the chosen monetary policy.
Just recently, Russia's conflict with Ukraine highlighted how foreign nations manage their money supply and relative value/exchange rate of its currency.
Moscow - Russia sold a record $11.3 billion in foreign currency to support the ruble on March 3, when the ruble came under unprecedented pressure due to concerns about conflict in Ukraine, central bank data showed on Wednesday.
The above quote could just have easily replaced "foreign currency" with "gold." During the panic, the Russian central bank sold foreign currency in order to take rubles out of circulation, shrinking its supply, and propping up its value relative to the foreign currency it was selling. A single day took $11.3 billion out of Russia's reserves. It wouldn't take many more days like that before Russia was out of foreign currency reserves and would need to start selling gold.
The Russian central bank sold foreign currency to buy rubles and prevent the Russian currency from falling further in value, after the market reacted with panic to parliamentary approval for President Vladimir Putin's request to allow military action in Ukraine on what has been dubbed "Black Monday."
Yes, gold did rally on the initial news report of Russia's hostile actions, but that was a fear play, not a monetary play. Had Russia been selling gold instead of currency, it is unlikely gold would have rallied like it did. The big threat to gold is if Russia decides to fund its aggression by selling gold.
In fact, the Russian central bank has recently started to reduce its gold holdings. The following quote also highlights how the value of gold is intimately tied to the "Taper."
Russia reduced gold reserves for the first time in a year in September as Mexico cut holdings for a 17th straight month, according to the International Monetary Fund. Kazakhstan expanded assets for a 12th month.
Reserves in Russia declined about 0.37 metric ton to 1,015.1 tons, data on the IMF's website showed. Kazakhstan's holdings expanded 2.52 tons to 137.04 tons, the data showed.
Gold dropped in September for the first loss in three months as the U.S. Federal Reserve unexpectedly refrained from slowing its $85 billion in monthly bond purchases.
The Russian central bank only has $480 billion in foreign currency reserves, so clearly it wants to avoid any more "colossal" mistakes.
Russian news agencies said that the amount of foreign currency sold by the central bank on Monday was by far the most since records began, beating the previous record from September 2011 some five times.
Traders had already indicated the Russian central bank had made colossal interventions on Monday but this was the first time the bank's own data confirmed the magnitude of the activity.
The colossal intervention appears to have been successful, with the ruble rate now stabilizing after "Black Monday," when the Russian currency crashed in value and Russian equity markets also tumbled over 10 percent.
It was announced that China may have its first major domestic bond default this week. Depending on how the markets take that action, China may be forced to intervene into their markets much like Russia did.
China Is Headed For Its First Domestic Bond Default - And Here's Why That's A Good Thing
Chinese solar company Shanghai Chaori Solar Energy Science and Technology Company announced that it cannot pay interest in the amount of 89.8 million yuan (approx $14.6 million) on its 11 Chaori bond, that are due on March 7...But the solar company became another victim of China's excess capacity problem...But the bond default might actually be a good thing. "A normal economy needs defaults to better price bonds and other debt products," writes Ting.
Unlike 2008 when the US Federal Reserve dramatically intervened into the markets using US dollars and US Government Bonds as its tools of choice, many foreign central banks hold gold along with foreign exchange, so when a crisis hits them, they may sell gold to stabilize their financial crisis. Even if the central bank doesn't want to, once they run out of foreign currency they may be forced to. The point being, financial crises in the emerging market economies may have the exact opposite impact on the price of gold that the 2008 crisis did.
Disclaimer: This article is not an investment recommendation or solicitation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice. Past performance is no guarantee of future results. For my full disclaimer and disclosure, click here.
Disclosure: I am long GLL. 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.
Additional disclosure: I own calls on GLL.