World central banks attempting to diversify their reserves along with other demand factors like investment demand, access to investments (provided by ETFs) and hedging by institutional players like pension funds have been a cause of the current gold price spike. It was reported by Bloomberg on October 31, 2010, that Iran has changed some 15 percent of its foreign exchange reserves into gold and will not need to import the metal for the next ten years (citing Central Bank Governor Mahmoud Bahmani).
Further, a state-run news agency also reported that Iran’s gold reserves have multiplied several times in the past two years. From calculated numbers it seems that Iran may have around 300 tons of gold reserves at around 12% of estimated foreign exchange reserves of $100 billion. This is only the tip of the iceberg as many other central banks have also been trying to diversify their reserves. From “World Gold Council” and IMF reported data, it appears that:
Central banks will keep diversifying their reserve holdings into gold without trying to convey any price information to the market.
US dollar part of reserves has seen most of diversification as dollar reserves have declined more than euros and other currency reserves. Expectation of further weakness of dollars may exacerbate this trend (a positive feedback)
China, Middle Eastern countries, Russia and India will stay as most aggressive diversifiers of their reserves into gold.
(Click to enlarge)
Forex Reserves
According to the IMF, prior to the financial crisis in 2008, world reserves peaked at $7.5 trillion. Between September 2008 and March 2009, they declined by 4.3 per cent, largely as a result of countries’ efforts to stem currency depreciation. According to IMF data, global foreign exchange holdings have gone up by more than 3 per cent in the first six months of 2010, from $8.17 trillion at the end of 2009 to $8.42 trillion at the end of June 2010. The euros’ share in the forex reserves of these countries is up by over 11.63% from Q2 2007, to 25.15%. By contrast, the share of the US dollars has declined by 4.55% to 64.66%. The emerging markets showed a smaller increase in their Euro holdings. While the Euros’ share in their reserves increased by 2.75% to 29.51%, the dollar’s share fell by 6.46% to 58.04%. 
(Click to enlarge)
The second set of figures has only limited significance, though; especially since lately the emerging markets have only given a breakdown of 40% of their forex reserves, as opposed to 86% in the industrial countries. The developed countries have seen their gold reserves decline by 1.72%, from 712.4 million ounces to 700.2 million fine ounces. By contrast, the gold reserves of the emerging markets have risen from 140.2 million to 170.1 million, i.e. by more than 21.37%.
(Click to enlarge)
Gold Reserves
There are no hard and fast rules for how much a country should hold in reserves. Commonly-used benchmarks include a sufficient amount to cover external debt coming due within 12 months, or enough to cover three to four months of imports. Countries hold reserves for a variety of reasons, including for day-to-day transactions like debt repayment. Some governments also hold reserves as a form of self-insurance against sudden loss of investment flows that could cause a financial crisis. Gold reserves held by central banks are estimated at 30,462 tons, which is estimated to be 18% of all the gold reserves in the world. Majority is held by US (8,135 tons), Germany (3,406 tons), IMF (2,981 tons), Italy (2,451 tons) and France (2,435 tons). World gold reserves as a percentage of world forex reserves were declining until Q3 2005, remained flat until Q3 2007 and started rising after that – about the same time as the parabolic run in the gold price started.
(Click to enlarge)
Global forex reserves rose to $8.42 trillion by the end of H1 2010, more than replacing the amount drawn down during the depths of the recession, according to IMF statistics ($11 trillion in total). Nearly all major reserve-holding economies resumed building stockpiles starting in April 2009. Some countries also used a portion of their reserves to fund stimulus programmes. Russia’s reserves showed the biggest decline, dropping $120.1 billion over a seven-month period. From IMF and WGC data, there appears to be enough momentum for diversification of the reserves for Russia, China and Middle East (which hold almost 50% of world forex reserves).
Effect on Gold Price:
From data published by World Gold Council and IMF, Russia, China, India, SE Asia and Middle Eastern central banks had been most aggressive diversifiers of their reserves since 2007. Assuming that other parts of the world will not diversify into gold and that the current slow diversification momentum (China, India, Russia and ME) into gold continues at the current pace, i.e. if China increases gold as percentage of total reserves by 50 bps (have risen from 0.8% of total reserves to in Q1 2007 to 1.4% of total reserves in Q2 2010), Russia 100 bps (gold % of total reserves have risen from 2.1% in Q1 2007 to 5.3% in Q2 2010), India 100 bps (gold as % of total reserves have risen from 3.1% in Q2 2007 to 7.1% in Q2 2010) and Middle Eastern Oil exporters by 50 bps (risen from 2.7% in Q2 2007 to 4.9% in Q2 2010).
The combined effect of these changes at current gold prices is $37 billion, whereas the current market cap of GLD is $56 billion. Marginal investment of $34 billion from pension funds, $605 billion (.05%) from other managed money may mean further upside to gold prices. If diversification is 5%, may require an inflow of $5 trillion. The current value of gold mined to date is around $6 trillion. On the marginal supply side we have observed a steady pick up in gold recycling (scrap) as result of higher gold price but it may be too small to cover the kind of diversification demand required by managed money and central banks.
(Click to enlarge)
Disclosure: Author long GLD
