Markets and Finance: When central banks turn bull operators

A former colleague from Reserve Bank of India (RBI) was in town last week. My schedule was full and I could not give him any time before 10pm. But the simple soul graciously agreed to drop by my office.

I was so touched by the gesture that I immediately called up my wife and told her that for the weekend we will have a guest for dinner. But after the meeting I changed my mind.

We briefly chatted about our respective careers during the past 18 years.

Probably sensing that I didn't have much to talk about mine, the friend turned my attention on to the changes that have happened at RBI over the years, including the recent purchase of $6.7 billion worth of gold from the International Monetary Fund.

Full circle

He swiftly took me down memory lane, reminding me how the RBI has come full-circle, from a central bank that was forced to sell gold (in 1991 India sold 67 tonnes of gold) to fund short-term import bills, to latterly becoming the ‘smart' fund manager of a nation sitting on $285 billion in foreign exchange reserves.

He went on about the rationale behind the gold purchase, emphasising the rising role of gold in private and government portfolios.

That is when it suddenly struck me, the danger of introducing him to my wife and the possibility of a central bank attestation as to my investment blunders.

(It is another matter that a wave of gold sales in 2000 by the Bank of England was what prompted me to sell her gold and buy shares.)

Without a second thought I decided to cancel the dinner plans.

Spreading forex

I fully agreed with him that the recent gold purchase by RBI is certainly a way of spreading India's forex assets, which are said to be currently over-weighted (more than 90 per cent) towards foreign currency, mainly in the form of US Treasuries.

Central banks across the globe have recently been net buyers of the yellow metal, following almost two decades of selling gold as part of the strategy to diversify their holdings.

It is not difficult to imagine that the recent rise in the price of gold is a response to the weak dollar (which becomes a circular process) and to concerns about long-term inflation.

Many analysts believe that even if the inflation fear fizzles out, and the dollar begins to strengthen, gold is unlikely to lose its sheen in the medium term, precisely because it is the central banks of the world that are backing the current bull-run.

The argument is that central banks around the world are now using the precious metal as a proxy reserve currency.

"The same exposure that keeps those banks from unloading dollars will soon be at work with gold.

The more yellow metal the central banks accumulate, the more they will have to support its price," says Daniel Brebner, a research analyst at Deutsche Bank.

Looks like it may be some time before I can invite my RBI friend home.