These days, central banks worldwide have worked up a good appetite for gold. Pictured here are bullion bars at the Rand Refinery in Germiston, South Africa. Image used for illustrative purposes. Image Credit: Bloomberg

Switzerland’s central bank, the Swiss National Bank (SNB), is expected to report net profits for 2019 following a net loss in 2018. The SNB cited income from its different foreign holdings as well as the appreciation in value of its holdings of physical gold.

Those holdings exceeded 1,000 tonnes in 2019 and made up more than 5 per cent of total reserves held by the bank. Other central banks, including those of China, Russia, India, Turkey, Poland, and Kazakhstan have also been shoring up their reserves by buying into the bullion.

Demand for gold, which caused its price to increase from the $1,200-1,300 level per ounce to the $1,500-1,600, has been fuelled by multiple factors.

One, the expected downturn in financial markets and the move by investors from other financial instruments to gold-related ones, such as Exchange Traded Funds (ETFs). In a recent report by the World Gold Council, such ETFs witnessed a growth of 14 per cent, resulting from net inflows of $19.2 billion.

Two, the trade conflict between the US and China and the uncertainty associated with it. Three, the geopolitical unrest in the wider Middle East region.

Hoarding pays off

Quite interestingly, the spike in gold price is also partly augmented by supply limits, with Russia buying most of its domestic production. According to Bloomberg, using data from the International Monetary Fund, Russia’s reserves of physical gold increased both in quantity and in value, exceeding $100 billion as of 2019. The Bank of Russia did earn billions of dollars as a result of its approach, with the price of gold surging by more than 15 per cent in 2019 alone.

Now, regardless of what’s driving the demand in gold and the increase in its price, this is an ensuing trend that has seen the price of gold climbing significantly from the fourth quarter of 2018 to the first quarter of 2020. Although investors could have triggered the trend as they fled other investments to gold, such a trend could only be exacerbated by governments through their central banks, diversifying their reserves by buying more physical gold.

Selling at the top of price curve

In fact, and in an analysis that I conducted five years ago on central banks and their reserves, today’s trend in purchases of physical gold by central banks is synonymous of ones witnessed over past decades. This has been especially true from 1960 onwards.

That is, and even when investors buy into gold because of the above-mentioned reasons, central banks are more interested in the diversification aspect and in making money out of their physical gold holdings. Given that central banks are more able to make bulk purchases, this also positions them best to make money from an upward swing in the price of gold.

Evidently, this is why central banks, including those identified earlier, have been buying into the current upward trend.

Not only that, but for most of the central banks included in the analysis, the decision to purchase physical gold or to offload it was based on fluctuations in its price rather than any other geopolitical factor. Similarly, and despite what may be reported, the decision today by central banks to buy or sell physical gold is driven by profitability first and foremost, unlike factors that drive other investors’ decision.

Diversification comes in second and is dependent on the central bank’s strategy with regards to its forex holdings and whether or not its country’s currency is pegged to another currency. The move into physical gold is anyway made possible by divesting holdings in foreign currencies, which may as well be based on which direction their related interest rates will take and the subsequent effect on their values.

Finally, analysts are predicting that the price of gold may reach the $2,000 per ounce level within the next two years if the current macroeconomic situation continues unabated. This is more so the case with $14 trillion to $15 trillion in negative yielding government debt, as reported by Deutsche Bank, and with central banks easing their monetary policies.

To conclude, the current increase in gold price is a trend that has been shaping over the past two years, and not a mere spike. While investors may have prompted such a trend, it is now owned and fuelled by central banks. Therefore, the prospect of gold breaking its own historic record is not a farfetched one.

The last thought that I want to leave you with: How will central banks offload their holdings of physical gold in a seller’s market?

- Abdulnasser Alshaali is a UAE based economist.