Central Banks and Gold

Central banks hold gold reserves that are designed to build confidence in fiat currency. This confidence is undermined if the price of gold falls significantly or rises significantly. Central banks thus have an incentive to manage the price of gold. Such management is evident in fixed gold prices in the early 20th century, in Central Bank Gold Agreements more recently and in the asymmetric correlation between monthly central bank gold reserve changes and gold price changes. The empirical analysis further analyzes gold lending by central banks, linkages between central banks, bullion banks and mining companies and the gold carry trade. We conclude that coordinated and shadowy gold operations by central banks are necessary for successful gold price and gold reserves management and demonstrate the power of market forces relative to central banks.

Gold is the 3rd largest reserve currency after the US dollar and the euro with the US holding the largest gold reserves at close to 70% of its FX reserves (e.g. World Gold Council, 2011 and 2013). More surprising perhaps, gold is also among the most heavily traded assets in the world. The London Bullion Market Association (LBMA) estimates the average daily turnover at $240bn (LBMA, 2011) which is higher than the global daily turnover of any currency pair except for the dollar/euro, dollar/yen, dollar/sterling and dollar/Aussie dollar (Financial Times, 2011).1 The World Gold Council (2011) also argues that the liquidity and depth of the gold market is no coincidence in the context of gold reserve holdings by central banks as a liquid market is essential for a reserve asset.

Central Banks and Gold