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Gold Offers Diversification For EM Central Banks As They Add Alternative Reserve Assets - WGC

By Debbie Carlson of Kitco News
Wednesday March 13, 2013 7:00 AM

(Kitco News) - It’s no secret that central bankers in emerging markets have sought to add gold to their reserve assets in an effort to diversify their portfolio holdings from traditional holdings like U.S. dollars and euros.

Central banks bought about 534 metric tons of gold last year, with the bulk of the buyers from emerging markets. In addition to buying gold, they are adding other reserve assets like Canadian and Australian dollars and to an extent, Chinese renminbi. By adding these alternative reserve assets, they are lowering the total amount of U.S. dollars and euros the emerging-market central banks hold.

A new study from the World Gold Council, the promotional group for the gold industry, suggests that emerging-market central banks’ holdings can benefit from having an 8% gold allocation as part of their total reserves.

The study assumed that central banks will continue to hold 65% of their reserve assets in U.S. dollars and euros, and using portfolio optimization analysis, the study sought to find the best mix for the remaining 35%. The study looked at both traditional assets such as Japanese yen, British pound and gold, which have been held by central banks in the past, plus other currencies that have started to become part of reserves, such as Chinese renminbi, Canadian and Australian dollars, Swiss francs and Danish kroners. Those currencies are in demand because of strong returns in recent years and strong economic fundamentals.

Under a “blue sky” scenario, where the only consideration is portfolio optimization, renminbi, the Australian dollar and gold took the top three spots in the 35% portfolio allocation, at 13%, 6% and 5%, respectively. However, the study also looked at market liquidity and the allocations reshuffled to put yen, gold and sterling as the top three preferred assets, at 8% each for gold and yen, and 6% for sterling. Of the 65% allocation to the U.S. dollar and the euro, the U.S. dollar took 47% of the allocation and the euro had 18%.

Under the “blue sky” scenario, the portfolio optimizer selected China and Australia for their highest recommendations because of their highest yields, at 3.3% and 2.9%, and it shows a strong role for alternative assets in portfolio diversification.

Although gold’s return in the past several years has been strong, for the study, the WGC gave gold a reduced return of 2% with the assumption that it would at least perform at the level of the Federal Reserve’s long-term inflation target. That yield put it high middle-range of the other assets included. Using Barclays Capital Aggregates from January 2005 to October 2012 to determine estimates for volatility and correlations between reserve assets, gold’s volatility was put at 20%. That was the highest of all the assets studied.

Even though gold had a lower yield input of 2% and the highest volatility, the model still ranked gold above the Canadian dollar, Japanese yen, British pound, Swiss franc and Danish kroner in the blue sky scenario because of the metal’s diversification properties.

“That’s the beauty of gold. It’s an asset that’s not correlated with any other asset,” Ashish Bhatia, manager for government affairs at the World Gold Council, told Kitco News in an interview.

MARKET CONDITIONS A FACTOR

An optimal portfolio may rank renminbi high for portfolio diversification, but central banks must take into consideration market conditions when selecting assets. The idea behind holding reserve assets is that they are easily sold if need be. The problem with loading up with alternative assets like the renminbi or the Australian dollar is that the market size is much smaller than it is for traditional assets, and they may be more correlated with riskier assets.

Considering central banks hold hefty pools of reserves, selling or exchanging those assets in the market could unintentionally affect market performance. The study adjusted the optimization analysis to take into considering market size. 

When the study was rerun, optimal holding were shifted to allocate 8% each to yen and gold, 6% to the British pound, with the Canadian dollar at 5%, the renminbi at 5%, the Australian dollar at 3% and kroner and Swiss franc at 1% each.

The rerun study still makes the case for alternative assets, but also suggests that emerging-market central banks should give greater consideration to the traditional reserve assets, too.

“The Chinese renminbi, the Australian dollar and the Canadian dollar all have attractive fiscal conditions, but (the market liquidity is small) so it’s not practical to hold so much,” Bhatia said.

Finally, the study showed that many of the currencies, like renminbi, and the Canadian and Australian dollars, have a higher correlation with economic growth and commodity market sector strength. That can make them more susceptible to price swings, as measured by the MSCI World Index and the S&P GSCI Commodity Index.

For the full study, see www.gold.org

Optimal Reserve

 

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By Debbie Carlson of Kitco News dcarlson@kitco.com

Disclaimer: The views expressed in this article are those of the author and may not reflect those of Kitco Metals Inc. The author has made every effort to ensure accuracy of information provided; however, neither Kitco Metals Inc. nor the author can guarantee such accuracy. This article is strictly for informational purposes only. It is not a solicitation to make any exchange in precious metal products, commodities, securities or other financial instruments. Kitco Metals Inc. and the author of this article do not accept culpability for losses and/ or damages arising from the use of this publication.

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