Central banks adding gold and alternative assets to diversify US dollar and euro reserves

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A new report by the World Gold Council, ‘Central Bank Diversification Strategies – Rebalancing from the dollar and the euro,’ examines the growing trend of central banks’ actively looking to diversify their reserve portfolios.

While the dollar is still the primary global currency, its long-term dominance is less certain. In response, central banks are reducing allocations to US dollars and euros while increasing purchases of traditional assets such as gold and Japanese yen and new alternatives including Chinese renminbi.

The official reserves of global central banks have grown from $2 trillion in 2000 to more than $12 trillion in 2012. During this same twelve-year period the data shows significant shifts away from the US dollar while the share of “other” currencies in reserve composition has tripled in absolute terms since 2008.

Gold has a long history as a reserve asset for central banks, and as such is considered a traditional one. Gold is statistically uncorrelated with other traditional reserves and new alternatives, making it one of the most important assets for diversifying out of the US dollar and euro. In line with this trend, central bank gold buying in the fourth quarter of 2012 marked the eighth consecutive quarter of net purchases by the official sector and the highest level since 1964.

Ashish Bhatia, Manager for Government Affairs at the World Gold Council, said: “Building gold reserves in tandem with new alternatives is an optimal strategy as central banks remain under-allocated to gold and many attractive alternatives are either too small or, as is the case with the renminbi, not yet open to broader international participation.”

“Gold has a deep and liquid market with no credit risk, making it one of the most attractive assets for central banks to consider as they diversify away from the US dollar and euro. Gold’s tail-risk hedging properties add to its appeal as a particularly valuable component of a diversified reserve portfolio,” Bhatia added.

The study is predicated on the assumption that central banks will continue to hold 65% of their assets in dollars and euros, while looking for high quality alternatives including Chinese, Canadian, Australian, Swiss, and Danish denominated assets for the balance of their reserves. It quantifies the benefits of these alternatives using portfolio optimisation methodology and examines their diversification benefits while providing context for potential limits to their use due to limited availability or access.

Key findings

nChinese renminbi and Australian assets emerge in this study as important assets for diversification. However, in the portfolio optimisation analysis which took into account market size and access constraints, gold received a prominent 8% allocation, surpassing the 4% allocation to renminbi and 3% to Australian assets. Gold’s allocation was matched only by Japanese yen which was also weighted at 8% of the optimised portfolio.

nDue to the large size of the gold market, approximately $3.2 trillion, central banks have sufficient access to gold for large investments. The gold market is highly liquid with average daily trading volume estimated at $240 billion.

nEmerging market central banks are investing in assets denominated in the following currencies: Canadian dollar (CAD), Australian dollar (AUD), Swiss franc (CHF), nDanish krone (DKK) and Chinese renminbi (CNY). Given part of the strength of alternative assets is related to economic growth and commodity sector strength, these assets also carry risks that are associated more broadly with economic cycles.

nThe size limitation of alternative reserve assets actually re-emphasises the role traditional assets can play in diversification. In the market scenario optimisation, which adjusts for the market size of a particular asset, there is a greater allocation to traditional assets such as gold (8%), JGBs (8%), and Gilts (6%), than to alternatives such as the Swiss franc (1%), Danish krone (1%), and Australian dollar (3%).

nDespite the attraction of the Chinese renminbi market, it remains difficult to access. Foreign investors must be part of the QFII programme which currently consists of approximately 13 central banks and sovereign related entities. Participation by individual institutions is limited to $1 billion, which is too small to provide adequate scale for central banks.

nThis analysis demonstrates that gold and traditional reserve assets can play a complementary role alongside alternative assets as central banks seek diversify their US dollar and euro heavy reserve portfolios. The results suggest it would be prudent for reserve managers to build gold reserves to achieve optimal levels relative to other traditional and alternative reserve assets.