Will gold be money again?

By P. Samarasiri

A brief history of gold as money

The world moving away from the barter system, where commodities were directly exchanged for trade, was looking for something as money to be exchanged in between trade. The latest period of evolution of money was linked to gold. This resulted from the high asset value attached to gold by the public as gold was scare, long lasting, and producible in small pieces and as precious jewellery.

At the beginning, gold coins were physically used as money. Later, in the 17th century in London, receipts issued by goldsmiths (people who engaged in the gold jewellery industry) to their clients for deposits of gold the clients made for the safe-keeping of gold with goldsmiths became money. These clients started using such gold deposit receipts as money for their trade and loan transactions in trust of their gold deposits which were 100% guaranteed by gold.

Since goldsmiths experienced that only a small portion of gold deposits with them was withdrawn daily and there was no expectation that all gold deposits would be withdrawn at once, they started issuing fictitious gold receipts to their gold borrowing clients. The public who accepted gold receipts as money believed that those gold receipts could be exchanged for gold over-the-counter at any time by presenting them to goldsmiths who issued such receipts.

Later emerged banks and central banks that issued currency notes of their own as promissory notes on gold payable upon demand (similar to a cash cheque payable in cash upon demand). Such period of evolution of money backed by gold was known as the ‘Gold Standard’.

A new version of the official global ‘Gold Standard’ started when the International Monetary Fund (IMF) was established in 1947 on the Bretton Woods Agreement among 44 countries. Under the Bretton Woods system, a gold pegged/linked exchange rate system was introduced.

As the leading member, the US agreed to fix their exchange rate as US$ 35 = one ounce of gold and buy and sell gold at that rate between other member countries of the IMF. Therefore, the amount of the dollars in circulation in the world was believed to be backed/guaranteed by gold at a particular exchange rate. In turn, other member countries fixed their exchange rates of local currencies against the dollar and their central banks issued local currencies at those exchange rates when they buy or receive dollars from the banks.

The source of dollars to those countries was the gains on international trade and borrowings. This international monetary system was known as the ‘Gold Exchange Standard,’ where the world money/currency system was indirectly linked to gold through the US Dollar. This gold backed world currency/money system ended on 15 August 1971 when the US stopped the gold convertibility of the dollar after increasing the dollar-gold exchange rate (devaluing the dollar) several times due to later developments in excessive printing of dollars without gold and increasing trend of countries to convert dollars into gold from the US central bank.

Meanwhile, central banks in the world too had already started printing/issuing paper money as per provisions given in the respective legislations. Accordingly, central banks now issue high security paper notes and low-valued metal coins as money based on the assets they create or buy. Such assets are gold and foreign exchange (foreign reserves) they buy and loans they grant to banks and governments.

Customarily, central banks continue to hold gold as a part of foreign reserves and, therefore, the currency (money) system is linked to gold only to the extent of such gold holding. The rest of the currency is mostly backed/created by non-physical financial assets (i.e., credit) acquired by central banks. The public also hold gold primarily to perform a function of money as a liquid (easily saleable) store of wealth/value. Meanwhile, gold continues to be traded in financial markets along with other financial products where investors move among gold and other financial products depending on the comparative profits.

World trend of gold supply, demand and price

At present, there is a market concern of low prices of gold prevailing since the beginning 2012 as against the world ever highest gold price of US$ 1,900 per oz reported in mid 2011 in New York market. By 15th April, 2013, the New York gold price plummeted to US$ 1,352 by 29% from the peak in mid 2011. The reasons for such a plunge are being analysed by the market analysts and investors and several predictions are made as to what the price trend will be in the immediate future.

In economics, the price of anything is determined by the various factors connected with demand for and supply of it, all of which may not be captured by the analysts. If the demand falls relative to the supply, the price should fall and vice versa. In 2011, the both supply of and demand for gold increased while they fell in 2012, but at different volumes. Therefore, the net impact on the price depends on the net change in demand and supply which reflects the net of opposite impacts on price.

In 2011, the net gold demand increase (demand increase less supply increase) was 274 tons, resulting in a significant price increase (see Table 1). In contrast, in 2012, the net gold demand decline was 114 tons, leading to a reduction in gold price. This decline in demand primarily took place in investment demand (by 165 tons) where the share of investment in total gold demand fell to 35% in 2012 from 38% in 2010 (see Table 2).

However, gold demand for central banks’ reserves continued to increase. This increase mainly came from central banks in emerging economies. However, gold holdings of those central banks in reserves are individually less than 5% whereas central banks in developed countries hold gold in reserves between 20% and 80%. For example, 75% in the US, 72% in Germany, 71% in Italy, 70% in France, 90% in Portugal, 59% in Netherland and 55% in Austria.

As at end of March 2013, total gold reserves held by central banks were 31,695 tons whereas nearly 61% of such reserves was held by the US, Germany, IMF, Italy and France. Emerging economies tend to hold more financial assets in hard currencies such as US$, Euro, Sterling Pounds and Yen in their foreign reserves compared to gold. Therefore, money and foreign reserves in emerging economies are less gold backed as against the developed countries whose the physical gold coverage of money is significantly high.

World gold price trend

Historically, there has been a rising trend in gold price with a number of short periods of price cycles from time to time. The gold price started moving above US$ 100 from 1973. During 70 years from 1900 to 1970, the gold price has been below US$ 40. From 1979 to 1980, the price has sharply increased to about US$ 615 and then plummeted to around US$ 272 in 2001. From 2002 onwards, a continuously rising trend of the price was seen up to third quarter 2011 recording the world ever highest of US$ 1,900 and then started moderately declining in a few cycles.

In August-September 2011, the price rose faster above the trend and declined cyclically in the second quarter of 2012. The current price cycle started with a decline of US$ 438 from US$ 1,790 in early October 2012 to US$ 1,352 on 15 April 2013, the biggest two-day fall in 30 years (12 and 15 April 2013). During the last 10 years up to the highest point of US$1,900, the price has increased from US$ 330 level by US$ 1,569 or 475%. However, the increase up to 15 April 2013 is US$ 1,022 or 310%.

During the 10 years from 2003 to 2012, the world annual gold demand has increased by 1,212 tons (from 3,194 tons to 4,406 tons), which is more than double the increase of world gold supply by 516 tons (from 3,937 tons to 4,453 tons). Therefore, as usual this increasing price trend should continue even in future due to faster increase in gold demand relative to lower increase in gold supply constrained by the limited production of gold due to natural factors. As such, sooner or later in the immediate future, the gold price has to increase. In fact, the price has increased by US$ 128 to the level around US$ 1,480 as at the end of fourth week of April 2013. During last six months, the gold price has fluctuated between US$ 1,752 and US$ 1,600 before the price started plummeting beginning April 2013. The decline in the price in April alone by 15 April 2013 is about US$ 248.

According to some market analysis, the recent plunge in gold price is due to a market correction from the price overshooting seen in 2011. This view is not acceptable as the decline has occurred with a significant time lag after a few price cycles in 2012 and first quarter 2013. Further, the market goes on its own way unless intervened and price overshooting or slums or normal trend is own behaviour which cannot be prejudged.

The significant price fall in 2012 towards the first half of April 2013 could be a result of speculative investors who attempted to reduce the price in order to buy and stock gold at lower prices as indicated by the significant fall of demand for gold investments. This may have been motivated by the expectation that in future the gold will have significant position in money and financial markets.

One such indication is the increase in gold reserves by central banks in 2011 and 2012. Their share in gold demand has increased from 2% to 12%. If central banks continue to increase gold holdings against which they print money, they may be looking for a near gold standard to support the public confidence in the paper money based on physical-value underlying the money.

Further to this trend, there is a possibility that gold may become a type of money again among the public. This has already begun to some extent. For example, laws were passed in Utah State of the US to legalise gold and silver coins as money. Recently in Arizona State, a bill was passed to take effect in 2014 to permit people to use precious metal as money among the people who accept such precious metal money. In the States of Minnesota, North Carolina, South Carolina, Idaho and Colorado in the US, lawmakers have been debating on similar laws in recent years.

The experiences in financial crises that eroded the value of monetary and financial assets within a short-period, fear of such worse crises in future and monetary easing/excessive printing of money that has been taking place in last six years in the US and Europe which may continue in the foreseeable future until those economies recovers last five-year recession may also encourage the public to use gold as a safe asset.

The gold money may consist of standardised gold coins of different denominations for physical exchange among transactions or transfer of value electronically based on gold held at depositories. Accordingly, if gold may not perform as a medium of pricing of goods and services, there will be exchange rates between gold and other currencies in circulation.

All gold holders and gold analysts at present are concerned about what the near future gold price trend will be. In terms of the historical gold price trend and demand and supply factors, there is no issue of the gold price getting back sooner or later to the rising trend in the future. However, the price getting back to the normal trend around US$ 1,800 based on recent prices requires an increase of nearly US$ 320. Already, the gold price has reached US$ 1,470-1,480 (even passed US$ 1,480) by end of April reversing from the US$ 1,352 on 15 April 2013.

However, the price resurgence may not be on a smooth line because of speculative short-term market forces and would be a combination of a few short-term price cycles as seen in the past because speculative investors generally try to make profit out of short-term price fluctuations. They may keep buying to push the prices up and sell at high price to make profits, which will push the prices down for them to start buying again. However, it is opportune for long-term investors to buy gold now if they are prepared to hold on to gold until it reaches the price at the normal trend in the near future.



(The writer is Assistant Governor and Secretary to the Monetary Board of the Central Bank and Chairman of the Sri Lanka Accounting and Auditing Standards Monitoring Board. The views stated are his personal views.)