Financial markets have a nasty habit of proving eminently logical decisions utterly wrong. Take the 1999 decision by Gordon Brown, the British Finance minister at the time, to sell more than half his government’s gold reserves. The right of currency holders to turn paper into gold at central banks had long since ceased — ending gold’s special position as a form of reserve currency and removing an essential reason for governments to keep it. All things considered, Lenin’s famous suggestion that all gold should be melted down to build public lavatories seemed a tad less absurd than before.
In the late ’90s many financial experts agreed that because governments no longer had a technical reason to hold gold, it seemed best for them to sell it before its real value fell even further. Responding to this new view, Brown asked the Bank of England to off-load 395 tons of it from the government’s vaults, and the central bank won plaudits for selling slowly to prevent sharp price drops.
But shortly after the bank had finished, the commodity entered a nine-year bull market. Gold reached a record nominal high above $1,900 an ounce in early September before dropping to $1,600 an ounce later in the month. The U.K. achieved an average sale price of merely $275 from 1999 to 2002. Had it waited until late last month, the U.K. would have made about $21 billion — six times the $3.5 billion it earned by selling when it did.
China and India have recently followed the opposite course to Brown’s by aggressively building reserves. The Reserve Bank of India bought 200 tons of gold from the IMF in 2009. The People’s Bank of China has increased stocks to more than 1,000 tons since 2003. Both countries have made a notional profit, as the price has kept climbing. When India bought from the IMF, the price was still only about $1,045 — allowing India to earn an extremely high return. Gold now accounts for 8.5 percent of India’s foreign currency reserves and as high as 88 percent of the reserves of Western governments that did not sell as aggressively as the U.K. under Brown.
Should governments take the bet of buying gold even now, after such sharp price rises in recent years, in the expectation that it will resume its upward trajectory? Olivier Accominotti, a gold expert at the London School of Economics, says the gold market finds particular strength when interest rates are low, because this reduces the cost of holding a commodity that does not earn interest.
Central banks will need to ramp up borrowing costs when strong economic growth returns — especially if global commodity prices continue to ascend, keeping inflation above central banks’ targets.
