More on Gold Lending (October 22, 2008)
Our last Gold Brief (Gold Plunges – What’s Going On, October 16) generated much interest and questions about the mechanics of gold lending. In that piece, we suggested the recent breakdown in the price of gold was much more a reflection of stepped up central bank lending of gold — and much less a result of actual central bank gold sales or liquidation of long futures positions by hedge funds and other large-scale speculators, both of which seem to have grabbed all of the credit among gold analysts and the financial press.
Central banks, eager to earn a small return on their official reserve holdings, have long been lenders of gold. However, the ownership of gold lent to (or on deposit with) bullion banks remains with the central bank lender. Thus, gold-lending activities are off the books and gold lent continues to be counted by the lender as official monetary reserves. Hence, there is no statistical reporting by any of the central banks engaged in gold lending – and analysts are, like Sherlock Holmes, left to deduce this important piece of the gold-market puzzle.
It is my firm conviction that gold loans to bullion banks in recent weeks and months have been an off-balance sheet tool utilized by some central banks to augment their efforts to provide liquidity to the banking system — since gold lent (placed on deposit) is sold for cash and typically reinvested in U.S. Treasure bills or other securities by the bullion bank/gold dealer.
In the last decade, estimates of gold loans on deposit with gold bankers and bullion dealers have ranged from 4000 tons on up to as much as 16,000 tons. In my view, the true number today lies somewhere in between. By comparison, annual world mine production is less than 2500 tons a year.
Changes in the level of gold loans can and often do have a very pronounced effect on the metal’s price because ultimately the metal is sold in the market, not by the central bank lender but by the bullion bank borrower. Therefore, an increase in outstanding central bank gold deposits should be viewed as additional supply, no different in effect from mine production, scrap recovery, or central bank sales . . . and a decrease in central bank gold deposits outstanding should be counted as a withdrawal or lessening of supply.
When a central bank lends (or deposits) gold with a banker or bullion dealer, what happens next?
The bullion dealer either:
- re-lends the metal (at a higher interest rate) typically to a jewelry manufacturer, other industrial end user, or gold-mining company . . . or
- sells the metal in the physical market, receiving cash (at the current spot price) which it will invest in Treasury bills or other debt instruments (at a higher interest rate than it is paying the central bank on its gold deposit), while at the same time hedging its price risk by purchasing an equal quantity of metal in the futures or interdealer markets.
For the jewelry manufacturer, borrowing gold is an attractive mechanism for financing its gold inventory and, at the same time, avoiding any price risk. The jewelry manufacturer will purchase the gold after it is manufactured simultaneous to its sale of jewelry to its customer, perhaps a jewelry retail chain or department store, at the price prevailing at the time it prices and delivers its manufactured jewelry.
For the gold-mining company, borrowing gold is a means of financing mine development and/or hedging its own price risk. Either way, the mine borrows gold and sells it for cash, with the loan to be repaid from future production. By doing so, it locks in the current gold price and stands neither to win nor lose from future variations in the metal’s price.
If central banks want to push liquidity into the banking system, it makes sense that gold loans would be in their toolbox. At the same time, it makes sense that bullion banks seeking to improve their cash positions would want to borrow as much gold as their central bank (or other institutional holders) are willing to lend.
At times when the demand for gold deposits is high, gold-loan interest rates may rise even when increased gold deposits are forthcoming – and, I think this, along with the rising risk premium attached to rates in the interbank market, explains the recent surge in gold loan rates. I expect with the thawing of credit and a gradual resumption in bank lending, gold loan rates will fall back toward more normal levels.
