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Central Banks and Gold: Why Countries Hoard Precious Metals
By Victor Rosario MONEY RESEARCH COLLECTIVE
In the aftermath of the industrial revolution, much of the richest countries’ official reserves consisted only of gold. This changed in the latter half of the 20th century, when the world’s leading economies shifted to an economy based on fiat currencies.
Although no country operates on a pure gold standard anymore, many central banks have large amounts of gold reserves as a safeguard against the threat of economic crisis. Read on to learn more about the history of central banks hoarding gold and the reasons why they do it.
Why central banks buy gold
Central banks buy gold for several key reasons, as gold plays an important role in the global financial system.
Hedge against inflation
As commodities that cannot be artificially inflated, gold and other precious metals such as silver work as a safeguard against the rising interest rates of fiat currencies such as the U.S. dollar. Gold has been known historically to be a “safe haven” asset, maintaining its value during periods of economic instability.
Diversification of assets
Gold is said to have an inverse relationship with the U.S. dollar: it typically rises when the dollar drops in value as entities buy gold to hedge against inflation. This means buying gold can be a good investment to avoid total dependence on the U.S. dollar and is a practice in de-dollarization, which many countries find useful in times of economic uncertainty.
Insurance against government instability
In times of budget deficits or during a financial crisis, a country can sell some of its gold reserves to prevent defaulting on its debt. Political turmoil, sudden changes in government policies and wars can all lead to unforeseen dips in fiat currencies. Gold provides protection in what can be a fickle economy, especially in unstable political landscapes.
Recent history of central banks hoarding gold
The way we look at gold and the U.S. dollar changed dramatically with the signing of the Bretton Woods agreement after the Second World War. Then, it changed again with the replacement of this system in favor of fiat currencies.
The gold standard era
In 1944, during the latter stage of World War II, 730 delegates from 44 countries representing the allied powers met in Bretton Woods, New Hampshire. The goal was to determine what rules and institutions would regulate the emerging international financial system after the war.
Many countries blamed the economic tensions rising out of the First World War as one of the main reasons the Second World War happened in the first place. The Bretton Woods agreement stipulated that participating countries would guarantee convertibility of their currencies into U.S. dollars within 1% of fixed parity rate and the dollar would be convertible to gold at a rate of $35 per troy ounce.
This allowed countries to make gold purchases from the U.S. Treasury and tied the U.S. dollar to the value of gold, creating a “gold standard” for most developed countries. The agreement also created the International Monetary Fund and the World Bank to monitor exchange rates and lend money to countries, as they could not devalue their currency in order to fight inflation.
The Bretton Woods agreement stood as established until the U.S. ended the convertibility of the dollar to gold in 1971.
After the Bretton Woods system
The Bretton Woods system forced the Federal Reserve to continuously increase the money supply in the U.S., running a trade deficit to provide Europe its reserve currency needs. European pressure and the growing cost of the Vietnam War led to the depreciation of the U.S. dollar and the eventual end of the gold standard in the U.S. economy.
The U.S. dollar became a fiat currency and most of the world powers followed, with the gold standard being largely abandoned afterwards. Nonetheless, countries have continued to build on their physical gold reserves to protect their interests, settle international debts and resist the hegemony of the U.S. dollar in national bank reserves.
The U.S. Treasury has the most gold holdings of all countries, with over 8,100 metric tonnes of gold. However, other countries such as China, Turkey and India have been aggressively buying substantial amounts of gold in the last decade.
Why countries hoard precious metals FAQs
Why are China and Russia buying so much gold?
Gold is traditionally a hedge against inflation and is inversely associated with the U.S. dollar. China and Russia do not have large gold reserves compared to other economic superpowers, leading them to heavily invest in gold in the last decade. Russian and Chinese interests also seek de-dollarization to prevent U.S. hegemony.
How do geopolitical tensions contribute to the appeal of gold as a safe asset?
Unstable political landscapes, especially in financial markets where currencies are used as foreign exchange reserves, can lead to an increase in gold demand. This can counterbalance the instability of a fiat currency such as the U.S. dollar.
How does the accumulation of gold reserves by central banks impact the global economy?
The downturn of foreign exchange reserve currencies such as the U.S. dollar usually results in a surge in gold prices, as many entities, including central banks, choose to invest in stable assets to offset inflation.
What is the trade association for gold?
The World Gold Council is an international trade organization for gold. Its members are gold mining companies and the organization is headquartered in London.