The world is undergoing challenges to many traditional notions. Longstanding safe havens have become less reliable, the international monetary system will likely shift away from a U.S. dollar-dominated model and political uncertainty looks set to be the norm. Under these circumstances, the case for holding gold as a strategic investment asset is clear. For institutional investors seeking to navigate current geopolitical and economic challenges, gold may provide a means to counteract the unpredictable path of the U.S. dollar and other world currencies. As the world becomes less predictable, gold may be one of the few assets that can continue to safeguard long-term value. This is best reflected by the pace of central bank gold buying that is at the fastest in decades.
In the second quarter, central banks' net purchases of gold totaled 224.4 metric tons, bringing total net purchases for the first half of 2019 to 374.1 metric tons, which is the highest year-to-date net purchase of gold by central banks since 2010. This follows a record-breaking year of central bank gold buying in 2018 when a total of 651 metric tons of gold was bought, the highest since the end of gold's linkage to currency in 1971. In addition, the diversity of buyers has also notably improved. In 2016, demand was highly concentrated in Russia, China and Kazakhstan. By 2018, it had become far more diverse, with 19 individual central banks buying over one metric ton of gold, according to International Monetary Fund data. Countries such as India and Egypt that had been absent from the gold market for many years became notable buyers of gold and even European Union members re-emerged as a net buyer, due to substantial purchases from Poland and Hungary.
There are several reasons behind the phenomenon of central bank gold buying, chief among which is the growing headwinds on the U.S. dollar as the world's reserve currency. In the U.S., the federal deficit is at levels seen only during wartime and this is further exacerbated by a willingness of the Federal Reserve to weaken the currency via unconventional monetary policies. Meanwhile, currency tensions and trade wars also cloud the horizon, giving impetus to a policy of de-dollarization as countries look to reduce their exposure to the U.S. dollar. Russia, which faces sanctions and restrictions on U.S. dollar-based transactions, has significantly decreased its U.S. Treasury holdings while regularly adding gold to its reserves. Dmitry Tulin, the first deputy governor of the Bank of Russia, stated that gold has become a strategically important asset because it is a "100% guarantee from legal and political risks."
Headwinds for the U.S. dollar also stem from the shift in economic power to East from West. China is now the world's largest economy on a purchasing-power parity basis and will continue to be a key driver of global growth for years to come. This reconfiguration of the global economy and China's rising global footprint will have an impact on the use of the renminbi outside of its borders. In 2016, the renminbi was included in the IMF's special drawing rights basket and since then, its share in official reserves has surpassed those of the Australian dollar and Canadian dollar, standing at 1.95% as of March 31. It is therefore likely that the renminbi will play an increasingly large role in the international monetary system, a transition that may be accompanied by market turbulence from destabilizing speculative flows that would weigh on the U.S. dollar.
Having said that, while the Chinese government is keen to continue the internationalization of the renminbi, perhaps for trade reasons, its currency's global usage is still in its infancy with less than 2% of global foreign-exchange reserves being denominated in renminbi. This is perhaps reflective of the long road ahead for the renminbi to become a truly international currency: Its exchange rate would need to be market determined, the capital account would need to be opened and the current account would need to run a deficit. Considering the challenges facing the U.S. dollar, the hurdles still in the path of the renminbi's ascendancy, and the ongoing structural problems besetting the euro and the Japanese yen, it is clear that gold will have a larger role to play as a reserve currency in the years to come.
From an investment standpoint, in the era of historically low interest rates — the total amount of negative yielding debt in the world is currently at $16.72 trillion, investors, in their hunt for yield, have been increasingly compelled to take on riskier debt or long-duration sovereign bonds such as Austria's 100-year bond that could have price volatility comparable to equities.
With U.S. equities now at record valuations after the longest bull run in history, and vulnerable to an unpredictable geopolitical climate, the relative risk/reward of investing in gold looks increasingly positive. Throwing into the mix the strong underlying demand from central banks that will likely continue, the demand dynamics for gold are also very favorable. The merits of holding gold may already be familiar to seasoned investors, but what makes gold truly stand out from other alternative assets is the structural changes taking place in the world today that have elevated the precious metal's importance to long-term investors.
Shaokai Fan is director, central banks and public policy at the World Gold Council, based in Singapore. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.