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Gold plays an important role in central banks’ foreign reserves – BIS white paper

Thu Nov 26 2020


Gold's role in a nation's foreign exchange reserves is not expected to diminish anytime soon, according to a recent working paper from the Bank of International Settlements (BIS).


In a recent research report from BIS, analyst and author Omar Zulaica said that determining the amount of gold in a reserve portfolio is not a trivial matter and depends on the purpose and implementation of the reserve management. Zulaica suggested in his report that in the current environment, central banks could continue to add to their gold reserves.


Zulaica noted five key findings in his research into gold as a reserve asset. First, the negative market news, he noted that from a market perspective, because gold's volatility doesn't do well in a low-duration reserve currency fixed income portfolio.


However, an increase in duration and gold can have positive effects on a portfolio.


"For higher durations, gold can provide an effective hedge against the portfolio's sensitivity to changes in yields. This is evidenced by increases in portfolio duration beyond two years, which can give support to gold holdings above 10% of total FX reserves, on average," he noted.


Zulaica added that gold is an important diversification tool not just in the long-term but for nations that don't have reserve-currency status and high volatility. He noted a 20% position on average in gold might be optimal in cases where the numeraire is a commodity currency or one from an Emerging Market economy.


As global economic conditions deteriorate, Zulaica said that a 20% to 50% position in gold "as a rainy day fund" may be adequate in the presence of elevated yield sensitivity or exchange rate risks.


Zulaica also concluded that gold's "insurance value" could lead to higher allocations in a reserve portfolio, particularly in the current low interest rate environment.


Zulaica said that gold's role in a portfolio also goes beyond the traditional "risk/reward" evaluation. He explained that there are intangible benefits that go beyond FX reserve diversification and that aren't easily captured by standard metrics.


"The possibility of large-scale, adverse non-financial events may lead to further reflection. For example, a major war, a period of very high inflation, or – speaking to more recent events – a systemic cyberattack or a global pandemic may give central banks enough reason to hold on – if not add – to their bars of gold," he said. "Indeed, in highly adverse scenarios, a country's stock of the precious metal could be one of the ultimate means to ensure confidence in the stability of its finances. The relatively high gold allocations observed in practice, therefore, may be a measure of the importance attached to these broader considerations within the reserve management community. There is more to gold than risk and return."