We're not talking about conspiracy here, however, we're talking about stupidity
Somewhere deep in the bowels of the world’s Western central banks lie vaults holding gargantuan piles of physical gold bars… or at least that’s what they all claim. The gold bars are part of their respective foreign currency reserves, which include all the usual fiat currencies like the dollar, the pound, the yen and the euro.
Collectively, the governments/central banks of the United States, United Kingdom, Japan, Switzerland, eurozone and the International Monetary Fund (IMF) are believed to hold an impressive 23,349 tonnes of gold in their respective reserves, representing more than $1.3 trillion at today’s gold price. Beyond the suggested tonnage, however, very little is actually known about the gold that makes up this massive stockpile. Western central banks disclose next to nothing about where it’s stored, in what form, or how much of the gold reserves are utilized for other purposes. We are assured that it’s all there, of course, but little effort has ever been made by the central banks to provide any details beyond the arbitrary references in their various financial reserve reports.
Twelve years ago, few would have cared what central banks did with their gold. Gold had suffered a 20-year bear cycle and didn’t engender much excitement at $255 per ounce. It made perfect sense for Western governments to lend out (or in the case of Canada – outright sell) their gold reserves in order to generate some interest income from their holdings. And that’s exactly what many central banks did from the late 1980s through to the late 2000s. The times have changed, however, and today it absolutely does matter what they’re doing with their reserves, and where the reserves are actually held. Why? Because the countries in question are now all grossly over-indebted and printing their respective currencies with reckless abandon. It would be reassuring to know that they still have some of the ‘barbarous relic’ kicking around, collecting dust, just in case their experiment with collusive monetary accommodation doesn’t work out as planned.
You may be interested to know that central bank gold sales were actually the crux of the original investment thesis that first got us interested in the gold space back in 2000. We were introduced to it through the work of Frank Veneroso, who published an outstanding report on the gold market in 1998 aptly titled, “The 1998 Gold Book Annual.” In it, Mr. Veneroso inferred that central bank gold sales had artificially suppressed the full extent of gold demand to the tune of approximately 1,600 tonnes per year (in an approximately 4,000 tonne market of annual supply). Of the 35,000 tonnes that the central banks were officially stated to own at the time, Mr. Veneroso estimated that they were already down to 18,000 tonnes of actual physical. Once the central banks ran out of gold to sell, he surmised, the gold market would be poised for a powerful bull market… and he turned out to be completely right – although central banks did continue to be net sellers of gold for many years to come.
As the gold bull market developed throughout the 2000s, central banks didn’t become net buyers of physical gold until 2009, which coincided with gold’s final break-out above US$1,000 per ounce. The entirety of this buying was performed by central banks in the non-Western world, however, by countries like Russia, Turkey, Kazakhstan, Ukraine and the Philippines… and they have continued buying gold ever since. According to Thomson Reuters GFMS, a precious metals research agency, non-Western central banks purchased 457 tonnes of gold in 2011, and are expected to purchase another 493 tonnes of gold this year as they expand their reserves.1 Our estimates suggest they will likely purchase even more than that.2 The Western central banks, meanwhile, have essentially remained silent on the topic of gold, and have not publicly disclosed any sales or purchases of gold at all over the past three years. Although there is a “Central Bank Gold Agreement” currently in place that covers the gold sales of the Eurosystem central banks, Sweden and Switzerland, there has been no mention of gold sales by the very entities that are purported to own the largest stockpiles of the precious metal.3 The silence is telling.
Over the past several years, we’ve collected data on physical demand for gold as it has developed over time. The consistent annual growth in demand for physical gold bullion has increasingly puzzled us with regard to supply. Global annual gold mine supply ex Russia and China (who do not export domestic production) is actually lower than it was in year 2000, and ever since the IMF announced the completion of its sale of 403 tonnes of gold in December 2010, there hasn’t been any large, publicly-disclosed seller of physical gold in the market for almost two years.4 Given the significant increase in physical demand that we’ve seen over the past decade, particularly from buyers in Asia, it suffices to say that we cannot identify where all the gold is coming from to supply it… but it has to be coming from somewhere.
To give you a sense of how much the demand for physical gold has increased over the past decade, we’ve listed a select number of physical gold buyers and calculated their net change in annual demand in tonnes from 2000 to 2012 (see Chart A).
As can be seen, the mere combination of only five separate sources of demand results in a 2,268 tonne net change in physical demand for gold over the past 12 years – meaning that there is roughly 2,268 tonnes of new annual demand today that didn’t exist 12 years ago. According to the CPM Group, one of the main purveyors of gold statistics, the total annual gold supply is estimated to be roughly 3,700 tonnes of gold this year. Of that, the World Gold Council estimates that only 2,687 tonnes are expected to come from actual mine production, while the rest is attributed to recycled scrap gold, mainly from old jewelry.5 (See footnote 5). The reporting agencies have a tendency to insist that total physical demand perfectly matches physical supply every year, and use the “Net Private Investment” as a plug to shore up the difference between the demand they attribute to industry, jewelry and ‘official transactions’ by central banks versus their annual supply estimate (which is relatively verifiable). Their “Net Private Investment” figures are implied, however, and do not measure the actual investment demand purchases that take place every year. If more accurate data was ever incorporated into their market summary for demand, it would reveal a huge discrepancy, with the demand side vastly exceeding their estimation of annual supply. In fact, we know it would exceed it based purely on China’s Hong Kong gold imports, which are now up to 458 tonnes year-to-date as of July, representing a 367% increase over its purchases during the same period last year. If the imports continue at their current rate, China will reach 785 tonnes of gold imports by year-end. That’s 785 tonnes in a market that’s only expected to produce roughly 2,700 tonnes of mine supply, and that’s just one buyer.
Then there are all the private buyers whose purchases go unreported and unacknowledged, like that of Greenlight Capital, the hedge fund managed by David Einhorn, that is reported to have purchased $500 million worth of physical gold starting in 2009. Or the $1 billion of physical gold purchased by the University of Texas Investment Management Co. in April 2011… or the myriad of other private investors (like Saudi Sheiks, Russian billionaires, this writer, probably many of our readers, etc.) who have purchased physical gold for their accounts over the past decade. None of these private purchases are ever considered in the research agencies’ summaries for investment demand, and yet these are real purchases of physical gold, not ETFs or gold ‘certificates’. They require real, physical gold bars to be delivered to the buyer. So once we acknowledge how big the discrepancy is between the actual true level of physical gold demand versus the annual “supply,” the obvious questions present themselves: who are the sellers delivering the gold to match the enormous increase in physical demand? What entities are releasing physical gold onto the market without reporting it? Where is all the gold coming from?
There is only one possible candidate: the Western central banks. It may very well be that a large portion of physical gold currently flowing to new buyers is actually coming from the Western central banks themselves. They are the only holders of physical gold who are capable of supplying gold in a quantity and manner that cannot be readily tracked. They are also the very entities whose actions have driven investors back into gold in the first place. Gold is, after all, a hedge against their collective irresponsibility – and they have showcased their capacity in that regard quite enthusiastically over the past decade, especially since 2008.
If the Western central banks are indeed leasing out their physical reserves, they would not actually have to disclose the specific amounts of gold that leave their respective vaults. According to a document on the European Central Bank’s (ECB) website regarding the statistical treatment of the Eurosystem’s International Reserves, current reporting guidelines do not require central banks to differentiate between gold owned outright versus gold lent out or swapped with another party. The document states that, “reversible transactions in gold do not have any effect on the level of monetary gold regardless of the type of transaction (i.e. gold swaps, repos, deposits or loans), in line with the recommendations contained in the IMF guidelines.”6 (Emphasis theirs). Under current reporting guidelines, therefore, central banks are permitted to continue carrying the entry of physical gold on their balance sheet even if they’ve swapped it or lent it out entirely. You can see this in the way Western central banks refer to their gold reserves. The UK Government, for example, refers to its gold allocation as, “Gold (incl. gold swapped or on loan).” That’s the verbatim phrase they use in their official statement. Same goes for the U.S. Treasury and the ECB, which report their gold holdings as “Gold (including gold deposits and, if appropriate, gold swapped)” and “Gold (including gold deposits and gold swapped),” respectively (see Chart B). Unfortunately, that’s as far as their description goes, as each institution does not break down what percentage of their stated gold reserves are held in physical, versus what percentage has been loaned out or swapped for something else. The fact that they do not differentiate between the two is astounding, (Ed. As is the “including gold deposits” verbiage that they use – what else is “gold” supposed to refer to?) but at the same time not at all surprising. It would not lend much credence to central bank credibility if they admitted they were leasing their gold reserves to ‘bullion bank’ intermediaries who were then turning around and selling their gold to China, for example. But the numbers strongly suggest that that is exactly what has happened. The central banks’ gold is likely gone, and the bullion banks that sold it have no realistic chance of getting it back.
Our analysis of the physical gold market shows that central banks have most likely been a massive unreported supplier of physical gold, and strongly implies that their gold reserves are negligible today. If Frank Veneroso’s conclusions were even close to accurate back in 1998 (and we believe they were), when coupled with the 2,300 tonne net change in annual demand we can easily identify above, it can only lead to the conclusion that a large portion of the Western central banks’ stated 23,000 tonnes of gold reserves are merely a paper entry on their balance sheets – completely un-backed by anything tangible other than an IOU from whatever counterparty leased it from them in years past. At this stage of the game, we don’t believe these central banks will be able to get their gold back without extreme difficulty, especially if it turns out the gold has left their countries entirely. We can also only wonder how much gold within the central bank system has been ‘rehypothecated’ in the process, since the central banks in question seem so reluctant to divulge any meaningful details on their reserves in a way that would shed light on the various “swaps” and “loans” they imply to be participating in. We might also suggest that if a proper audit of Western central bank gold reserves was ever launched, as per Ron Paul’s recent proposal to audit the U.S. Federal Reserve, the proverbial cat would be let out of the bag – with explosive implications for the gold price.
Notwithstanding the recent conversions of PIMCO’s Bill Gross, Bridegwater’s Ray Dalio and Ned Davis Research to gold, we realize that many mainstream institutional investors still continue to struggle with the topic. We also realize that some readers may scoff at any analysis of the gold market that hints at “conspiracy.” We’re not talking about conspiracy here, however, we’re talking about stupidity. After all, Western central banks are probably under the impression that the gold they’ve swapped and/or lent out is still legally theirs, which technically it may be. But if what we are proposing turns out to be true, and those reserves are not physically theirs; not physically in their possession… then all bets are off regarding the future of our monetary system. As a general rule of common sense, when one embarks on an unlimited quantitative easing program targeted at the employment rate (see QE3), one had better make sure to have something in the vault as backup in case the ‘unlimited’ part actually ends up really meaning unlimited. We hope that it does not, for the sake of our monetary system, but given our analysis of the physical gold market, we’ll stick with our gold bars and take comfort as they collect more dust in our vaults, untouched.
2 See notes in Chart A.
5 Mine supply estimate supplied by World Gold Council; YTD gold mine production data suggests that total 2012 gold mine supply will come in lower around 2,300 tonnes, ex Russia and China production. In addition, Frank Veneroso has recently published a new report that warns that the supply of recycled scrap gold could drop significantly going forward due to the depletion of the inventories of industrial scrap and long held jewelry over the past decade.