What role does gold play in central bank reserves?

Central banks and gold have a long history, although the use of gold as money predates established monetary authorities by millennia. The use of gold by central banks has played a key role in shaping the modern world. The great period of global economic expansion between the end of the Napoleonic Wars (1815) and the First World War (1914) was undoubtedly made possible in part by the introduction of a gold standard, a monetary system in which a country’s currency has a value directly linked to gold. The resulting currency stability allowed for a remarkable period of growing trade and global investment. This coincided with the opening of massive gold deposits in the Americas, southern Africa and Australasia, creating a global expansion by effectively lubricating the world’s money supply. The system was largely controlled by the Bank of England in cooperation with other central banks. This came to an end with the onset of the First World War, when most belligerent nations suspended the free convertibility of gold. During the interwar period, the re-establishment of a gold standard by some nations met with mixed success. By the early 1930s, more and more countries had to abandon the gold standard under the stresses and strains of the Great Depression. After the Second World War, the Bretton Woods system with gold – once again – playing a key role in policies adopted by the world’s major central banks. Bretton Woods was based on an implicit pegging of currencies to gold. The currencies of the participating central banks were pegged either to the US dollar or to the price of gold directly. The system worked because the United States had large amounts of gold reserves. The subsequent currency stability played a major role in ensuring economic recovery after the war. The Bretton Woods system effectively collapsed in 1971 due to inherent contradictions and tensions in the system. Freed from the constraints of Bretton Woods, the price of gold rose considerably over the rest of the decade, largely boosted by double-digit inflation as central banks pursued expansionary policies. The end of Bretton Woods resulted in gold no longer playing a central role in the international financial system, shifting precious metals off central bank priorities. Still, more than five decades after the collapse of the Bretton Woods system, gold continues to play a useful role in the international financial system and constitutes a notable part of global foreign exchange reserves. Official sector purchases of gold are an important, if little discussed, component of gold demand. Together, central banks are the world’s largest holders of precious metals, and their buying and selling decisions can have a significant impact on prices. Every independent central bank in the world holds at least some precious metals. Gold’s status as a currency is therefore confirmed by the fact that precious metals are counted as part of a central bank’s foreign exchange reserves. It is the only commodity currency that has survived as money into the electronic age. This suggests gold’s unique monetary status.

One of the most interesting features of central bank gold reserves is the broad distribution of holdings Last year, central banks accumulated gold at the fastest pace since the late 1960s, a period when the Bretton Woods system was coming to an end. However, the official sector has not always been a precious metal buyer. A long series of gold sales by central banks, which began in 1991, started to taper off at the start of this century.

Table 1: Central bank holdings around the world

Source: IFS, HSBC

The percentage of total foreign exchange reserves held in gold, calculated by the World Gold Council. The value of gold holdings is calculated using the LBMA end-of-month gold price published daily by the ICE Benchmark Administration. In January 2023 the end-of-month gold price was USD 1 923.9/oz. Data for the value of other reserves are taken from the IFS table ‘Total Reserves minus Gold’.

Holdings of gold

One of the most interesting features of central banks’ gold reserves is the wide, varying and uneven distribution of holdings. On average, governments hold around 10% of their official reserves as gold, but this varies widely, and holdings among the world’s central banks are highly skewed (see Table 1). Those in the euro area, including the European Central Bank (ECB), hold significant amounts of gold. The United States and Japan are also significant holders, with the United States being the world’s largest official holder of precious metals, accounting for just under a quarter of all central bank gold. The Central Bank Gold Agreement (CBGA) signatories, which are a subset of the euro area, hold around 30% of all central bank gold. Members of this group were significant sellers during the 1990s and the first decade of this century, and their sales patterns played a role in the bear market for much of that period. The CBGA, which regulated sales by signatories beginning in 1999 and extended every five years for 20 years, officially ended in September 2019. Despite robust purchases in recent years by emerging market (EM) central banks, holdings continue to be considered for OECD banks. As a share of total central bank reserves, gold’s share has also fallen over the decades (see Chart 1).

Why are central banks increasing their gold holdings?

What is the rationale behind a central bank maintaining existing holdings or increasing gold reserves? And what has triggered a renewed period of precious metal buying? Although gold no longer plays a crucial role in international finance, it is still considered a valuable part of a nation’s foreign exchange reserves. Some of the reasons reserve managers choose to hold gold include: – Portfolio diversification.
Gold can act as a portfolio diversifier and reduces the risk of holding other nations’ currencies and debt instruments. Gold purchases can be a way to reduce heavy USD holdings. This seems to be an increasing cause in recent years. – Risk mitigation.
Gold has no counterparty risk, which means that holding gold carries no credit risk. – International payments.
Gold can be used in a balance of payments crisis such as occurred during the Asian crisis of 1997-98 and can be used to cover essential imports or support a domestic currency. It can also serve as collateral for loans.

– Emergency funding.
Gold is reliable in emergencies. In times of national emergency or conflict when national currencies may not be redeemable, gold can be mobilized. – Inheritance
Many developed market central banks hold substantial amounts of gold in the form of inheritance, from decades ago. – Prestige
For some EM central banks, there may be a tendency to mimic OECD gold holdings. Non-OECD central banks, such as the People’s Bank of China (PBoC) and the Reserve Bank of India, are moving up the league tables in terms of central bank gold ownership. While some smaller EM central banks may hold relatively low amounts of physical gold, this can still translate into a large share of their total reserves, given correspondingly low foreign exchange reserves. Gold remains a useful and robust component of a central bank’s portfolio, and holdings at many central banks are far from static. Reserve managers’ decisions on gold allocation depend on a host of factors, including policy objectives, risk tolerance, costs and the like – but the status of precious metals seems rock solid. As the global economy continues to evolve, economic and geopolitical uncertainty appears to be on the rise, creating an atmosphere in which central banks may continue to increase their holdings of gold.

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