Note from the editor
The case for gold in the eurozone bail-out
By Jack Farchy
Tuesday November 22 2011
Ever since the eurozone bond markets first started to get the jitters, hedge fund managers have been whispering that gold could play a part in resolving the crisis.
Until recently, this discussion has mainly been the preserve of gold market conspiracy theorists and backbench German politicians.
But now the use of gold to fund a eurozone bail-out is coming closer to reality. Buried within a draft of the European Commission study on joint ‘eurobonds’, reported by the FT this week, is the suggestion that yellow metal could be used as collateral for these bonds.
In order to “enhance” the guarantees on the eurobonds, the draft says, governments could provide collateral, including “gold reserves which are largely in excess of needs in most EU countries”.
Between them, the central banks of the eurozone hold 10,792 tonnes of gold – 6.5 per cent of all the yellow metal that has ever been mined – worth some $590bn.
Let’s be clear: this does not imply central banks are getting ready to sell gold to bail out the eurozone. Beyond the numerous legal problems (selling reserves to fund government borrowing contravenes the Maastricht treaty), gold disposals just looks too desperate.
But bullion could be used as collateral. In fact, if Europe’s politicians truly believe that the problems of larger eurozone countries such as Italy are based on liquidity rather than solvency, the use of gold as collateral could be a neat way to regain the confidence of the bond markets.
For prospective investors (no doubt including emerging market governments, sovereign wealth funds, and the like) the appeal comes from the likely hedge that the gold would provide against a default. If a country like Italy were to default, most analysts believe, the price of gold (certainly when denominated in euros) would go sky high.
For eurozone countries, gold-collateralised bonds could unlock a large pool of new financing. Italy’s central bank, for example, holds 2,451 tonnes of gold, worth roughly €100bn. While that pales in comparison to its total debt stock of nearly €2,000bn, it could alleviate some of the short-term funding pressure.
Italy needs to raise about €600bn over the next three years. If it used the gold as collateral for the first 20 per cent of the new bonds, therefore, it could cover its needs until mid-2014. A successful sale of the gold-backed debt would create a virtuous circle, making it easier to raise money through non-collateralised borrowing.
Such a deal has precedents. Indeed, Italy has done it before, when it received a $2bn bail-out from the Bundesbank in 1974 and put up its gold as collateral.
In 1991, India used its gold as collateral for a loan with the Bank of Japan and others.
And in 2008, according to the World Gold Council, Sweden’s Riksbank swapped its gold to raise cash and provide liquidity to the Scandinavian banking system.
As Paul Mercier, then deputy director of market operations at the ECB, told a gold industry conference in 2009: “In a generalised crisis that leads to the repudiation of foreign debts or even the international isolation of a country […]gold remains the ultimate and global means of payment that is still accepted and it is one of the reasons used by some central banks to justify gold holdings.”
The problem is, as that statement implies, that countries have historically turned to their gold reserves only in the direst of situations. And lenders are likely to require that the gold is moved to a neutral location. India’s move to ship 47 tonnes to the Bank of England in its 1991 deal caused outrage within the country.
Nonetheless, as the eurozone crisis grinds into its third year, it might just be time to dust off those Roman coins in the Banca d’Italia’s vaults.
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