Central Banks, Bullion Banks and the Physical Gold Market Conundrum
Tuesday, July 16, 2013
Eric Sprott & Etienne Bordeleau
The recent decline in gold prices and the drain from physical ETFs have been interpreted by the media as signaling the end of the gold bull market. However, our analysis of the supply and demand dynamics underlying the gold market does not support this thesis.

For example, Non-Western Central Banks have been increasing their holdings of gold at a very rapid pace, going from 6,300 tonnes in Q1 2009 to more than 8,200 tonnes at the end of Q1 2013 (Figure 1a) while physical inventories are declining (Figure 1b) (or being raided, as we argued in the May 2013 Markets at a Glance)1 and physical demand from large (Figure 1c) and small (Figure 1d) scale buyers remains solid.

Figure 1a -1b
Figure 1c -1d
Source: World Gold Council, Bloomberg, Hong Kong Census and Statistics Department
Average premium calculated as the average premium for the following 1oz. coins, as reported by the Certified Coin Exchange (CCEX): American Eagle, Maple Leaf, Krugerrand, Philharmonic, Panda, Isle of Man and Kangaroo. 
In previous articles we have argued that Western Central Banks have been filling the supply gap to satisfy the demand for physical gold.2 As shown in Figure 1a above, the official amount of gold held in the Western Central Banks and international institutions like the IMF has been steadily declining since 2000, only to stabilize at around 23,500 tonnes since 2008. Officially, this gold has primarily been sold by continental European Central Banks under what is known as the “Central Bank Gold Agreements” (CBGA) (also known as the Washington Agreement on Gold).3 Under this agreement (which expires after five years and has been repeatedly renewed since 1999), the “undersigned institutions will not enter the market as sellers, with the exception of “already decided sales” and “The signatories to this agreement have agreed not to expand their gold leasings and their use of gold futures and options over this period”. Sales under the CBGA are shown in Figure 2 below.
Source: World Gold Council4

The two points referenced above are particularly interesting because gold leasing (or swaps) has been the primary instrument used by central banks and bullion dealers to suppress the price of gold over time (Alan Greenspan testified, on 24 July 1998, to the House of Representatives that “central banks stand ready to lease gold in increasing quantities should the price rise”).5

It is important to remember that bullion banks (members of the London Bullion Market Association, or LBMA) hold gold in their vaults for their clients.6 Most of those clients, according to the LBMA, deposit their gold (or purchase gold) through an LBMA bank, for example ScotiaMocatta, in what is called an unallocated account.

This is an account where specific bars are not set aside and the customer has a general entitlement to the metal. It is the most convenient, cheapest and most commonly used method of holding metal.7 However, what the LBMA doesn’t say is that, just like regular fractional banking, the bullion bank does not need to keep the whole value of the gold deposit in gold, but only keeps a fraction of it in its vaults, hoping that not all depositors will request their gold at once.

This creates a potential shortage of physical (and an increasing supply of paper) gold and is one reason why bullion banks sometimes need to lease gold from central banks. Leasing gold is analogous to a swap or a collateralized loan, where a Central Bank gets cash in exchange for gold as collateral, and pays an interest rate on the cash loan.

The gold leasing mechanism works in the following way (also shown in Schema 1 below):8

A Central Bank leases its gold to a bullion bank for a pre-specified period (say 1 month). In exchange, the Central Bank receives cash for the value of the gold and has to pay the Gold Forward Offered Rates (GOFO) to the bullion bank. Then, the Central Bank lends the cash on the market and receives LIBOR for 1 month, with net proceeds of LIBOR minus the GOFO, which is called the lease rate. If the lease rate is positive (and it usually is), then it is profitable for the Central Bank to lease its gold. A high lease rate increases the incentive for Central Banks to lease their gold.

The bullion bank, once it receives the gold from the Central Bank, sells it on the gold spot market and collects the cash (depressing the price in the process by increasing supply in the market). For the bullion bank, this transaction is cash flow neutral and pays a carry (the GOFO rate) (the bullion bank can also buy the gold forward one month to make this a risk free transaction, or hope the price of gold stays constant or declines when it’s time to buy it back). Thus, the GOFO rate is a measure of “how much the bullion bank desires physical gold”. If it is small (relative to LIBOR, which implies a large lease rate), the bullion bank wants gold. If it becomes negative, then it means the bullion bank is ready to pay (negative carry) the Central Bank for the privilege to lease its gold (presumably to deliver physical gold to clients that redeem physical gold from their unallocated accounts).


In theory, at the end of the month, the bullion bank buys the gold back from the market and gives it back to the Central Bank. If the bullion bank repurchases the gold from the market, there is no net effect on overall gold supply. We say in theory because, as highlighted above, the language used in the CBGA hints at something else.

It is our hypothesis that, in practice, the bullion banks do not purchase the gold back in the market at the end of the lease to give it back to the Central Banks. Instead, they only roll the transaction over with the Central Bank, resulting in gold IOUs (paper gold, referred to as “gold swapped or on loan under Central Bank accounting jargón, in other words, a claim on gold that someone else holds) instead of real bullion in the Central Bank’s vaults. This can be seen in Figure 3 below. There is a clear negative relationship between the amount of gold leaving the vaults of the New York Federal Reserve Bank (other Central Bank’s official gold reserves) and the lease rate (how much carry a Central Bank owns by leasing out its gold). To us, this is a clear indication that Central Banks have been leasing out their physical gold against IOUs from their bullion bank partners.

Figure 3_2
Source: Federal Reserve Bulletin, Foreign Official Assets Held at Federal Reserve Banks, Earmarked Gold & LBMA. The 1-month lease rate is shown as an annual average.

Also, oddly enough, it seems from Figure 3 that the gold bull market started at about the same time (mid-2001/early 2002) as Central Banks and Bullion Banks stopped flooding the market with leased gold.

Another interesting observation is that the timing of official sales by European Central Banks and the International Monetary Fund (IMF) (Figure 2) do not really correspond with the outflows from the NY Fed’s vault (where most of the world’s Central Banks’ gold ex-US is stored; about 30% by our calculations). This is where the “already decided salesconcept referred to earlier comes into play.9

According to the IMF, they disposed of 403.3 tonnes of gold between 2009 and December 2010.10 However, the net outflows of gold out of the NY Fed’s vault were zero for those two years (and the NY Fed is the main vault for the IMF).11 If this rather large quantity of gold did not come from another vault, then it is plausible that it came out of the NY Fed’s vault, which experienced a net drawdown of 408 tonnes in 2007-2008, a full two years ahead of “official schedule”. Given this inconsistency, it is reasonable to believe that the IMF leased its gold reserves (in the manner explained above) to tame the gold market and rescue the bullion dealers, which probably got a lot of physical gold redemption requests they couldn’t meet during the financial crisis. Then, later on, they “sold” their paper gold to the dealers to net the IOUs and settled in cash.
A similar observation can be made of the European Central Banks’ CGBAs, which all happened well after all the gold outflows from the NY Fed’s vaults.

We are of the opinion that this is what an “already decided sale is: a Central Bank leases gold to a bullion dealer, that dealer sells the gold (or delivers it to a client) but never pays back the Central Bank its physical gold. Then later on, to balance things out, the Central Banks declare officialsales” of gold, but all that changes hands at that point is paper gold and cash, the real gold is long gone.

Lessons for the current market

It is important to remember that the bullion dealers are the same banks that are deemed too big to fail by their respective governments. Thus, it is very unlikely that Central Banks would abstain from intervening à la Greenspan in order to save their bullion bank partners from a “bullion run” (analogous to a bank run). On the contrary, if the bullion dealers get in trouble because their reserves of physical gold are too small to match redemptions of physical (anecdotes) and risk a bullion run, Central Banks will use their firepower and “stand ready to lease gold in increasing quantities should the price rise” (Greenspan, 1998).

The thing is, it might not be that simple anymore Since the beginning of the financial crisis, we have seen unprecedented demand for physical gold (see Figure 1a-d above) while at the same time, gold miners are shutting down mines and Central Banks have been relatively quiet in terms of official gold sales (Figure 2) (depressing supply). In fact, the announcement by the German Bundesbank (the second largest gold reserve in the world according to IMF data) that they would repatriate their gold from the NY Fed’s vaults can be seen as a sign that European banks are no longer as keen to lease (or swap) out their gold.12 Other very detailed documents released at the same time show that since 2008, the Bundesbank has not made use of gold leases or swaps.13 To us, this signals that Central Banks are less and less willing to participate in the gold leasing scheme.

Still, the price of gold has experienced a large decline over the past few months, only slightly recovering over the past 2 weeks or so. Given the strong physical demand, we think that this decline was engineered by a bullion bank that flooded the COMEX (paper market), only to then redeem physical gold from the various available sources at depressed prices (i.e. ETFs, see our discussion of this topic in the May 2013 Markets at a Glance). To further support our price manipulation hypothesis, we overlay the 1-month GOFO rate with days where the gold price suffered significant declines (more than 3%) in Figure 4. Unless it is the actual price drop that sparks all this increased demand, it seems counterintuitive that the gold price would decline precipitously before large declines in the GOFO rate, which implies increased demand for physical gold from bullion dealers.
Figure 4_2

It now seems that bullion banks are in desperate need of bullion, as evidenced by the increasingly negative GOFO rates we are seeing (Figure 4 below). Remember that a negative GOFO rate signifies that the bullion banks are ready to pay holders of physical to lease their gold, in this case for a month.

Historically, negative GOFO rates have happened in very few occurrences. The last one was in November 2008 at the height of the financial crisis and after which gold rose 156% from through to peak. Before that, we saw negative GOFO rates in March of 2001 (about the start of the bull market) and September of 1999 (announcement of the first CBGA).

In our view, the bullion banks’ fractional gold deposit system is testing its limits. Too much paper gold exists for the amount of physical gold available. Demand from emerging markets, who do not settle for paper gold, has perturbed the status quo. Thus, our recommendation to investors is the following: empty unallocated gold accounts and redeem your gold in physical form (while you still can), invest in allocated, physically backed products (like the Sprott Physical Bullion Trusts) or in those that have access to physical gold in the ground (gold miners).

3See https://www.gold.org/government_affairs/reserve_asset_management/central_bank_gold_agreements/ for a discussion of the history of the Central Bank Gold Agreements (CBGA).
4Signatories to the third Central Bank Gold Agreement which commenced in September 2009. The signatories include: ECB, Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, Netherlands, Portugal, Slovakia, Slovenia, Spain, Sweden, Switzerland. Estonia became a signatory upon joining the Euro in January 2011.
6The bullion dealers are: Bank of Nova Scotia–ScotiaMocatta, Barclays Bank Plc, Deutsche Bank AG, HSBC Bank USA, NA and Société Générale
8For more on this topic, see “On the Lease Rate, Convenience Yield and Speculative Effects in the Gold Futures Market”, Swiss Finance Institute Research Paper Series 09-07. ,http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1365180
9We would like to acknowledge the use of this blog as a source of inspiration: http://victorthecleaner.wordpress.com/

Markets Insight

July 16, 2013 2:45 pm

Central banks err in over-sharing

The Bundesbank in its heyday back in the 1980s took pleasure in wrong footing the markets with unexpected changes in interest rates. To central bankers of the current generation such behaviour would be regarded as outrageously uncouth and ill-judged. They recall with horror experiences such as the bond market rout of 1994 when an unexpected hike in interest rates by the Federal Reserve was reckoned to have inflicted notable damage on the US economy.
There followed a long period in which the Fed, under the chairmanship of Alan Greenspan, managed market expectations with extreme delicacy. This culminated in the experience between 2004 and 2006 when the Fed raised rates by just 0.25 per cent no less than 17 times. This morally hazardous spoon feeding of the markets facilitated a credit bubble that led to the credit crunch of 2007 and the subsequent financial crisis.

The response has not been to abandon spoon feeding, but to make it more sophisticated. In the current period of unconventional central banking measures we now have forward guidance, whereby policy makers pre-commit to a trajectory in the hope this will lower borrowing costs. The risk in such guidance is that people conclude the economy is weaker than previously thought so a discouraged private sector reduces its spending.

Policy makers have tried to overcome this difficulty by specifying the economic indicators that will dictate their future moves, an approach known in the jargon as state-contingent threshold guidance. Fed chairman Ben Bernanke has provided the most conspicuous example of the genre by tying any retreat from the Fed’s asset purchasing programme to particular labour market and inflation indicators. Yet when he offered a tentative statement about the Fed’s intentions on reducing the rate of asset purchases, bond and stock markets swooned across the world. Why such an extreme reaction?
Part of the explanation relates to market structure. Henry Maxey of the Ruffer fund management group points out that the intermediation capacity of the financial sector has been significantly reduced since the start of the financial crisis.

Because of balance sheet concerns and regulatory pressure, banks are less able to take on big inventory positions to buffer flows. At the same time, he adds, the size of global fixed income markets has grown from around $40tn to $100tn over the past 10 years. This is a destabilising combination, further exacerbated by a hedging dynamic whereby the need to hedge interest rate risk by selling bonds increases as interest rates rise.

So selling begets selling. The result is an extreme over-amplification of marginal changes in US monetary policy.

The combination of quantitative easing and the spoon feeding process is also unhelpful. Since the onset of fiscal austerity, central banks have taken on responsibility for the real economy as opposed to their traditional mandate to address inflation. Market expectations of the central banks are pitched too high. And because markets are so fragile there is a risk that central bankers are over-communicating policy, all of which leads to excessive gyrations whenever a policy maker hazards an anodyne statement.
In fairness, it is very difficult to communicate forward guidance, which is why so many statements in both the US and Europe have been botched. Consider the European Central Bank’s recent decision to abandon its aversion to pre-committing on future interest rates. ECB head Mario Draghi said interest rates would be maintained at or below their current level for an “extended period”. The definition of an extended period was left unclear. And when ECB executive board member Jörg Asmussen came close to clarifying it, statements had to be put out to declare that Mr Asmussen had not intended to give guidance on the extent of the extended period. Ambiguity and confusion were probably inevitable because of Mr Draghi’s need to secure the support of both ECB doves and hawkish northern Europeans for the controversial policy.

This took place against the background of a fire fighting operation in the US. After the market swoon Fed governors sought to explain that the pace of bond purchasing would be dictated by the economic outlook, not the calendar, and that as long as bond buying continued it would be adding monetary policy accommodation even at a lower level of purchases.

I vividly recall in the early 1970s overhearing at a party the head of public affairs at the Bank of England explaining that his role was to keep in contact with the media and ensure he conveyed nothing of significance. We cannot go back to that. But where transparency is concerned, it is possible in markets to have too much of a good thing.

The writer is an FT columnist 

Copyright The Financial Times Limited 2013.


July 16, 2013, 4:37 p.m. ET

The Fed's Credibility Gap

Shifting Economic Circumstances Are Undermining the Talk of Tapering Bond Purchases


     Having suggested it will start scaling back its bond purchases in September, the Federal Reserve is beginning to look like a taper tiger.

    When the Fed's policy-setting committee met in June, it had a decidedly upbeat outlook on the economy. Household and business spending were on the upswing, it said, and inflation, while low, was getting pushed down by "transitory influences." The projections the Fed released pointed to a stronger economy through the remainder of the year than the bulk of Wall Street economists predicted.

    That was the context for the committee's decision to authorize Fed Chairman Ben Bernanke to say that the Fed could begin winding down its bond-buying program "later this year."

    Since then, the context has changed.
    Bloomberg News
    The Federal Reserve, led by Chairman Ben Bernanke, is starting to look like a taper tiger.

    A week after the Fed met, the Commerce Department said that gross domestic product had grown by an annualized 1.8% in the first quarter, less than its earlier estimate of 2.4%, largely because consumer spending wasn't nearly as strong as it had thought.
    It has lately become clear that growth in the second quarter was also pretty weak, something that might be reflected in Mr. Bernanke's testimony Wednesday before Congress. A series of soft economic reports, including May wholesale inventory figures and, on Monday, June retail sales, led Macroeconomic Advisers to revise down its estimate for second-quarter GDP growth to 0.7% from 1.7% at the start of the month.
    Small wonder investors have lately been marking down their expectations for how quickly the Fed will taper, pushing the yield on the 10-year Treasury note lower.
    Economists hope things will improve in the second half, as the effects of higher taxes and reduced government spending wear off. But what scant data there are suggest it hasn't happened yet.

    Indeed, unemployment claims have lately risen. And Gallup's daily reading on consumer confidence has retreated since late May even as the stock market has rebounded.
    Unless things pick up soon, the Fed will have an increasingly hard time cutting back bond purchases without fostering the impression it is basing policy on Little Orphan Annie expectations for the economy, where better times are always a day away.
    Copyright 2012 Dow Jones & Company, Inc. All Rights Reserved

    miércoles, julio 17, 2013



    China Grows Down

    Andrew Sheng, Xiao Geng

    15 July 2013

     This illustration is by Paul Lachine and comes from <a href="http://www.newsart.com">NewsArt.com</a>, and is the property of the NewsArt organization and of its artist. Reproducing this image is a violation of copyright law.

    HONG KONGFor more than three decades, China’s GDP has grown by an average of more than 10% annually. But former Premier Wen Jiabao rightly described this impressive growth performance as “unstable, unbalanced, uncoordinated, and unsustainable,” highlighting the many economic, social, and environmental costs and challenges that have accompanied it. Now China must choose between the export-based, investment-driven growth model of the past and a new, more viable economic order.
    Cheap credit and perverse incentivessuch as promotions for officials who contribute most to GDP growth – have led to massive but redundant investment, which, in turn, has contributed to excess capacity in manufacturing and infrastructure. This model is not only inefficient; channeling government resources to support investment also undermines China’s social development.
    Given this, China’s leaders have decided to stop using GDP growth as the primary criterion for evaluating officials’ performance. Indeed, the 12th Five-Year Plan, which extends until 2015, aims to shift China’s economy to a new, more sustainable growth model based on quality and innovation, and accepts that annual GDP growth will likely fall to 7% during the transition.
    Most discussion of growth models nowadays is based on work by the Nobel laureate Robert Solow. For Solow, GDP growth is determined by the factor inputs of land, labor, and capital, together with the economy’s total factor productivity (TFP, or the change in output not accounted for by changes in the volume of inputs, but by factors like technological innovation and institutional reform).
    Since 1978, China, by implementing major reforms, has achieved three periods of high TFP growth, each lasting 5-7 years. First, in the early 1980’s, following the introduction of the rural household-responsibility system, which boosted agricultural productivity and released a large amount of unskilled labor to work in the higher-productivity urban and industrial sectors, annual TFP growth accelerated to 3-4%.
    The second such period followed Deng Xiaoping’s southern tour in 1992, during which he emphasized the need to shift to a market-based – albeit state-controlled – system by opening China’s economy to foreign direct investment and establishing special economic zones to help develop export-oriented industries. This time, TFP growth soared to 5-6%, partly owing to the “catching up process facilitated by China’s adoption of foreign technology and know-how.
    Finally, after major reforms of state-owned enterprises (SOEs) and the tax system, China acceded to the World Trade Organization in 2001. With the country fully integrated into global supply chains, TFP growth hit 4%, where it remained until 2007. Since then, however, the TFP growth rate has fallen by almost half.
    Indeed, China’s economy has experienced a significant – and ongoinggrowth slowdown in the wake of the global economic crisis that erupted five years ago. By 2012, human capital’s contribution to China’s GDP growth fell almost to zero, with fixed-capital accumulation accounting for roughly 60% of total growth.

    Large-scale, debt-funded capital investments have raised the country’s credit/GDP ratio to nearly 200%, increasing the financial system’s vulnerability – a development reflected in the recent spike in interbank interest rates.
    In order to achieve more balanced and sustainable GDP growth, China’s leaders must implement a set of deep, comprehensive, and long-lasting institutional reforms aimed at boosting TFP. In particular, the reforms should be designed to facilitate China’s transition from its traditional supply-based growth model, which assumes that building hard infrastructure leads automatically to demand growth.
    In fact, GDP growth may be slowing precisely because existing investment in manufacturing and infrastructure, undertaken largely by local governments and SOEs, does not match the pattern of domestic demand. As a result, China now faces the problem of short-term excess capacity.
    Improving the quality of GDP growth will depend on Chinese leaders’ willingness to enact market-oriented reforms. Rather tan directly driving investment, the state must emphasize its regulatory and enforcement functions, including setting and overseeing standards, building an effective property-rights infrastructure, and managing macroeconomic conditions. At the same time, the state must improve the quality and delivery of education, health care, and security, while minimizing corruption and administrative abuses.
    In short, China must shift its focus from meeting GDP growth targets to creating an environment that fosters innovation and competition, thereby enabling market forces to set prices and allocate resources more effectively. The state would thus become an intermediary agent, facilitating the development of a sustainable economic order in which less is morethat is, a system in which less intervention creates more opportunities for creativity.
    SOEs undoubtedly played an important role in China’s previous growth model, delivering the infrastructure and services that were deemed necessary for the global manufacturing supply chain to function. But access to cheap credit from state-controlled banks creates an incentive for SOEs to generate surplus capacity, which increases systemic risk in the economy. To correct China’s excess-capacity problem would require the relevant enterprises, whether SOEs or private firms, to exit the market.
    Unless China’s leaders implement major structural reforms aimed at establishing a market-based growth model, they will be unable to avoid the “middle-income trap” that has prevented so many developing economies from attaining advanced-country status. The deceleration in GDP growth that such reforms would cause would be more than offset by increased market dynamism and overall economic stability.
    Andrew Sheng, President of the Fung Global Institute, is a former chairman of the Hong Kong Securities and Futures Commission, and is currently an adjunct professor at Tsinghua University in Beijing. His latest book is From Asian to Global Financial Crisis.

    Xiao Geng is Director of Research at the Fung Global Institute.