Central bankers return to gold and dollars

Submitted by cpowell on 07:50AM ET Saturday, July 11, 2009. Section:

A second lesson is that in an extreme crisis, there is no alternative to the US dollar. Indeed, far from needing a new "super-sovereign currency," most central banks need more US dollars. Moreover, those dollars need to be invested in the safest instruments possible, namely US Treasury bills, notes, and bonds. All other assets in a crisis are ineffective.

A third lesson is that where higher return is still a valid objective, there must be something more appropriate than GSE debt. Higher-yielding, implicit government-guaranteed bonds still have allure -- but a 14 per cent allocation is excessive, and it feeds into global imbalances. US authorities will need to review their strategy for the US housing agencies. Foreign central banks are unlikely to participate as they once did in an expanding GSE business model.

A fourth lesson is that gold is shifting back from a sovereign reserve asset central banks were inclined to underplay to one of growing, strategic interest. This shift is logical; gold remains the world's primary financial asset that is no one's liability. In the past few months China has reported a rise in its official gold holdings of 15 million troy ounces (about 450 tonnes), more than the amount sold by the UK, Spain, and the European Central Bank combined in the previous six years. Despite this massive addition, China's gold allocation has risen from less than 1 per cent to only 1.6 per cent, a fraction of the amount commonly found in Europe and the US. With China holding 20 per cent of total international currency reserves, where it goes, others take heed.

In the worst crisis in decades, central banks found their new wealth in conflict with their primary function of maintaining orderly markets and supporting the global banking system. The impulse to protect their owned capital collided with more pressing responsibilities of calming the credit markets and stabilising systemically important financial institutions. "Excess reserves," US dollars and even gold are now seen as extremely useful, counter-cyclical tools for future crises. One should expect the world’s fastest growing institutional client segment -- that is to say, central bank reserve managers, not hedge funds or even sovereign wealth funds -- to have more of all three in future.

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The writer is global head of sovereign client services at UBS Investment Bank.