Central Bank Gold Operations And Its Ramifications, Part - 3

Gold Price "Management" By Central Banks

August 10, 1997

The following rhetoric is quoted from "The Bullish Case for An Imminent Gold Rally" -- as taken from the WWW. Unfortunately, I do not remember the name of the author. Although these are not the fruits of my research, I nonetheless concur with all. If any reader knows the source, please advise the GOLD-EAGLE - and full credits will be given this insightful investigative work.

"CENTRAL BANK GOLD RESERVES DATA"

"World gold reserves as a percentage of monetary reserves were 64% in 1960, dropped to 32% in 1971, rose to 67% in 1980, and has fallen back to a very low 20% in 1995.

Asian gold reserves as a percentage of total reserves is now at a very low 5.2%. China, India, Indonesia, Japan, Korea, Malaysia, Pakistan, Philippines, Singapore, and Thailand combined held 1,086 tons in 1976 when gold was US$176 which was 12.1% of their total reserves. When gold shot over $600 in 1980 they held 1,764 tons for 37.4% of their total reserves. The amount of gold held has risen steadily to 1,972 tons in 1995 representing only 5.2% of their total reserves! The Asian central banks have continued to add gold to their reserves but at a much lower rate than the rate they're accumulating paper, backed by the full faith and credit of the US government, in the form of dollars and US Treasuries.

Central banks sell forward and write call options to earn premium income. Gold is usually loaned by central banks and borrowed by jewelers, speculators - and increasingly since the late 1980s, by mining companies. This year mining company borrowings have jumped unbelievably, to about 700 tons. Also, the gold derivative positions held by Latin American central banks have become huge and are growing. To offset the risk of purchasing gold calls dealers go short (or borrow) gold to hedge their call exposure. The Bank of England numbers suggest the combination of central bank and speculator gold borrowings may have exceeded 700 tons in an 18 month period (1995-1996). Some central bank short positions are well in excess of their reserves. Brazil is a typical example. The largest country in South America has reportedly sold gold calls against 100% of its gold reserves! INDEED A DANGEROUSLY INSANE POSTURE!

Central banks sell forward and write call options to earn premium income.

Some mining companies have hedged their full production for the next five to ten years. These gold-loan contracts are typically between a commercial bank, which lends to the gold mining company, and a central bank. The short term contract binding the commercial bank and central bank is only for a few months at time. The commercial bank profits by charging the mining company a short-term loan rate of about 6% minus the gold loan rate paid to the central bank. In 1994 this paid an effortless 5% but now pays much less. When the commercial banks decide they can't make enough profit to bother, the mining company will have to return the gold - that they have not yet mined - to the central bank. However, since they've already sold their production for the next few years they will have to buy the gold on the open market where it is becoming more scarce all the time as demand continues to outpace mine supply. Per world acclaimed gold expert Frank Veneroso, the annual production deficit (demand minus supply) is on the order of 1,000 to 1,400 tonnes - with no sign of abating.

During November and December 1995 South African mining company JCI sold forward 227 tons, their entire Western Areas mines gold production for the next 8.5 years. THIS IS THE LARGEST FORWARD SALE YET AND IS EQUIVALENT TO THE ANNUAL PRODUCTION OF AUSTRALIA, THE WORLD'S THIRD LARGEST GOLD PRODUCING COUNTRY.

THIS IS LUDICROUS! The Financial Times describes the sale as potentially putting a cap on the gold price due to heavy supply, whereas, in reality it just caps and potentially inverts the earning power of JCI. Other recent South African forward sales include Gencor's 90 tons for six years, Anglo American's 35 tons at $429 "in order to rescue the risk in the future of the profit margin squeeze experienced over the past two years". Randgold sold 3.26 tons for six months in the face of sliding profitability. Randgold's previous management had been ousted in 1994 due to their forward sales practice and history may be about to repeat itself.

These forward sales are extremely bullish in the long-term, because as gold rises in the next few years, these hapless and short-sighted gold producers will be forced to frantically scramble to cover their short-positions - which will add fuel to the raging fire under gold prices. The executives of these companies will come under tremendous shareholder pressure if gold prices rise above $429. In order to keep their jobs they'll have to try to increase earnings which they locked in at the forward sales price, less any increase in the short term notes. Demand may increase rapidly when these squeezed mining companies enter the open market to buy gold bullion to replace central bank loans.

The Russians were so desperate for hard currencies they sold their gold reserve down from a typical 2,500 tons to 115 tons, or, from 8.3% of world gold reserves to 0.4%. Russian gold production fell 10% in 1995 amid rising production costs. Recent reports from the CIS suggest gold production continues to decline - due to political and economic instability. The Russians have nothing left to sell to depress the gold price - and the Asians continue to buy gold.

Many central banks, especially in Latin America, are loaning out their gold to major gold mining companies that have sold it forward for years to come at less than US$400. They've also written many call options against it. When the gold rally breaks $420, or so, they're going to have to cover those shorts and the short-covering burst phase of the rally will kick in. As previously mentioned, the largest country in Latin America, Brazil, has sold calls on 100% on its total gold reserves. THIS IS FINANCIALLY LUDICROUS! Conceivably, this could explode the value of the yellow metal to $500+ within a very brief period.

Ian McAvity (renowned Canadian gold expert) points out that "if, as, and when gold exceeds the first two major resistance price levels of $405 and $509 gold will take off like a scalded cat." In early 1993 the volatility was down to 6.5% and rose to over 16% by the end of the year. It hit 22% at the end 1990. Volatility is likely to triple back to a more typical historical value as a result of a significant price change. If gold goes over $420, short-covering will begin in earnest and the rally will really get interesting. An $80 rally would have a profound effect on the price of unhedged gold mining companies.

Many central banks, especially in Latin America, are loaning out their gold to major gold mining companies that have sold it forward for years to come at less than US$400.

 

According to Jim Rogers we have worldwide low production capacity, worldwide growth in demand, and a worldwide surge in liquidity. Saudi Arabian King Fahd's successor Crown Prince Abdullah is expected by some to tighten oil supplies to drive up the price which could exacerbate rising inflation rates worldwide. As evidence of this inflationary scenario Michael Rouzee compiled a population-weighted gold index expressed in the local currencies of ten countries: Britain, China, Germany, India, Indonesia, Japan, Mexico, South Africa, Egypt, and the United States. China represents 40% of the index, India 30%, and Germany, Japan, and the US combined only 15%. This gold index has more than tripled since 1982 while in dollar terms gold has been virtually flat. There are by far more gold buyers, and potential buyers, in developing countries that have experienced a gold bull market, than there are in the post-peak economies of the world.

If that's not enough, then traditional safe haven concerns such as North Korea massing troops near the 38th parallel (DMZ) or press reports that China is menacingly rattling its sabers in front of Taiwan continue to remind the world of the need for gold as a store of value and the precariousness of fiat currencies. And not too long ago China and Japan entered the fray in their dispute over the sovereignty of a few islands. It's a potential powder-keg - which bodes well for the noble metal."

Gold is using for heat dissipation in some cars.