Driven by increased demand, international gold prices are at record highs, surging over 30 per cent in the past two years.

Limits of the Global Gold Rush

• Price increases have been much sharper in Indian markets.
• The recent price movement contradicts an important theoretical characteristic associated with gold.
• Since gold does not generate any cash flow, the opportunity cost of holding it is low when interest rates are low.
• However, gold prices have increased significantly even as global interest rates are at a multi- decade high.
• Officials at the US Federal Reserve are signalling that interest rates may remain higher for longer.
• Prices have also risen despite a relatively strong US dollar.
• Since gold is a dollar-denominated commodity, prices tend to increase when the dollar weakens.
• One of the main reasons for increasing gold prices is sustained buying by central banks. Even as exchange-traded funds saw an outflow in the first quarter of 2024, for instance, central banks continued accumulating gold.
• According to the World Gold Council (WGC), central banks accrued 290 tonnes of gold during January-March 2024, a record for the first quarter.
• Among the leading buyers were the central banks of China, India and Turkey. Central bank demand is projected to remain robust in 2024.

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But Why Are Central Banks Buying So Much Gold?

• Gold has traditionally been an important part of central bank reserves.
• According to estimates, central banks hold about one-fifth of gold ever mined.
• While several countries were on gold standard in the past, central banks now generally buy gold for diversification.
• Historical data shows gold has a low correlation with traditional assets such as bonds and stocks.
• It is being argued that some central banks are accumulating gold to reduce their dependence on US treasuries for several reasons.
• One is the heightened level of geopolitical tension and fragmentation.
• The seizure of Russia’s foreign exchange reserves by the US and its allies after the Ukraine invasion has raised the fear factor. 
  • About $300 billion worth of Russia’s reserves were frozen by Western countries. A country not on the US side in the geopolitical equation can face similar consequences. Holding gold has no such risks, assuming it’s stored within the country.
• Physical gold has zero default risk.

However, it is worth debating whether gold can emerge as the primary or dominant instrument serving as a store of value for central banks even amidst escalating geopolitical fragmentation and tension.

Can Gold Emerge as the Dominant Instrument for Central Banks?

It may be possible for small countries to shift large parts of their reserves to gold, but not for large central banks with significant foreign exchange exposure. 

• Even after buying large quantities and being one of the largest holders of gold in the world, it constitutes only 4.64 per cent of China’s total foreign currency reserves.
• For the Reserve Bank of India (RBI), which has the ninth largest holding of gold stock among central banks, it constitutes under 10 per cent of the total foreign exchange reserves.
• For Russia, gold is now worth 28 per cent of total reserves.
• There are strong reasons why gold will not replace financial assets in central bank balance sheets in a big way.
• It is worth noting that one of the most “valuable” features of gold is its limited supply. Therefore, a substantial increase in its position in large central bank reserves can significantly push prices and potentially increase investment risk.
  • For instance, if China doubled its gold reserves, it would need all the gold mined for about three quarters.
• Further, central banks like the RBI maintain large foreign exchange reserves to smooth the impact of capital flows on currency.

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Conclusion

Thus, despite increased central bank gold buying due to geopolitical tensions, gold is unlikely to replace financial assets significantly due to its limited supply and investment risks.

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