14th November 2009, www.lankabusinessonline.com
Sri Lanka's central bank, which maintains a soft peg with the US dollar, said gold would be an 'important anchor' for its foreign reserves, which have zoomed in 2009 with large foreign inflows.Gold has hit new highs in recent weeks, with the US dollar again weakening under extended loose monetary policy, reversing gains made in late 2008.
"In very volatile circumstance across the world you need to have intrinsic value created in your portfolio," Central Bank Governor Nivard Cabraal said.
"In reserve management you have different types of instruments, as well as different types of reserve currencies and reserve positions which will give you a certain balance.
"We took a decision about seven months ago that we would increase our gold portfolio as well."
Gold ReservesOver thousands of years gold has been selected by markets as a preferred medium of exchange and a store of value, which gave stability to economies and protected the property rights of the people by preventing appropriation by the state through inflation.
Unlike limitlessly inflationary paper fiat paper money, it is not possible to increase the supply of gold as and when a government wishes and generate 'inflation' as gold has 'intrinsic value' and is relatively rare and 'costly' to produce.
When the first central banks started appearing in Europe, they were required to exchange paper money for gold on demand. Excessive printing of paper would cause the 'price' of paper would 'fall' and that of gold to 'rise'.
The high price of gold would trigger demands for gold returns under a convertibility undertaking, preventing further printing and a hike in interest rates. The metal therefore acted as a 'domestic monetary anchor' against inflation.
Because the same anchor was used in all countries, exchange rates tended to be fixed, unless money printing forced a 'devaluation' against gold.
From 1834 to the creation of the Federal Reserve in 1913, gold was 20.67 US dollars an ounce, up from 19.75 dollars an ounce in the previous century and there was no sustained 'inflation'.
The Bank of England lifted gold convertibility as money was printed during the First World War. The sterling started to '
float' against the gold and the US dollar.
After a failed return to the gold standard in the 1920s, (when the sterling continued to float against the US dollar and gold) which Alan Greenspan later said led to the Fed to triggering the Great Depression, Britain lifted convertibility again in 1931.
The US devalued its currency to 35 dollars an ounce during the Great Depression under President Roosevelt's so called New Deal. The Bretton Woods system was also created under a 35-dollars-an-ounce standard after World War II.
Rise of Paper MoneyUnder the Bretton Woods system the importance of gold as a reserve asset diminished.
Mercantilist economists launched calculated assaults on the psyche of the people to convince them that the use of gold as money was not useful and that high inflation came from sources other than paper money.
Proponents of welfare states made powered by paper money supply expansion, also labeled people who insisted on the virtues of gold as 'gold bugs'.
Under Bretton Woods, non-US central banks were expected to peg to the US dollar as an 'external monetary anchor'.
Dollar notes were expected to be 'as good as gold' with the US by then having most of the world's monetary gold. But continued loose US policy drove the gold price up relentlessly. Essentially the US dollar had also by then also started to 'float' against gold.
Desperate central banks then created their own internal gold market at 35 dollars an ounce and tried to pretend that the rest of the world did not exist. A gold pool was created in London to try to even up prices.
Following the Vietnam War, excessive Fed printing created the first oil shock and drove free market gold price up further, leading to massive US reserve losses by 1971.
In August 1971 President Nixon closed the gold window and imposed trade and price controls amid the first oil shock.
The dollar was then re-pegged at 38 dollars in December. After a final failed peg at 44 US dollars and the last vestiges of Bretton Woods was finally abandoned in 1973. Oil rose to new highs.
Developed nations went to floating fiat paper currencies while developing nations continued to struggle with unstable Bretton Woods style pegs of various kinds while a few like Singapore and Hong Kong returned to hard pegs or 'currency boards'.
The major reserve assets of floating central banks became government Treasury bills. Deliberately flawed price indices became 'domestic monetary anchors' instead of gold.
Peak GoldFollowing the Great Inflation of 1970s, gold peaked at around 800 dollars an ounce during the 'second oil sh
ock of 1980. During that year Sri Lanka saw the highest inflation in its history until the 2008 bubble.
US Fed chief Paul Volcker then went into strict monetary targeting and bought inflation and the gold price down below 300 dollars an ounce in the 1980s.
In 2001, when the Fed went on its ill-fated series of rate cuts to head off 'deflation' gold was only 270 dollars an ounce. Oil was about 20 dollars a barrel.
When the commodity bubble peaked in 2008 gold hit 1,000 US dollars in March. As the US went into debt deflation, and the dollar strengthened, gold fell to around 850 US units.
Amid continued loose monetary policy the US dollar is now floating weaker against gold and has topped 1,100 US dollars, against just 20 dollars when the Fed was created in 1913.
According to the World Gold Council, the US still had 8,133 tonnes of gold. Sri Lanka had 5.3 tonnes by September, Bangladesh 3.5 tonnes and India 357 tonnes.
Sri Lanka had started to increase its gold reserve assets over several months as foreign inflows increased and reserves rose dramatically from around a billion US dollars in March to nearly five billion by October.
Golden Aims"We took a decision about seven months ago that we would increase our gold portfolio as well," says Cabraal.
"And I think it was the right decision because a) it ensures that your exposure to volatile currencies is reduced, b) it has intrinsic value and c) it gives you a kind of stature overall that you are moving to a reserve management that takes into consideration different types of commodities as well as currencies.
"All those have been achieved."
Sri Lanka's and India's gold purchases came as the International Monetary Fund is selling down its stock. According the World Gold Council, an industry body that promotes the use of gold, the IMF had 3,200 tonnes in September. IMF is selling gold to raise revenue. Reserve Bank of India bought 200 tonnes.
Lanka has a peg to the US dollar. For a pegged country however, putting cash in non-pegged assets is a risk. During late 2008 Sri Lanka lost about 200 million US dollars by investing large portions of reserves in non-dollar assets.
The 1980s have shown that when the US is committed to tight monetary policy, such as in the 1980s, the price of gold can reverse dramatically versus gold in a setting where gold is demonetized.
But current fed chairman Ben Bernanke, dubbed 'helicopter Ben' for repeating Milton Friedman's remarks about the dropping dollar notes on the economy from the air, is not considered an inflation hawk.
The World Gold Council said it was "delighted" by Sri Lanka's move to increase gold assets.
"As the dollar continues to weaken and central bankers around the world realise the continuing importance of gold in providing economic stability…," chief executive Aram Shishmanian said in a statement.
"We believe more central banks in Asia and beyond will now announce increased allocations to gold."
Sri Lanka is not about to abandon its dollar peg to which it has clung loosely and with chronic high inflation and depreciation since a currency board with Sterling was abolished in 1950.
But like developed nations did in 1971, Sri Lanka's as well as India's decision to increase gold reserves spell growing unease about the holding US reserve assets and indirectly confidence in the dollar as an external anchor.
So far Sri Lanka's central bank is sitting pretty on its gold holdings.
"The way we have accumulated has been slow; it has not been spectacular purchase," says Cabraal.
"And I think what we have done is the right thing and today's prices reflect that.
"So we are happy about that and we see that over time it will be a very important anchor for our reserve."
