Gold: Panacea or Placebo6. May 2013 by Herman Brodie
This is not the first time that central bank gold reserves have been evoked as a partial solution to public debt problems. In the depths of the Greek crisis, the sale of nation’s bullion reserves was briefly discussed as a means to bring down the debt burden, but the holdings were too small to make any difference. In Cyprus, a proposal to sell the bulk of the island’s gold reserves was endorsed, at least by EU finance ministers. So, it was not shocking to hear about a proposal to put Italy’s ample bullion holdings – the second highest in the EU after Germany’s – to use in tackling its massive debt overhang. The problem of the relative size of the debt to the value of the gold remains an obstacle even in the case of Italy. The country’s 2,452 tonnes of reserves is worth over €88bn at current market rates (less if the Banca d’Italia actually tried to sell it, of course). This sum pales in comparison to the €2,000bn Italy currently owes to it sovereign bond holders.
Nonetheless, argues the World Gold Council (WGC), the gold could help the country address a funding bottleneck and the buy time it needs to get economic growth on the right track. It wouldn’t even need to sell the gold; it simply needs to use it as collateral for new bonds at lower interest rates. By backing a fifth of the face-value of a new bond with gold, Italy could cover its funding needs for the next two years at more favourably rates. This would allow it to direct more resources to stimulus measures in order to steer the country out of recession and to ameliorate the suffering of its citizens. The Council even went as far as to commission a survey to show that this is precisely what Italians want their new government to do. The WGC’s sudden concern for the welfare of the Italian electorate is not as selfless as it appears. The global cheerleader for the gold industry would certainly like gold-backed bonds to be a template for other governments.
The problem with the idea is that the Italy’s existing bond holders already believe the obligation to be partially backed by gold. It was not made explicit, of course, but when they lent money to the government they took into consideration all of the public and private wealth the state could access in order to service and repay the debt. If part of that wealth is suddenly isolated and made subject to an explicit covenant, the yield on the non-gold-backed bonds would have to rise. The WGC is assuming a free-lunch, but there is none.
A second misconception concerns the lower yield on the gold-backed bond. The WGC assumes investors would demand a substantially lower return on a bond backed in part by gold. The appeal is simple: in case of default, investors could claim their share of central bank gold reserves, which as a result of the crisis would be even more valuable than they are today. However, for this to be the case, investors would have to trust the promises of a counterparty who has just defaulted. What is the likelihood that some who has just reneged on a contract to deliver interest or principal adheres to a contract to deliver gold? To assuage investor fears, Italy would have to set up escrow accounts and transfer all of its gold outside the country. These are additional costs the state would have to bear before turning its attention to fiscal stimulus.
At first glance, the idea of gold-backed bonds appears attractive and deceptively simple. However, the assumption of a free lunch is hardly the basis for debt reduction strategy. Perhaps the whole idea is simply aimed at binding, and thereby preventing the sale of huge central bank gold reserves. This would be very reassuring for the gold market and come at no additional cost to the WGC. No that is what I call a free lunch.