RBI joins peers to buy gold insurance as US-China trade war escalates

So far, China and Russia are the most aggressive buyers, but Reserve Bank of India (RBI) is now the 10th largest gold reserve holder in the world, as of June, according to IMF

As US-China trade negotiations drag the world to uncertain territory, central banks around the world are readjusting their foreign exchange reserve mix in favour of gold for safety and strategic reasons.

All countries have their own unique reasons, but central banks, mandated with the financial stability of their countries, are finding reassurance in the world’s oldest insurance against uncertainties — gold.

So far, China and Russia have been the most aggressive buyers, but the Reserve Bank of India (RBI) is now the tenth-largest gold reserve holder in the world, as of June, according to the International Monetary Fund (IMF).

In 2009, India surprised the world by buying 200 tonnes of gold from the IMF. For seven years after that the RBI did not buy any gold. But in 2017, it bought 0.3 tonnes, in 2018 42.3 tonnes, and in 2019 so far, a further 12.1 tonnes. This took the gold holding to 612.6 tonnes.

According to the World Gold Council (WGC), central banks’ demand for gold soared to a multi-decade high of 651 tonnes in 2018, a 74 per cent rise over 2017. The amount was also the highest since the dissolution of the Bretton Woods system in 1971.

In 2018, Russia, Turkey, and Kazakhstan remained key buyers throughout the year, but they were joined by other central banks as well.

“Heightened geopolitical and economic uncertainty throughout the year increasingly drove central banks to diversify their reserves and refocus their attention on the principal objective of investing in safe and liquid assets,” the WGC noted in its report. “Despite a decade passing since the global financial crisis, times seem no less certain. Central banks reacted to rising macroeconomic and geopolitical pressures by bolstering their gold reserves,” the WGC said.

The case for Russia and China is a bit different than global uncertainties. They are actively buying gold to move away from the US-centric economic system.

The US is threatening to impose 25 per cent tariffs on $325-billion worth of Chinese goods, inviting retaliatory tariffs. If the US is not in a mood to compromise, the trade talks will collapse on June 29. If that happens, the world may get into a recession in three quarters, Morgan Stanley’s chief economist Chetan Ahya said in an interview to Business Standard. India won’t remain immune in such a scenario, Ahya warned.

However, that doesn’t mean that the US dollar will be dumped by investors, quite the contrary. In times of global turmoil, investors rush to the dollar as this is the de facto currency for global trading. The Euro tried to challenge the dollar dominance, but Brexit and other uncertainties now threaten the existence of the European Union itself. Trades are increasingly happening in Chinese Yuan, but the currency is tightly controlled and not freely convertible. This cannot replace the dollar.

Dollars, on the contrary remains the most liquid currency worldwide. Importantly, it is called ‘petrodollar’ because oil purchases are done in dollar. Saudi Arabia bills its oil exports in dollar because under an agreement with the US, it would do so in exchange of protection of its oil field. It is also not possible to pay Saudi in its local currency Riyal.

“India has a large trade deficit with Saudi Arabia, making it difficult to shift to oil payments in the Saudi Riyal. Bilateral currency pair transactions normally work with a trade surplus. Also, despite efforts to diversify into non-conventional reserve currencies, the dollar is likely to dominate in the foreseeable future,” said Saugata Bhattacharya, chief economist at Axis Bank.

But that doesn’t mean dollar would continue to maintain its dominance forever. Countries are forming their strategic blocks, such as BRICS (Brazil, Russia, India, China, and South Africa) that work as a block and vote on strategic matters together. The BRICS nations hold almost equivalent share of 16 per cent as that of the US in IMF, which cannot take any decision influenced by the US, being the largest shareholder as the BRICS block may not approve that. Still, nobody can think of shunning the yellow metal altogether just yet.

“The emerging markets’ central banks appear to be buying gold, taking into account the very low yields on the euro-denominated assets like the German bunds and uncertainty around the Brexit affecting the Pound denominated assets,” said Gaurav Kapur, chief economist of IndusInd Bank.

Besides, the trade-related uncertainties also loom large in the minds of central banks globally, including in India. According to an RBI official, the country must prepare to shield itself from any undue calamity arising out of the trade talks.

“Diversification is important in this volatile day and age. Why only gold, the RBI can look into increasing its share of other currencies, or special drawing rights (SDR) of the IMF,” said the official. The RBI’s foreign currency assets are maintained in as a multi-currency portfolio comprising major currencies, such as US dollar, euro, pound sterling, Japanese yen, etc. and are valued in terms of US dollars. SDR of IMF is outside the FCA and maintained separately.

As on June 7, India held $423.55 billion in foreign exchange reserves, of which 395.8 billion is in foreign currency assets, about $23 billion in gold, $1.45 billion equivalent in SDR, and $3.35 billion as reserve position in the IMF.

Gold bonds remain an important consideration behind the purchase anyway, and that could be the key reason for gold purchases, Kapur said.

Gold can potentially give higher returns in times of uncertainties.

“The uncertainties will only push up gold prices. Even if the US dollar doesn’t lose its value due to the trade tension, it is likely that gold would give more return than the dollar. Most central banks are, therefore, diversifying,” said Soumyakanti Ghosh, chief economic advisor of State Bank of India.

The RBI annual report for 17-18 said till June 2018, gold bonds worth 23.5 tonnes were sold. Bond issues have been continuous and industry analysts estimate it to have reached 30 tonnes by now.

Bonds are sold in cash and online netbanking investors are given ~50 per gram (~5 crore per tonne or around 1.5 per cent) discount to promote online sales and transparency. Besides, 2.5 per cent per annum return is given on the amount.

After eight years of maturity, the money has to be paid back at the prevailing price, making this a risk. Buying gold by the RBI as a part of foreign exchange reserves is also a hedge for the price risk that the government has taken in sale of sovereign gold bonds.

But are global central banks trying to hedge their risks of dollars coming under pressure?

“If we talk mathematically, the quantity of gold in the RBI reserves is inversely proportional to the global dominance of dollar. If dollar starts losing because of the trade tension, you will see the share of gold increasing. The direction, though, is getting clearer,” said an economist.