Why Gold Was Rolled

Sydney Morning Herald

Friday July 11, 1997

Malcolm Maiden

It was not just commodity traders who were shocked when the Reserve Bank announced last week that it had sold more than $2 billion worth of bullion. The bank and the Government were unprepared for the savage market reaction, writes MALCOLM MAIDEN.

THE decision that rocked gold investors and miners in Australia and overseas was already a fait accompli by the time Reserve Bank officers handed their recommendation to their board late last year.

In the bank's opinion, there was not much for the directors to discuss: the price of gold had been trending down for years, and on any rational analysis it was going to stay weak. Central banks around the world had themselves removed the metal's safety net in the early 1990s when they began lending gold to traders out of their vast bullion reserves totalling more than 30,000 tonnes.

Bureaucrats inside the Reserve began debating whether to sell gold about a decade ago, and by the early '90s those favouring a sale had the numbers. But the bank held off while Australia's finances were repaired. It did not want to be seen as a forced seller.

By late last year Australia's budgets were moving into surplus, and the dollar was strong. The time had come, the board was told, to begin offloading gold.

It was a decision that would produce large profits, because the gold had been acquired at the old, pre-1972 fixed price of $US35 an ounce, and the bank would need to obtain the approval of the Federal Treasurer, Peter Costello, to reinvest the funds instead of rebating them to Canberra. But the sale itself could be decided by the board ahead of an approach to the Treasurer.

The board gave the sale the go-ahead, and the decision was communicated to Costello by the Reserve's governor, Ian Mac farlane. Costello approved the bank's plan to use the proceeds to buy United States, German and Japanese government bonds that would return $150 million a year more than the Reserve Bank had been earning on its gold.

By April, the job was done. Working through international brokers, believed to be Merrill Lynch and J. P. Morgan, the Reserve wrote contracts for the sale of 167 tonnes of gold, enough to cut its stocks to just 80 tonnes.

In doing so, it joined a growing group of central banks selling the metal. In January this year, the Dutch central bank disclosed that it had sold 300 tonnes of gold. During 1996 the Belgian central bank revealed that it had sold 203 tonnes. Austria, Canada, Portugal and even South Africa, the world's biggest producer, have been sellers. Switzerland has flagged its intention to sell, and the International Monetary Fund is also expected to offload bullion soon.

From the Reserve Bank's perspective, the case for selling was even more compelling than it was for non-producing countries such as the Netherlands, because Australia has so much gold in the ground.

In the past decade, a host of new gold mines has come into production in this country. Gold product ion in 1996 was up 14 per cent, or 35 tonnes, to 289 tonnes, more than twice as much as was produced in 1987, and the third-highest total in the world after South Africa and the United States.

What the bank had not counted on was the psychological impact of its announcement. With the benefit of hindsight, it is clear that the Reserve executed a brilliant market strategy but miserably failed to get the politics of the selldown correct.

The announcement of the sale, when it came a week ago, shocked the market. And the surprise was compounded by the Treasurer, who in confirming the deal stated unequivocally that gold "no longer plays a significant role in the international financial system".

It was the truth, at least as long as inflation stays supine. But it was an observation the Reserve had not made, and it exposed the dollar to selling raids by the speculators who dominate the gold market, trading the equivalent of annual production every two days.

Three trading days after the Reserve disclosed the selldown, Australian gold shares were down 16 per cent, or $2 billion. Gold bullion had fallen by about $US14 (about $18.90), to $US318 an ounce, a level last seen in the mid-'80s.

Australian producers "forward sell" their production, which means much gold produced now is still attracting last year's prices. But as the forward sales deals wind down progressively this year and next, about 40 per cent of our mines will start losing money. Many could close. In the past two days Australian gold stocks have recovered about a third of their losses. But bullion is still on the floor, at about $US320 an ounce.

ROBERT Champion de Crespigny, the executive chairman of Normany Mining, Australia's biggest gold-mining group, says: "I think the Reserve Bank has hand led this extremely clumsily." His companies produced 45 tonnes of gold last year, making it the 12th-largest producer in the world, and he was one of the people Costello phoned this week about the sale decision, and its aftermath.

De Crespigny says the Reserve's arguments against gold are shallow, and he points out that the US Government is not selling. It holds 25 per cent of central bank reserves. Gold has a future "if you take the longer term view", he says, adding that the Reserve "clearly didn't know what effect their announcement was going to have on the gold price. If they were real pros they would have sold and bought back at the lower price."

Joe Gutnick, the executive chairman of Great Central Mines, which has extensive operations in Western Australia, is livid. Great Central itself is a low-cost producer, but more than 30 other companies are threatened, he says.

"It was the way they came out and just wrote off gold - the second-biggest export earner this country has got," Gutnick complains. (Gold miners exported $5.6 billion worth of gold in 1995-96, second only to coal.)

"Other central banks have been selling for years, but it hasn't been done abruptly - not two-thirds of their assets in a single day."

Macfarlane said this week that the sale was taken "in the national interest", and although the impact on the gold miners was unfortunate, "all of our decisions have a sectoral impact".

It is open to question, however, whether the sectoral impact of the sale was addressed by the bank in detail ahead of the decision. Reserve Bank officers were surprised by the suddenness and severity of the reaction, but insist that the decision to sell was the right one.

Bill Shields, who was hired from the Reserve Bank in the '80s to become Macquarie Bank's chief economist, says gold "no longer has a role in a monetary system, and with low inflation it is an unattractive investment relative to interest-bearing securities and equities".

"I think the gold price will remain under pressure, and depending on how supply responds, it could even fall lower," he says.

But Shields adds that the Reserve could have stage-managed the exit more skilfully by "considering the impact of the way the decision was communicated and announced". A staged sale was an obvious alternative but, "quite frankly, they could not have logically expected their sale to produce as big a reaction as it did".

Gold is genuinely rare. On average, there is about 0.004 grams of it per tonne in the Earth's crust, compared with 55 grams per tonne of copper and 0.07 grams of silver. Only 132,300 tonnes of it have been mined, enough to make a cube 19 metres by 19 metres by 19 metres. Of that, 59,800 tonnes of it is jewellery, and a further 24,100 tonnes is held by investors.

The critical issue for the market is what happens to the 32,800 tonnes that sits in the vaults of central banks around the world. In markets for other metal commodities such as copper, investors get nervous if stocks account for more than a few months of production.

But if all other sources of gold, including mines, disappeared, the central banks alone could satisfy global demand from jewellers, investors, electronics companies and mints for about a decade.

Central banks are not only selling gold - with some notable exceptions including, so far, the US and France - they are lending gold to facilitate forward sales. The practice began earlier this decade and it underlines the ominous import of America's 1972 decision to decouple its currency from gold.

The decoupling of gold from the currency raised the risk that long-term gold's special status would fall away. It will continue to be rare, and it will have quasicurrency status for developing nations. Its continued "special status" is recognised by the Reserve, which says its remaining store of 80 tonnes is not for sale.

But gold's price did not jump during the last big political- military crisis, the Gulf War in 1990-91, because supply, often from central banks, was easily able to meet demand. Its future while the huge central bank stockpiles remain in suspense must be uncertain.

"Nobody knows what's going to happen to gold; nobody has a crystal ball," says Gutnick. "But I don't think human nature has changed that much. I can't envisage two billion people in China all wanting paper issued by Wall Street in preference to gold. The demand is coming out of Asia."

NEWTON'S OTHER LAW

THE economist John Maynard Keynes called gold in 1923 a "barbarous relic" of earlier economic systems and recent developments suggest he was right.

The gold price was established as a bulwark of the international economic system in 1717 by the great English scientist and bureaucrat Sir Isaac Newton. After defining a clockwork universe that was unchallenged until Einstein, Newton decided on a career change and in 1699 became Master of England's Royal Mint.

He was still in the job 18 years later, when the market price of England's gold guinea began to rise above its face value. Newton fixed the guinea's price at 21 silver shillings.

Nominal gold prices were stable for the next 210 years, and the value of gold was formally fixed in 1816. But the gold fix was an illusion because the metal's real value rose and fell with deflation and inflation.

The real price seesawed in the first three decades of this century, halving as inflation rose during World War I, and jumping by almost 300 per cent between 1919 and 1935 because of the Great Depression, which collapsed other prices.

In 1931, England abandoned the gold standard and, in 1933 and 1934, the United States pushed the price up from just over $US20 an ounce to $US35 an ounce to help reflate its economy.

The gold standard's last hurrah began in 1944, when 44 nations met in Bretton Woods, New Hampshire, and agreed to tie the US dollar to a fixed price of $US35 an ounce for gold.

As gold prices rose along with inflation in the '60s, the eight biggest central banks joined to sell gold in an attempt to hold the $US35-an-ounce level. But they failed, despite selling massive amounts of gold, and in 1968 their consortium, called the London Gold Pool, was disbanded.

Gold and world currencies began to float in 1972, when the gold-US dollar link was formally abandoned. The result was chaotic: the US dollar dived and the OPEC oil-producing nations quadrupled the price of oil. Inflation soared, and economic growth collapsed, producing "stagflation." Gold also rocketed upwards, peaking at an astonishing $US850 an ounce in 1980.

But by then central banks, led by the US Federal Reserve's chief, Paul Volcker, had already decided that monetary policy would be used aggressively to rein in inflation. As inflation came under control, and as world financial markets became increasingly adept at managing exchange rate movements, gold's importance as a reserve asset declined and its price in real terms fell.

The final nail in the coffin occurred early this decade, when central banks began lending gold as collateral for forward sales by gold producers.

In effect, they were signalling that their massive reserves of over 30,000 tonnes were available to the market. Many analysts say gold's situation will not brighten until those central bank reserves are substantially sold.