Why central banks hold gold

Why central banks hold gold
Monetary authorities have long held gold in their reserves. Today their stocks amount to some 30,000 tonnes - similar to their holdings 60 years ago. It is sometimes suggested that maintaining such holdings is inefficient in comparison to foreign exchange. However, there are good reasons for countries continuing to hold gold as part of their reserves. These are recognised by central banks themselves although different central banks would emphasise different factors.


Diversification
In any asset portfolio, it rarely makes sense to have all your eggs in one basket. Obviously the price of gold can fluctuate - but so too do the exchange and interest rates of currencies held in reserves. A strategy of reserve diversification will normally provide a less volatile return than one based on a single asset.

Gold has good diversification properties in a currency portfolio. These stem from the fact that its value is determined by supply and demand in the world gold markets, whereas currencies and government securities depend on government promises and the variations in central banks’ monetary policies. The price of gold therefore behaves in a completely different way from the prices of currencies or the exchange rates between currencies.

Economic Security
Gold is a unique asset in that it is no one else's liability. Its status cannot therefore be undermined by inflation in a reserve currency country. Nor is there any risk of the liability being repudiated.
Gold has maintained its value in terms of real purchasing power in the long run and is thus particularly suited to form part of central banks' reserves. In contrast, paper currencies always lose value in the long run and often in the short term as well.

Physical Security
Countries have in the past imposed exchange controls or, at the worst, total asset freezes. Reserves held in the form of foreign securities are vulnerable to such measures. Where appropriately located, gold is much less vulnerable. Reserves are for using when you need to. Total and incontrovertible liquidity is therefore essential. Gold provides this.

Unexpected needs
If there is one thing of which we can be certain, it is that today’s status quo will not last for ever. Economic developments both at home and in the rest of the world can upset countries’ plans, while global shocks can affect the whole international monetary system.
Owning gold is thus an option against an unknown future. It provides a form of insurance against some improbable but, if it occurs, highly damaging event. Such events might include war, an unexpected surge in inflation, a generalised crisis leading to repudiation of foreign debts by major sovereign borrowers, a regression to a world of currency or trading blocs or the international isolation of a country.
In emergencies countries may need liquid resources. Gold is liquid and is universally acceptable as a means of payment. It can also serve as collateral for borrowing.

Confidence
The public takes confidence from knowing that its Government holds gold - an indestructible asset and one not prone to the inflationary worries overhanging paper money. Some countries give explicit recognition to its support for the domestic currency. And rating agencies will take comfort from the presence of gold in a country's reserves.
The IMF's Executive Board, representing the world's governments, has recognised that the Fund's own holdings of gold give a "fundamental strength" to its balance sheet. The same applies to gold held on the balance sheet of a central bank.

Income
Gold is sometimes described as a non income-earning asset. This is untrue. There is a gold lending market and gold can also be traded to generate profits. There may be an "opportunity cost" of holding gold but, in a world of low interest rates, this is less than is often thought. The other advantages of gold may well offset any such costs.

Insurance
The opportunity cost of holding gold may be viewed as comparable to an insurance premium. It is the price deliberately paid to provide protection against a highly improbable but highly damaging event. Such an event might be war, an unexpected surge of inflation, a generalised debt crisis involving the repudiation of foreign debts by major sovereign borrowers, a regression to a world of currency and trading blocs, or the international isolation of a country.

How much gold?
This is a matter for countries and central banks to decide in the light of their particular circumstances. The international average is about 10.2% at current market prices but, in the EU it is over 50% and the USA holds around 75% of its reserves in gold. Countries facing particular volatility in their economic and/or political circumstances will want to consider the level of gold in their reserves.

source;http://www.reserveasset.gold.org/why_hold_gold/.

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