Central banks buying gold to diversify foreign exchange reserves: UBS

April was a turbulent month for investors, with rising tensions in the Middle East and reaccelerating US inflation fears casting doubts on the prevailing investor enthusiasm. While gold tends to shine in such stress situations—and indeed it did—this performance spurt just builds on an already notable rally: Following double-digit returns in 2023, it is up by nearly 15% again this year, outperforming other assets like equities and bonds.
 

Interestingly, this rally has evolved without traditional support from ETF buying and declining real interest rates. In fact, gold ETF holdings stand at the lowest level since September 2019 and real US interest rates are close to the highs seen before the global financial crisis. The comparison between gold and real interest rates is one of the most striking ways to illustrate the remarkable rally in the price of gold: Gold has deviated more than three standard deviations away from its historically close correlation with real interest rates.

Figure 1: Moving apart

10-year real interest rates (in %) versus gold price (inflation-adjusted)

Source: Bloomberg, UBS, as of May 2024

But if real interest rates and inflows into gold ETFs fall flat as the drivers for the gold rally, what has been pushing prices to record highs? We think the rally can be attributed to a combination of structural drivers, including fears of higher-for-longer inflation, investors trying to diversify away from USD- denominated assets due to a rapidly growing US debt burden and perceived sanction risks, fears of a devaluation of the Chinese renminbi, and rising geopolitical tensions.

While these concerns apply to investors from developed and developing countries alike, we note that central bank reserves[1] in developing countries have far less gold exposure than those from developed markets (Figure 2). Among central banks, only three of the ten largest gold owners—Russia, China, and India—are from developing nations. Large emerging countries like Saudi Arabia, Brazil, Mexico, or South Africa don’t appear in the top 15. Collectively, central banks from the members of the Gulf Confederation Council—arguably the wealthiest region on the planet—possess less gold than Switzerland or the Netherlands.

Figure 2: Lagging behind in terms of reserve allocation
 

Absolute and relative (in % of foreign exchange reserves) gold exposure by country

Source: WGC, IMF IFS, UBS, May 2024
 

On average, the gold allocation of developing countries’ reserves is about half the level seen in developed market central banks (16% vs 29%), according to data collected by the World Gold Council from the IMF’s International Financial Statistics division. If emerging market central banks were to increase their relative allocation to 29% too, they would have to buy approximately additional 29,000 tons, corresponding to around ten years of global production or 15% of the worldwide gold stock.
 

Concerns that large reserve losses undermine the credibility of a central bank and its currency are a key argument why central banks invest their reserves foremost in defensives assets like high grade bonds and gold. However, fixed income markets can be quite turbulent at times, and large write-offs of debt securities can quickly lead to substantial equity erosion. The associated credibility loss may lead to exchange rate volatility and heightened financial stability risks. History suggests that restoring investor confidence can be tough, and that such situations may lead to greater political dependency of the central bank.
 

Investors also appear increasingly uncomfortable about the rapidly growing US debt burden and question its sustainability. In recent years, the US fiscal deficit averaged around 7.5% of GDP—an unusually high number, especially in times of full employment—and public debt rose to 129% of GDP according to IMF estimates. And although the US shares its adverse debt trajectory with many other countries, its deterioration happened faster and from a higher level than in other countries. According to IMF estimates, the US will be the fourth most indebted advanced nation in 2028, with an estimated debt-to- GDP level of 136%. The country has already lost its AAA rating from Fitch and S&P’s, and Moody’s has a negative outlook; CIO has the US on negative outlook as well, suggesting further rating downgrades in the years ahead.
 

However, despite these fundamental headwinds, few countries have actually been lowering their US Treasury exposure (Figure 3). Among the nations with the highest exposure, Mainland China (-29%), Saudi Arabia (-26%), and Brazil (-20%) reduced their exposure significantly in recent years, but total foreign exposure actually increased by more than one trillion US dollars (+15%), to USD 8.09 trillion per March 2024, according to data published by the US Treasury.

Figure 3: Foreign US Treasury exposure is growing, not shrinking
 

Major foreign holders of US treasury securities, level as of March 2024 and change since January 2020, in USD billions

Source: US Department of the Treasury, UBS, as of May 2024
 

The prominent role US Treasury securities continue to play in reserve portfolios may also relate to the notion that there are few other securities (and hence currencies) providing similar market breadth and depth. Treasury markets in Europe, the UK, and Japan suffer from similar fundamental challenges, i.e., debt sustainability concerns and inflation risks, while being less liquid, and the very few markets—like Switzerland—which look healthy from a fundamental point of view, (consequently) don’t have enough outstanding debt to offer sufficient liquidity.

Finding new solutions also isn’t easy: Brazil’s Lula da Silva recently floated the idea of a BRICS+ currency. While such a construct might offer appeal for those trying to reduce exposure to US Treasuries, such a currency unit would require some innovative financial engineering to offer the stability aspects required to become a suitable reserve asset, in our view.
 

Lastly, the risk of US sanctions may also have led some emerging market central banks to diversify their foreign exchange holdings away from US Treasuries. Since early 2000, the number of designations issued by the US Treasury Office for Foreign Asset Control (OFAC) increased significantly, which may have further incentivized some institutions to reduce US asset exposure. Russia is a good example for both dynamics: The country appeared as a strategic gold buyer with the start of the global financial crisis in mid-2007 and then more than doubled its monthly purchases following its invasion of Crimea in March 2014 before lowering its reported purchases again at around the start date of the pandemic.

Figure 4: Systematic gold buying has increased since the global financial crisis

Aggregated monthly gold purchases by central banks, in tons

Source: WGC, IMF IFS, UBS, May 2024
 

So, what’s our conclusion? Emerging market central banks were among the biggest gold buyers in recent years and we expect these buyers, who are less price sensitive than private investors, to continue accumulating gold going forward, suggesting structural tailwinds for the yellow metal. In the near term, however, the gold rally looks stretched, which increases the risk of a correction. For these reasons, we prefer structured strategies to buy gold on dips.

At the same time, we also see value in following central banks in their diversification efforts. Private investors typically balance their urge for security with the ambition to grow their wealth (the latter objective is typically not relevant for central banks). An optimal combination of the two objectives can be achieved by a thorough diversification across asset classes and regions and systemic risk-taking to achieve the targeted medium- to longer-term investment returns.
 

The role of alternative assets—which also include gold and other commodities—is of paramount importance here, because they tend to be an effective portfolio diversifier while offering an appealing longer-term risk- reward. Moreover, assets like real estate, commodities, hedge funds, and private equity allow investors to buy real assets, providing an effective hedge against the risk of higher-for-longer inflation and/or structural US dollar weakness.

 

By Niels Zilkens, Head WM Middle East, UBS Global Wealth Management and

Michael Bolliger, Chief Investment Officer Global Emerging Markets, UBS Global Wealth Management