Can Gold Act as Savior in the Eurozone Debt Crisis?

Category: ECB-European Central Bank | Gold Trading
September 4, 2012 | Comments Off |
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Gold Eurozone Debt Crisis

Can Gold Act as Savior in the Eurozone Debt Crisis?

Gold, the world’s favorite safe haven asset in all times of crisis may just be what the Doctor ordered – The answer to solving some of Eurozone’s debt crisis. ECB President Draghi faces huge challenges this week as he struggles to arrive at a amicable solution on the future of the Euro, his plans to build a so- called banking union & in winning support among the German public for market intervention. Germany reiterated its support yesterday for Bundesbank President Jens Weidmann, following reports last week that he had considered resigning over his opposition to ECB bond purchases.

EU Outlook Cut By Moody’s:

The European Union’s rating outlook was cut to negative by Moody’s Investors Service, reflecting the risks to Germany, France, the U.K. and the Netherlands that account for about 45% of the group’s budget revenue. The ratings company lowered the outlook on the EU’s Aaa long-term bond rating from stable, according to a statement released in Frankfurt late yesterday. It also changed to negative from stable its outlook on the provisional Aaa rating for the EU’s medium-term note program. The change “reflects the negative outlook on the Aaa ratings of the member states with large contributions to the EU budget,” Moody’s said. “The creditworthiness of these member states is highly correlated, as they are all exposed, albeit to varying degrees, to the Eurozone debt crisis.” Ratings of European nations have declined under the sovereign debt crisis and Spain, which held the top Aaa rating from Moody’s between 2001 and 2010, is now on the cusp of junk at Baa3. Risks of a downgrade to the EU’s sovereign debt rating come from a “deterioration in the creditworthiness of EU member states,” Moody’s said. “Additionally, a weakening of the commitment of the member states to the EU and changes to the EU’s fiscal framework that led to less conservative budget management would be credit negative,” reported Bloomberg. The outlook for the EU’s ratings could return to stable if the outlooks on the ratings of the key Aaa countries with contributions to the EU budget also returned to stable.

The ECB Plans to fight crisis:

Chancellor Angela Merkel said yesterday that Germany must show solidarity with Europe, and indicated she would back a more active crisis-fighting role at the European Central Bank. Her nation shoulders the largest cost of bailing out weaker governments. ECB President Mario Draghi told officials yesterday he intends buying government bonds with maturities as much as three years away to bring down borrowing costs for nations in financial distress. The European Commission, the EU’s executive arm, borrows on behalf of the EU, which has 52.7 billion euros of bonds outstanding, data compiled by Bloomberg show. About 10.7 billion euros of notes come due before the end of 2015, the data show.

Roll of Gold in solving the Eurozone crisis:

Courtesy: World Gold Council.

As the Eurozone crisis rumbles on, and politicians continue to seek out a comprehensive and lasting solution, the key question remains: how can countries continue to practise austerity while simultaneously stimulating the growth required to pay down debt and emerge as self-sustaining robust economies? Numerous possible solutions to this dilemma have been proposed, some of which have focused on how to get the most out of the substantial Gold Reserves currently held within European Central Banks.

The Eurozone’s Gold Reserves stand at almost 10,000 tonnes, and it is well known that some of the countries affected by the crisis, including Portugal and Italy, are responsible for a significant proportion of these assets. These reserves have served those countries well over the years, not least over the last decade, thanks in part to Gold’s unique wealth preservation characteristics. Nevertheless, the question is rightly being asked as to the role that these Gold Reserves can, and should, play to help alleviate the problems now facing the Eurozone and the individual member states within it.

Most agree that outright sales of Gold are not the answer. Aside from the obvious problem that the outstanding debt level of the struggling European counties far surpasses the value of their Gold reserves, existing EU laws prohibit such a move. As do the provisions of the Central Bank Gold Agreement, which limits Gold sales in order to protect the collective value ofWestern Europe’s reserves. To illustrate this point, the Gold holdings of the crisis-hit Eurozone countries (Portugal, Spain, Greece, Ireland and Italy) represent only 3.3% of the combined outstanding debt of their central governments. A one-time sale of all of their Gold reserves would not cover even one year’s worth of their debt service costs. This would be akin to an individual selling everything they owned in order to make one month’s mortgage payment.

If we exclude Gold sales therefore, what contribution can Gold make to a comprehensive and robust solution? The answer lies in the unsustainable borrowing costs now facing the most challenged Eurozone countries. During this crisis, Portugal’s borrowing costs have reached Euro-era highs; more than 20% for five year government bonds and more than 16% for ten year debt. Meanwhile, Italy’s borrowing costs have risen inextricably closer to the 7% ten year yield that most see as the point at which government borrowing becomes unsustainable.

Both of these countries, and in particularItaly, have significant reserves of Gold. Using only a portion of these Gold Reserves as collateral could significantly reduce the rate at which each of these countries could issue debt. Not only would this help these governments reduce their funding costs, it would allow them to regain the confidence of the bond market, and provide breathing space in which to implement structural reforms or growth focused strategies.

There are various ways to structure such a Gold backed bonds solution. For example, the bond could simply be partially backed by Gold or a tranche based structure could be developed to appeal to different types of investors.

Gold is well suited for such a role. Not surprising then, there are precedents for Gold being used in this manner.Italy, for example, received a $2bn bail-out from the Bundesbank in 1974 when it put up its Gold as collateral. In 1991, India used its Gold as collateral for a loan with the Bank of Japan and others. Portugal raised around $1 billion during the 1975-77 financial crisis from the BIS, Bundesbank and Swiss national bank, the bulk of which was secured by pledging a proportion of the country’s Gold Reserves.

Gold’s lack of credit risk makes it an ideal asset to be used as collateral. We are already seeing this use of Gold develop in the private sector for that reason. Clearing houses across the globe for instance are increasingly accepting Gold as collateral. In Europe, both LCH. Clearnet and ICE Clear Europe now accept Gold as collateral for the clearing of derivatives contracts.

Of course, just like every other solution being presented in the Eurozone, there are a number of legal issues that need to be considered for Gold backed bonds to proceed – not least the fact that Eurozone Gold is held and managed by central banks and not governments – but these are surmountable.

Gold is one of the oldest forms of collateral. It has been used in this way by individuals and institutions for centuries. To a great extent, this is Gold’s purpose. For those countries that have been wise enough to build up substantial reserves of Gold over the years, now could be the time to harness the benefit.


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