Can Gold Reserves Save The Eurozone?

The eurozone crisis has been brewing for a long time now. Every week it seems there are new announcements, new austerity measures, new bailouts and more bond auctions as governments and central banks just about keep their heads above water.

The issue of countries and gold is one which has been brewing for some time now. With countries in debt to each other many are wondering how they will get their money back if this really is the end of the eurozone.

When the Greek crisis was dominating the headlines, now pushed to one side by multiple crises, many asked if its lenders were entitled to the country’s national gold reserves. Much of the media asking the question was almost hostile, accusing Portugal and Italy, as well as Greece of "sitting on billions of dollars" implying that perhaps they weren’t as broke as previously thought, or at least weren’t playing by the rules.

The debate has slipped in and out of the public consciousness for the past year or so. Most significantly, last November rumours swirled that discussions regarding the European Redemption Pact were allegedly including the idea of issuing eurobonds which would be partially backed by gold.

On Thursday it was brought back to the fore when Gillian Tett, in the FT asked if it was "time of the eurozone to reach for the gold reserves?"

Tett has been prompted to ask this question after learning about the World Gold Council’s new idea for eurozone governments to start using their gold reserves in slightly more creative ways than leaving them in a vault. They suggest using a proportion of a country’s gold reserves to back government bonds. The WGC believes this would add further security and reassurance to investors.

The WGC points out that this has been done before;

"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."

Unlike previous solutions offered by the media to simply sell the gold reserves, the WGC suggests this is not an advisable idea, for a start, the levels of outstanding debt for each of the countries in question far outstrips the current price of the gold reserves. Aside from this small issue, it is in fact illegal to do this.

Current EU treaties, such as Article 123, ensures there is a separation between government and central banks and therefore the latter are prohibited from effectively bailing out the government. Also, the Central Bank Gold Agreement, responsible for many problems normally, places a limit on gold reserve sales "so as to protect the collective value of the region’s reserves."

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Having said that, previous EU treaties seem to have been "forgotten," for example Article 125 otherwise known as the "no-bailout clause," so what is to stop countries turning a blind eye to the CBGA and Article 123?

The gold standard of solutions?
Tett points out that whilst this is in no way a gold standard, it does demonstrate a changing of attitudes and understanding of what the markets have, so far, believed to be "safe" assets, such as government bonds.

Using gold as collateral is no longer such an unusual idea. Tett points out:

...groups such as a LCH.Clearnet, Intercontinental Exchange, and the Chicago Mercantile Exchange have increasingly started to accept gold as collateral for margin requirements for derivatives trades. And earlier this summer the Basel Committee on Banking Supervision issued a discussion paper that suggested that gold should be one of six items used as collateral for margin requirements for non-centrally cleared derivatives trades, alongside items such as Treasury bonds.

On the announcement, LCH.Clearnet’s Director, David Farrar, said “Market participants want greater choice when it comes to assets that can be used as collateral. Gold is ideal; as an asset it typically performs well in times of financial stress, remains liquid and has a well-established pricing mechanism.”

Movements by financial institutions that show they see gold increasingly as an important asset with low counterparty risk. This is going a long way for the remonetisation of gold and will prove extremely bullish for the gold price.

Can governments be trusted?
Chris Powell of GATA, points out that using gold as collateral would have to push the boundaries of trust. He suggests moving the gold from the debtors vaults to that of the lender’s; otherwise it would "be just another government scam."

Considering central banks are doing their utmost to prevent an audit of their gold reserves, who is to say they’re even in existence? "Especially insofar as the supposed gold of the anticipated borrowers probably already has been sold, swapped, leased, and hypothecated into oblivion anyway," argues Powell.

Issuing gold-backed government bonds means governments will finally see an incentive to have a high gold price, as the higher the number the less gold which will have to be put up as collateral. Whilst this isn’t the ideal solution, for some governments hell bent on saving the eurozone this may be seen as the last, and best resort.

It may also be seen as a far more attractive solution to lenders who are currently desperate for the eurozone to stay afloat in order to keep their own interests above water. But if the loans do turn bad, they have gold to protect them.

Seriously?
Whilst the idea of gold being used as collateral on a political level does not appear to have been considered seriously by the eurozone, and other countries, it does show that this discussion is coming further to the fore.

Whilst the appreciation of gold as a safe asset seems to be growing in financial institutions, the small man on the street is still giving up on gold too soon, stories of cash for gold shops in Lisbon closing down due to an early deluge of customers is just one of many examples showing that in the short-term, cash is King.

Perhaps as the mainstream get to grips with this idea, which they seem to be slowly with even the Telegraph and the Irish Times floating this idea earlier in the year, this means that they will soon disregard their gold is in a bubble theory.

Written By: The Real Asset Company