Gold Derivatives, Gold Lending, Official Management Of The Gold Price And The Current State of the Gold Market by Frank Veneroso

Fifth International Gold Symposium

Lima, Peru

May 17th, 2002

Part 1

Gold Lending And Official Management Of The Gold Price

Let's begin with an explanation of gold banking and gold derivatives.

It is a simple, simple idea. Central banks have bars of gold in a vault. It's their own vault, it's the Bank of England's vault, it's the New York Fed's vault. It costs them money for insurance - it costs them money for storage--- and gold doesn't pay any interest. They earn interest on their bills of sovereigns, like US Treasury Bills. They would like to have a return as well on their barren gold, so they take the bars out of the vault and they lend them to a bullion bank. Now the bullion bank owes the central bank gold---physical gold---and pays interest on this loan of perhaps 1%. What do these bullion bankers do with this gold? Does it sit in their vault and cost them storage and insurance? No, they are not going to pay 1% for a gold loan from a central bank and then have a negative spread of 2% because of additional insurance and storage costs on their physical gold. They are intermediaries---they are in the business of making money on financial intermediation. So they take the physical gold and they sell it spot and get cash for it. They put that cash on deposit or purchase a Treasury Bill. Now they have a financial asset---not a real asset---on the asset side of their balance sheet that pays them interest---6% against that 1% interest cost on the gold loan to the central bank. What happened to that physical gold? Well, that physical gold was Central Bank bars and it went to a refinery and that refinery refined it, upgraded it, and poured it into different kinds of bars like kilo bars that go to jewelry factories who then make jewelry out of it. That jewelry gets sold to individuals. That's where those physical bars have wound up---adorning the women of the world.

Now, this bullion banker is net short gold when he conducts this operation. Remember he borrowed gold and now he has a dollar financial asset. He is making a 5% return on the spread, but he now has a gold price risk. As a banker he is not normally in the business of putting on speculative positions like this. He is an intermediary, so what does he do? For the most part what he does is he hedges his gold price risk. He goes long the forward market to offset his physical short. Now if he goes long in the forward market someone else must go short, because every such contract in the forward market has two sides---a long and a short. In doing this he allows private market participants to go short the forward market. Who are those private participants who go short the forward market? They are producers hedging future production, they are jewelers who are hedging their inventory, and they are speculators who want to go short the gold market because they believe the price will go down and they earn a forward premium or ‘contango' which happens to be, in this case, roughly equal (though not quite) to the difference between the rate of interest on the dollar asset held by the bullion bank and the rate of interest paid on the gold loans by the bullion bank.

So, basically, in doing this operation the bullion banker has a hedged position on the gold price and he takes a small margin---like a half of one percent---from this intermediation. In doing so, he allows private market participants to go short gold. That's why we elide the two phrases---going short in the gold market and gold borrowing. The ultimate borrowers in the gold lending operation are these shorts in the gold futures and forward markets.

Now we have a conservative set of gold lending numbers and we have a more aggressive set of such numbers. Our range of estimates implies that somewhere between 10,000 and 16,000 tonnes of the official sector gold position has left those vaults by way of the lending process.

Now why do we think this?

I started out on this crazy voyage with a statement that was made by a man from the Bank of England---Mr. Terry Smeeton---who was in charge of the gold operations of the Bank of England. On something like November 21st or 22nd of 1995 at the 5th Annual Banking Conference in the city of London, he addressed the issue of gold lending. He gave some statistics. He basically said that gold lending had roughly doubled over the last year and a half. Precisely, what he said was that gold loans had more than doubled and gold swaps increased by more than 50%.

But he didn't give us any absolute numbers. However, he made a similar speech in Australia in March of 1994 and I went back and I checked what he said then. There he said that gold loans were 1500 tonnes based on a recent survey the Bank of England did, but he didn't make any reference to swaps. I called him up and asked him what the Bank thought the total swaps were in early 1994---a year and half earlier. He said to me he didn't remember exactly but he thought they were about 400 tonnes. What that meant is that the Bank surveys indicated that roughly 1900 tonnes of official gold had been lent around the beginning of 1994 and 18 months later---around the middle of 1995---the number had roughly doubled to 3700 tonnes, perhaps more. Now that was interesting because 3700 tonnes was a substantially larger figure than the consensus estimate of all those lendings, which at the time was about 2200 tonnes.

I thought this was intriguing and I did some analysis. I went to Mr. Smeeton from time to time under fairly casual circumstances and I asked him to give me an interpretation of his data. What he told me was that the Bank of England had done a survey of the fourteen principal market makers in the City of London and they had reported this data. I said to him, "Well, did that include the Swiss banks for example?" and he said, "No, absolutely not---only the fourteen principal market makers in the City of London." So I went to these fourteen bankers and I asked them "When the Bank of England came and asked you about this what did you tell them?"

I found out something very interesting. Some of these characters said to me, "I didn't report anything. I don't keep a big book in London---most of my book is outside of London. He doesn't know my loan position." Some of them said, "Oh, we complied. We gave them our global book, not only what was in London, but everywhere." From these conversations, I came up with the impression that, for these fourteen bullion bankers, this number was a partial total---it wasn't a complete total because many had not disclosed their books outside of London.

    Then a bullion banker friend of mine said, "Frank, that's only the half of it---those fourteen (14) principal market makers in the City of London." He said, "Take down this list of all the guys who take gold deposits from central banks." And I took down the list and there were thirty-seven (37) of them. So I took the other twenty-three (23) who were not surveyed, I put them in a list, and I put that list next to the list of the 14 that were surveyed. I went to ten bullion bankers and I asked, "Of these two groups, which are the most important?" Nine out of ten of those bullion bankers said to me that the 23 who were not surveyed were as important or more important in terms of their aggregate position as the 14 that were surveyed. I sat down and I said to myself, this is very interesting. The Bank of England survey showed that only 14 bullion bankers had lent 3700 tonnes and that total was partial. If I grossed up the 14 to their total and I threw in an equivalent total for the 23 that were not surveyed, I came up with some gigantic numbers. Perhaps 9000 or 10,000 tonnes of gold had been lent, based on this Bank of England survey. This was all by inference mind you, but none the less, it was very striking. The total estimated borrowed gold in the official Gold Fields Mineral Services statistics was only on the order of about 2200 tonnes at the time. There was a giant discrepancy (Table 1).

Table 1: Why Official Supply/Demand Exceeds Majority Opinion Estimates
- An Argument from the Supply Side

This discrepancy was so large that I tried to be conservative, and, for no good reason, I chopped the 9000 tonnes down to 6000 tonnes because that 6000 tonne figure was already so far removed from the official numbers. In any case, this Bank of England survey implied big, big errors in the consensus supply/demand balances and a hell of a lot more gold lending than anyone thought.

Now look, gold lending began in earnest in the early 1980s. By 1995 it was a process that had been going on for more than ten years. Now, what if there were 6000 tonnes of gold loans---not 2000 tonnes of gold loans as implied by the consensus supply/demand statistics. That means that there had been 4000 tonnes more lending, most of it over the last ten-year period. Gold lending was a small activity during the 1980s. It was a much bigger activity during the 1990s, so obviously it was a business that was occurring on an increasing scale. If the discrepancy was 4000 tonnes over ten to fifteen years, 300 to 400 tonnes a year---well, then it was probably 200 tonnes a year in the 1980s and it was probably nearer 600 tonnes a year by 1995. That meant supply and demand were underestimated by something like 600 tonnes a year.

Now, the Bank of England survey results suggested a yet higher rate of lending over the past two years alone. This fact makes the Bank of England survey data quite perplexing and difficult to interpret. That being the case we thought it was best to spread the final total out more smoothly over many years. In any case, I looked at this data and I said to myself, "How can this be? Is there any corroborating evidence? Low and behold we found corroborating evidence---so now lets go further.

The World Gold Council conducts annual surveys of gold demand for three uses - jewelry, bar, and official coin - in 27 countries in the world. Though this survey is only partial it clearly points to total global gold demands that are many hundreds of tonnes higher than the so called "official" statistics provided by GFMS.
For 1999, the WGC Gold Demand Trends Survey found that gold demand for the uses and countries it surveys was 3,282 tonnes. GFMS surveys end use demand for jewelry only in some countries not surveyed by the WGC. Their estimates of 1998 jewelry demand alone in only seven countries - Greece, Portugal, Spain, the former USSR, Iran, Columbia and Canada - totaled 268 tonnes. In addition, the GFMS estimated that global gold demand for uses not surveyed by the WGC was 458 tonnes in that same year. If we total these three demand items we arrive at the following;

1) GFMS occasionally reports end use demand. Their survey for 1998 included the estimate used here. There was no comparable estimate in their 1999 report. The WGC reported a large increase in global gold demand in 1999. Based on WGC global demand trends this number is probably conservative

2) GFMS total gold demands exceed this total by 170 tonnes. They attribute these demands to investment in Europe and North America. The text of their report suggests these investment demands correspond to speculative short covering. Therefore, these additional demands would be outside those demands surveyed by the WGC. That this is so is apparent from an analysis of the breakdown by use of gold demands surveyed by the WGC in the countries in Europe and North America which it surveys.

From the above it is clear that the WGC survey plus select additional items from the GFMS survey points to a total that exceeds GFMS's estimation of all global gold demands. This subtotal still excludes jewelry demand in more than 100 countries. It also still excludes official coin and bar demand in these 100 or more countries as well as the seven additional countries mentioned above. To be sure, these are all smaller countries than the principal countries surveyed by the WGC. Yet, their income, taken in aggregate, is very large and their gold consumption must be considerable. These additional demands would raise any WGC survey based estimate of global gold demand well above the GFMS estimate.

We might add that this disparity between the WGC and GFMS demand surveys has been increasing progressively over time.

In the Gold Book Annual 1998 we compared growth in the estimates of demands for gold of the WGC and GFMS. We calculated that, for the years 1991-1996, the WGC data series showed annual demand growth that averaged 1.6 percentage points per annum more than the GFMS series. Again, if one compares these two data series for the years 1997 to 2001 (Figure 1), there is once again an average annual disparity but in this period it is even greater. This is a very large discrepancy and suggests that one of these two data series is very wrong.

Figure 1:

GFMS Gold Demand v WGC Gold Demand (1997-2001)

If one looks at Eugene Sherman's data on almost 200 years of private non monetary demand data, such gold demands have grown at a 4% to 5% rate for as long as we have data. During this period the "real" price of gold was more or less constant. Global income has probably grown at 3% to 4% per annum over this time period. This implies an "income elasticity of demand" in excess of unity. Gold demand has slowed since 1971 relative to the past. However, this occurred because of the more than threefold increase in the real dollar price of gold from 1971 to the beginning of the decade of the 1990s. Several studies (e.g. David Gulley) show that gold demand has a significant price elasticity. If one adjusts this rate of growth of gold demand for the elasticity of demand in response to gold's rising real price, it appears that, if anything, the rate of growth of private non-monetary gold demand relative to a constant real gold price actually rose slightly during the 1970s and 1980s. (See chapter six of the Gold Book Annual 1998). The gold industry has had a superior growth trend and can be classified as a durable moderate growth industry. The WGC gold demand data indicates this long-term trend has more or loss persisted into the 1990s. The GFMS data, by contrast, shows roughly a less than 2% rate of increase in global gold demand in the 1990's despite a significant decline in the real gold price and average annual growth of global income of more than 3%. This implies a drastic decline in the growth of gold demand relative to its past income and price determinants

Obviously, there is a huge disparity in the level and growth in global gold demand implied by the WGC and GFMS data. This is most conspicuous in recent years. GFMS shows almost no growth in global gold demand from 1995 to 2001 despite a very large decline in the real price of gold and more than a 20% increase in global income. As noted above, historical data shows that private non monetary demands for gold have exhibited an income elasticity in excess of unity and a significant price elasticity. The WGC data since 1994 shows some adverse shift in those historical income and price elasticities but it is still basically consistent with history. The GFMS data shows a massive departure from these historical parameters over this five year period. The degree of shift in these parameters implied by the GFMS data strains credibility; the shift implied by the WGC data does not.

The World Gold Council data, then, was quite corroborative, quite significant.

Now, in addition to the above we did a little bit of field research---we have had other people make inquiries with bullion bankers. (We went to other parties to make the inquires, since we feared that, as analysts, these dealers would be less forthcoming with us.) Some of these bankers had left bullion banking, some had been fired and felt disaffected and inclined to speak, some are still employed. In any case, they were willing to talk. Every year we have come upon one or several new reports on bullion bank present and past deposit positions. We have gotten, albeit crude, estimates of gold borrowings from the official sector from probably more than 1/3 of all the bullion banks. We went to bullion dealers and we asked, "Are these guys major bullion bankers, medium bullion bankers, or small scale bullion bankers?" We classified them accordingly and from that we have extrapolated a total amount of gold lending from our sample. That exercise has pointed to exactly the same conclusion as all of our other evidence and inference---i.e. something like 10,000 to 15,000 tonnes of borrowed gold.
Besides the above reasons for believing the official data on gold lending, gold supply and gold demand is flawed, we have many others. Some are less compelling and complex and not worth elucidating. Some are based on our "market intelligence", so we cannot disclose their nature and details. All we can say is in this regard is that some, (though not all) of the gold bug conspiracy talk on the internet seems to us to be more or less correct.

We conclude that we are quite confident our assessment of gold demand, gold supply and gold lending is correct.

One last issue. We explained earlier that the ultimate borrowers of gold lent by central banks are the shorts in the gold futures and forward market. In our estimation these shorts have now all been covered to some extent. We believe that some of the speculative shorts were covered in late 1998 when problems arose with many of the major hedge funds. More were covered during the gold price spike after the Washington Accord. Speculators, principally managed futures funds, continued to go short on price decline, but are all now very long. Lastly the producers have begun to reduce their shorts.

In the aggregate, then, total shorts in the gold futures and forward markets have been reduced. Does that mean that gold loans in the aggregate have been reduced ? No ! Why ? Because, at current gold price levels, where total fabrication and bar hoarding exceed mine and scrap supply and official sales, it is impossible for the aggregate gold loans to be paid down. When gold is lent, physical gold leaves the official vault and ends up in jewelry to be worn by the women of the world. Fabrication demand and bar hoarding must exceed mine and scrap supply and official sales in order for lent gold to be absorbed. There has been an absorptive constraint on the flow of borrowed gold and it has taken a decade and a half to build the outstanding stock of gold loans. What would it take to repay even a part of these loans. The bars lent by the central banks are no longer bars; they are now jewelry worn by the women of the world. To get bars to return to the central banks, the gold price must rise high enough to lower price elastic physical demand and raise mine and scrap supply and official sales and thereby create a surplus that can be made into such bars. That obviously has not happened. Therefore the gold loans cannot have been paid down, even by a small amount. In fact, according to our supply/demand balances, borrowed gold continues to flow into the market and the gold loan aggregate continues to grow.

We can phrase this in another way. The existence of a positive flow of borrowed gold requires a "deficit" in the gold market. When this happens, the women of the world become the ultimate longs in a market in which speculators and mining companies are the shorts. The shorts do not realize the women of the world are the longs. Nor do the women themselves. What do those longs do when the gold price rises. In aggregate nothing. Some cash in their gold; but others are inclined to value gold more and buy more. So the women of the world, the longs, are not inclined to deliver their gold to the shorts. In effect, gold lending led to an inadvertent corner in the gold market by the women of the world. The shorts didn't realize this, the bullion banks didn't realize it, the lending central banks didn't realize it either. In effect, they jointly acted to create unwittingly a "prison of the shorts".

But, you may ask, how have the shorts in the futures and forward market, in aggregate, been greatly reduced ? How can that be ? Very simply, the official sector has recognized the existence of this inadvertent corner, this prison of the shorts and it has had to intervene. It has quietly taken the gold shorts from private speculators and producers and transferred them to their books. In other words, the official sector intervened to prevent an explosive gold derivative crisis. We conclude from our argument based on the development of an inadvertent corner in the gold markets, from a "prison of the shorts", that, since the Long Term Capitol Management crisis in late 1998, the official sector has been managing the price of gold.

Part 2

The Current State Of The Gold Market

The gold price has rallied from the mid $270's to just over $310 and has traded in a stable fashion for about 2 months. It is our assessment that there has been relative stability in the physical market overall, large scale buying in the New York and Tokyo futures and forward markets and significant covering of hedges by gold mining companies. Taken together, there has been remarkably strong buying overall. For the market to not explode amid numerous bullish technical signals presumes strong offsetting selling. Since producers are covering hedges, we must assume this selling emanates from the official sector.

The Physical Market

There is a great deal of commentary on physical buying of gold by Japanese households. Apparently, a fear for the safety of bank deposits in Japan has created something of a gold rush. The Japanese government lifted deposit insurance on bank deposits at the end of Japan's March fiscal year. In addition, concerns are mounting among Japanese households about the eventual necessity by the country's monetary authorities to pursue a deliberate inflation to confiscate Japan's excessive debt. The combination of these two factors has led some Japanese households to begin to accumulate physical gold.

However, there is fairly limited data substantiating significant physical gold accumulation in Japan. The import data shows only a moderate inflow of physical metal into the country and dealers do not see a large pick up in shipments of refined metal from Western refineries to Japan. The increase in Japanese imports of gold suggests Japanese households are buying more physical gold than in the past, but it has probably been only on the order of 20 tonnes per month for several months.

How significant would such an increase in Japanese demand be for the physical market overall? In our estimation, it would only partially offset losses in Asian demand stemming from the regional recession and a strong dollar. We estimate overall physical demand to be on the order of 5000 tonnes per year. According to World Gold Council survey data, a weakening Indian currency plus a weaker economy had caused a drop in Indian overall fabrication and bar hoarding in the second half of 2001 when gold prices averaged about $275. This demand has always been very price sensitive in the past, and should have fallen further in the first quarter of 2002 because of the rise in the gold price. Altogether this would suggest that price sensitive Far East demand may well have declined in a fashion that offsets the increase in Japanese demand.

For the Pacific Rim economies, the global collapse in high tech spending has caused a recession that is, in aggregate, almost as serious as the regional recession of 1998. To this adverse shock to income we must add the renewed weakness in the currencies of the region. It is often thought that savers in the Asian emerging economies "go to gold" when their currencies weaken. The historical record shows that this is definitely not the case. These savers allocate a certain percentage of their incomes to gold jewelry and bar purchases. When their currencies weaken, the price of gold in those currencies rises and their incomes, denominated in those local currencies, buy fewer ounces, thereby depressing physical gold demand.
    Based on the most recent World Gold Council and Gold fields Mineral Services demand data, it is our view that a global recession and a strong dollar, coupled with a somewhat firmer dollar gold price, has depressed gold fabrication demand and bar hoarding. The pickup in gold demand in Japan only offsets part of this overall softness in global demand. Therefore, we cannot attribute recent strength in the gold price to physical buying.

The Futures and Forward Market

We have data on speculative gold buying on the two principal global futures exchanges: Comex in the U.S. and Tocom in Japan. The OTC forward market is much larger, but we have no data on such activity in this market. We presume it mirrors the visible futures exchanges but that much larger magnitudes are involved.

The Comex data shows that speculators in that market have gone significantly to the long side. They have not taken on record long positions, but their long positions are now close to (but not quite at) the peak levels seen on rallies over the last several years (Figure 2).

Figure 2:

CFTC Commitment of Traders Report

Net Speculator Positions in COMEX Gold Futures, May 1992 - May 2002

In Japan, the combination of a rising gold price and a weak yen has led to a huge rally in the yen price of gold. This, plus concern about the future value of yen bank deposits, has led to large scale buying in the Japanese gold futures market. Recently, the speculative long position on Japan's gold futures market is close to peak levels reached only three times since the mid 1980's.

In our opinion, most of the speculators in both the U.S. and Japanese gold futures markets are trend sensitive; they follow price momentum and will sell once the gold price trend reverses. Based on trading patterns that have prevailed in the past, we would expect considerable selling from these market participants if official selling caps the gold price and the gold price trend reverses to the downside.

Producer Hedging

What is probably making this rally significantly different from rallies in the past is the behavior of gold mining companies who hedge their production in the gold futures and forward market. Prior to late 1999, producers typically added to their gold hedges (or shorts) every year. Such hedging often occurred into gold price strength and acted to cap rallies driven by trend following speculators. There has been a series of spectacular corporate financial crises created by large producer hedge positions on gold price rises since mid 1999 (Ashanti, Cambior, Centaur). These examples have dampened prior producer enthusiasm to add to their hedge books on gold price rallies and the aggregate producer hedge book has therefore been stable to declining since then.

From what we can glean from reports emanating from the producer sector, these market participants, taken in the aggregate, began to reduce their outstanding gold forwards sometime last year. Such a move may have been accelerated by the 2001 decline in US interest rates, which now has almost eliminated the contango that producers earn on their forward hedges. It may also reflect a growing belief amongst mining companies that the gold price has been held artificially low by the official sector. The staff of Veneroso Associates talk often with gold mining executives. The skepticism they expressed in the past toward our unconventional views on gold supply/demand has now largely dissipated. This may be due to a growing awareness that the gold market deficit exceeds consensus estimates. They may now believe, as we do, that the gold price will be driven higher by commodity dynamics sooner than the "official" statistical portrayal of the market would expect.

Figure 3:

Producer Hedging for the period 1982 - 2001 (from GFMS - Gold Survey 2002)

Gold Fields Mineral Services estimates that net outstanding producer hedges declined last year by 147 tonnes (Figure 3). Based on anecdotal evidence, this seems somewhat low to us. Other market participants agree that hedge books are being reduced.

We believe that this reduction in producer gold hedges, which constitutes a form of buying in the gold derivatives market, may have intensified into the current gold price rally. The combination of speculator buying on the various global futures and forward markets, plus a reduction in producer hedge books, constitutes cumulative buying pressure in the gold derivatives market that may have no precedent over the last two decades.

The Official Sector

Physical gold demand may have weakened overall because of global recession and a strong dollar, but its overall decline is probably not significant, owing to recent physical buying by savers in Japan. If anything, global mine supply is basically flat. By comparison overall net buying in the futures market is probably huge. Yet the gold price has staged only a modest $35 rally and has now met considerable resistance at the $310 level. We must presume there has been offsetting selling of a comparable magnitude from the official sector. Furthermore, the way in which the gold price initially met the psychologically important $300 level with a sharp drop in volatility suggests that such official selling is not due to uncoordinated one off large scale official sales. This would suggest that the gold price is being managed by the official sector.

When the gold price rose to $300, Bundesbank Council head Ernst Welteke announced that the Bundesbank would sell gold at higher prices in the future. The gold price fell back thereafter. It soon recovered to $300. Welteke repeated his public comments. In the past, a major central bank like the Bundesbank would have avoided making such a controversial statement. To many the timing of Welteke's statements could be construed as part of an effort by the official sector to "cap" the gold price.

Sometime, in the coming months, we believe that data will be compiled that will show a significant net decline in producer hedging so far this year. Such a decline will not be readily squared with the consensus (GFMS) supply demand framework for the gold market except by assuming large scale unreported official selling. If one postulates large scale speculator buying, which Comex and Tocom data support, the inferred official sector selling will be larger yet.

From our contacts in the hedge fund industry, we understand that some of the recent buying in the markets for gold futures, gold forwards and gold equities has been spurred by a growing belief that the gold market is being managed by the official sector and that this management will at some point fail. Some such speculators believe, probably wrongly for the time being, that buying by Japanese savers will overwhelm official efforts to "control" the price of gold.

In our opinion, when data on a net reduction in outstanding producer hedges becomes available in coming months, the current suspicions regarding official management of the gold price will move closer to becoming convictions. At that point, speculators will recognize that at some point such management will fail. Though they will in all likelihood judge that it can persist for some time, they will be oriented to speculate on the long side of the gold market whenever there surfaces any reason to believe that official management of the price of gold might fail.

We believe the official sector appreciates the challenge such thinking by market participants poses for management of the gold price. Give the timing of Ernst Welteke's statement on Bundesbank willingness to sell its gold, we would not be surprised by further official statements or actions that might be construed as part of an attempt to manage the gold price. One or more of these statements or actions may be so extreme as to shock the market.

Conclusion

If history is any guide, official selling will "fill the boots" of trend-following speculators in the gold market and the gold price will fall back toward its prior trading range. The global recession and strong dollar, which curb gold jewelry and bar demand, have been facilitating the ability of the official sector to keep the gold price low.

Over time, the forces for a higher gold price will build. Though it may not happen over the short run, in the long run the dollar will fall - and substantially in our view. A dollar decline will lower the prices of gold in countries outside the dollar bloc, which will in turn stimulate price elastic demand.

The fear of dollar weakness may also shift official sector attitudes toward holding gold as a reserve asset relative to the dollar. Many central banks feel uncomfortable with the now higher share of dollars in their official reserves. The huge and ever increasing internal debt of Japan and the growing prospect of a Japanese bailout inflation, a by-product of which will invariably be a weaker yen, are making these same countries uncomfortable with the yen as an alternative reserve asset. Though the euro will be the prime beneficiary of a move by central banks to diversify from dollars, such diversification objectives may make some central bankers less inclined to sell or lend their gold. In fact, some may choose to buy gold. The Chinese central bank has a stated objective of reducing its high reserve holdings of dollars, and it may be noteworthy that they have reported the first rise in central bank gold holdings (in tonnes) in many years. As long as the dollar has remained strong, central banks have felt no pressing need to address their high dollar holdings, but an eventual reversal in the trend in the dollar exchange rate may change that perception.

The outlook for mine supply will also help lift the gold price. Over the last 4 years, mine supply has held up despite low gold prices because there was a pipeline of projects from the 1994-96 period of higher gold prices. That pipeline has now been almost depleted. In addition, mines initially high graded to improve cash flow at low gold prices. High grading increases output over the near term, but ultimately reduces overall life of mine output and brings forward in time depletion dynamics. We may be getting close to this crossover point. In a recent public statement, Wayne Murdy, chairman of Newmont Mining, forecast that mine supply should now decline by 3-4% per annum.

Declining mine supply will tend to put direct upward pressure on the gold price (Figure 4). More importantly, perhaps, the prospect of a decline in mine supply at current low gold prices may change producer sentiment on the gold price outlook and accelerate the move toward a reduction in gold forward sales that has already been underway.

Figure 4:

World Annual and Quarterly Gold Production (From Goldsheet.com)

Predicting private gold investment demand is far more difficult than forecasting gold commodity supply and demand. However, it does appear plausible that speculative and investment demands for gold may increase in coming years. As noted above, we believe that recent Japanese investment demand for physical gold is currently overrated by many. However, it must be kept in mind that, owing to price deflation, yen currency and deposits still provide high real returns and the controversy over the need for a deliberate debt confiscating inflation in Japan has been largely confined to professional circles. If there is eventually such a debt confiscating inflation, the current demand for physical gold in the country may prove to be the trickle that presaged the torrent once the dam broke. A debt confiscating policy of inflation in Japan will not go unnoticed in neighboring Asian economies that have also contracted the "debt disease". Though the same may never happen in the West, it is possible that, after 2 decades of having been perennial bears, Western futures speculators, seeing events in Japan, may be more inclined to "punt" from the long side in the future.

Lastly, we hear from our friends in the hedge fund community that our views on the gold supply/demand framework are gaining recognition. Our views imply that the official supplies that have been depressing the gold price must abate or end sooner than the consensus expects. It is our guess that we are correct in our views and that evidence will continue to surface to make our views more credible and more widely shared. This will interest more speculators on the long side of the gold market during future rallies. Over time, such speculation may reach a mass critical enough to have a permanent impact on the behavior of all market participants, including those from the official sector.