Gold Sales Cost Europe’s Central Banks Billions

Well how about that? The jobless rate dropped in April, according to the Australian Bureau of Statistics. It went from 5.7% to 5.4% as 27,300 new jobs were added to Australia’s economy. Economists were expecting the economy to lose 25,000 jobs.

Is this a number you can believe? Maybe so. It sure seems like it is at odds with what everyone in the business community is saying. And most economists still expect unemployment in Australia to creep towards 10% by 2010. But for a month at least, the numbers say otherwise.

Speaking of numbers, try US$74 billion (or $100 billion, if you like your numbers in Aussie dollars). That’s the combined total of how much capital the U.S Treasury Department thinks America’s 19 largest banks will need to survive further losses. Under the “more adverse” scenario, Treasury modelled how banks would survive with a loan loss rate of around 9.1%.

U.S. stock markets reacted to the tests by closing down over one percent. Is that because the results were already pretty well known? Or is it because most people know the ‘stress test’ exercise actually did more harm than good? Investors spent weeks speculating about which banks were under the most pressure. But frankly, we’re not much closer to that answer today.

There are also two big things the ‘stress tests’ did NOT do. First, they did not clarify how raising additional capital improves the quality of around US$2 trillion in housing-related assets that are currently rotting on bank balance sheets (because it doesn’t). Second, they did not show how converting preferred shares into common shares actually improves a bank’s capital position.

In fact, converting preferred into common doesn’t really put any more money into the bank. It’s just an accounting gimmick. It’s a painless way to improve tangible common equity, against which banks can offset future losses. So just to be clear, we can’t quite figure out how converting preferred shares into common improves a bank’s capital position in any meaningful way. More meaningful ways would include selling assets to raise actual cash, or selling new shares to raise actual cash.

More than anything, the ‘stress tests’ reveal a complete lack of resolve on the part of the U.S. government to deal with its banking crisis honestly. Instead, we’re going to get ‘zombie banks’ in America. The FT’s Lex column says, “In the short term, many shareholders will be diluted as banks convert preferred shares into common equity to raise capital.”

“But at the end of this process,” it continues, “many will be convinced the banks have been restored to health. Longer term, however, the $3,000bn-odd aggregate hole in US financial sector balance sheets is beyond the private sector’s ability to fill. Mirroring Japan more than a decade ago, Thursday may well mark less a revival of the sector than the beginning of zombie banking in America.”

And it’s because of the private sector’s reluctance to plug gaping holes in financial sector balance sheets that we can extend a warm welcome to the European Central Bank. It joined the “Quantitative Easing” (QE) club today, and it did so in style. First, Europe’s central bank cut short-term interest rates to just one percent. This was expected. The bank has cut rates by 325 basis points since last October.

What was less expected is that the inflation hawks at the ECB seem to have been outflanked by the counterfeiters (money printers). The ECB joins the U.S., Japan, and the U.K. in throwing caution to the wind and money from helicopters by pursuing a policy of Quantitative Easing . ECB President Jean-Claude Trichet said the bank will buy €60 billion worth of “covered bonds.” It will do so with brand spanking new euro notes.

So what does it mean? Well, in comparison with the QE efforts in other countries, the ECB is late to the game and modest in ambition. The ECB’s first foray into this strange new world is small, at just 0.5% of Eurozone GDP. That compares with QE efforts of 2% of GDP in the U.S. and 8% in the U.K. IN fact, just yesterday, the Bank of England said it would increased its bond purchases (QE) by £50 billion.

But what’s important about the ECB’s action is that it was the last major central bank to at least pay lip service to inflation that results when the monetary base expands so much. Now, the world’s major central banks are in ideological agreement that the response to falling asset prices is to support them directly through money printing. That is probably the most important development in financial markets all week. It means you can expect an even larger expansion of the global monetary base, the precondition for a big surge in inflation when banks begin lending again.

“Navigating the world is much harder than in the 1930s,” says Black Swan author Nassim Taleb. This is the most difficult period of humanity that we’re going through today because governments have no control.” Taleb was speaking at a conference in Singapore. He warned of “big deflation” ahead as asset values fell. But Bloomberg reports that he also thinks gold and copper could “rally massively” as governments print money.

We have tentatively named this the “Dr. Barbaric” trade. That’s a combination of copper’s nick name (Dr. Copper) and the moniker given to gold by John Maynard Keynes (the barbaric relic). Copper prices rise when an economy recovers. So we’re assuming here that Taleb’s forecast on copper is a kind of call option on future growth, while the gold forecast is a put option on paper money.

You know that copper will eventually be in demand again when global demand resumes growing (we’re assuming that it will, some day, in the future, perhaps in China and India). So for now, copper stockpilers or futures traders might like the idea of being in a practical metal that has real industrial and economic demand as opposed to, say, government bonds. Of course not everyone is going to do this. But for some traders, copper might be a good place to park capital in the coming inflation.

And gold? Well you know all about that. Yesterday’s Financial Times had three stories in a row on gold. The first was, “Beijing Bets on Bullion” and showed that even though China’s gold reserves have doubled since 2003, the country still only has 1.6% of its total foreign reserves in gold. The world average is 10.5%. This means that China-like Russia before it-is likely to be a ready buyer of IMF gold sales or sales from European Central banks. It’s yet another kind of Money Migration.

The second FT article said that “Gold sales cost Europe’s central banks $40 bn.” Central banks in France, Spain, the Netherlands, and Portugal followed Britain’s 1999 example and sold large chunks of their gold reserves when gold prices were around US$280. They sold around 3,800 tonnes of gold for around $56 billion, according to the FT. The FT reckons if they’d kept those gold reserves and not bought government bonds with the proceeds, those banks would be $40 billion better off. That would come in handy today, wouldn’t it?

As an aside, can you see how upside-down the world is? The ECB prints money to buy bonds. The Bank of England, the Bank of Japan, and the U.S. Federal Reserve all do the same thing. Meanwhile, central banks are selling a real tangible asset like gold. These people are supposed to be guardians of sound money with steady purchasing power? They seem to aiming for the exact opposite.

European central banks have a larger percentage of total reserves in gold compared to the rest of the world. The FT says that even after years of sales, European central banks typically have around 60% of their reserves in gold. So in theory, selling the gold reduces their exposure to one asset class and gives them greater diversification.

But at what price? Europe accumulated its large gold reserves through centuries of commerce and conquest. Now it’s selling the Continent’s accumulated monetary treasure off in order pay for unsustainable social welfare promises made by nanny state socialists over the last 50-years. Does that seem like a good long-term trade for Europe’s future?

Maybe the rising gold price and anxiety over huge deficits is causing a re-think. The third FT article on gold reports that “Central banks succumb again to bullion’s lure.” It reports that last year, “central banks sold 246 tonnes of gold, which was the lowest amount in ten years.” On an annual basis, Eurozone central banks sold the lowest amount of gold in the last ten years in 2008. And outside of Europe, central banks were net buyers of gold in 2008.

Our point? Serious, knee-rattling doubts about the financial system are held at the highest levels of global government and banking. Pay no attention to the drivel, pap, and platitudes you hear on a week-to-week basis. This latest market rally is a convenient distraction from fundamental changes that are afoot in the world’s monetary system. As investors, we need to keep that in mind and be positioned to profit from the right commodity investments.

Former Morgan Stanley analyst Andy Xie is certainly keeping it in mind. ” If China loses faith, the dollar will collapse,” he’s recently written.

“Emerging economies such as China and Russia are calling for alternatives to the dollar as a reserve currency. The trigger is the US Federal Reserve’s policy of expanding the money supply to prop up the banking system and its over-indebted households. Because the magnitude of the bad assets within the banking system and the excess leverage of its households are potentially huge, the Fed may be forced into printing dollars massively, which would eventually trigger high inflation or even hyperinflation and cause great damage to countries that hold dollar assets in their foreign exchange reserves.

Xie then makes a point Aussie investors ought to consider. Namely, the Fed’s big expansion sets off a cascade of global currency devaluations. This is the catalyst for a higher Aussie gold price, as the Reserve Bank lowers rates and the Federal government pursues larger deficits and more stimulus to deal with the crisis.

“As the Fed expands the money supply,” Xie writes, “it puts pressure on other currencies to appreciate. This will force other central banks to expand their own money supplies to depress their currencies. Hence major currencies may take turns devaluing. The end result is inflation and negative real interest rates everywhere. Central banks are punishing savers to redeem the sins of debtors and speculators.”

So what is the end game?

“China is aware it must become independent from the dollar at some point. Its recent decision to turn Shanghai into a financial centre by 2020 reflects its anxiety over relying on the dollar system. The US will not pay attention to something so distant. However, if global stagflation takes hold, as I expect it to, it will force China to accelerate reforms to float its currency and create a single, independent and market-based financial system. When that happens, the dollar will collapse.”

It may not happen this week or even this year. But we agree with Xie. That’s where we’re headed. With copper, oil, and gold all beneficiaries of money printing and U.S. dollar weakness, investors in Aussie resource stocks can turn the dollar crisis into an opportunity. What’s more, Chinese diversification out of dollar reserves has already proven to be resource bullish.

This resource exposure is a good hedge for the Australian economy. The Australian government may squander it by running up large and largely unproductive debts that steal away capital from the private sector. But since there’s nothing we can do about that except to point out that it’s idiotic, the best strategy is to turn the coming currency realignment into a benefit. More on that next week. Until then…

Dan Denning
for Markets and Money

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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4 Comments on "Gold Sales Cost Europe’s Central Banks Billions"

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Plenty of freaky stats Dan, here’s some more that’ll get you pondering:

U.S. PE ratios thru roof from 20 to 60 in 09. P falling, but E plummeting faster.

And this, are U.S. banks maxing out the Feds Amex card, like never seen before going back to the 20’s?
You wonder what frequent flyer benefits go with that; perhaps a one way trip to the nearest tropical tax haven?


Oops, try this one from the St Louis Fed:


Dear DR,

I agree with your belief that gold will increase in value when inflation hits. I also believe that as a result of huge deficits and irresponsible policies in the US, USD will collapse, rather sooner than later…

However, how can you make money by investing in gold if any increases in the gold price will be offset by an appreciation of the AUD/USD rate (assuming USD gets pounded and the Aussie dollar stays relatively strong)?

Do you think gold may be priced in a different currency in the future? Is it again only Americans doing money on gold?




Converting prefer’d shares to common DOESN’T improve a bank’s capital position, quite right. That move (the only one that will actually play out in the current financial environment- because no one will buy their assets OR shares)is intended to give the Feds control of those banks thru voting rights- of those shares.

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