Central Banks Seek Portfolio Diversification Using Gold

Central Banks Seek Portfolio Diversification Using Gold

As gold and silver continue to climb, reports are showing not only that central banks are turning into net buyers of gold, but that experts believe to see this trend continuing over concerns of inflation and instability.

April 14, 2011 10:23 AM GMT

Gold and silver prices climbed for a second day. A survey shows that central banks turned net buyers of gold in 2010 and cut exposure to debts issued by Greece, Ireland and Portugal. It's also unveiled that reserve managers found gold, investment-grade corporate bonds and AAA-rated bonds as more attractive than the year before. We believe the trend will continue as concerns over fiscal stabilities and inflation will trigger central bank purchases of the metal.

US President Barack Obama's budget plan to reduce the country's deficits by $4 trillion in 12 years is expected to generate criticism from Republicans regarding tax hikes. The market generally thinks the proposal is not aggressive enough. Indeed, Obama's deficit cut is lower than what were proposed by Paul Ryan, House Budget Committee Chairman, earlier this month and by Erskine Bowles and Alan Simpson, co-chairmen of Obama's fiscal commission, late last year. Ryan suggested cutting the deficit through spending cuts by $6 trillion over 10 years while the Bowles-Simpson commission proposed to trim deficits by $3.8 trillion over a decade.

A report by Benn Steil and Paul Swartz published in the website of the Council of Foreign Relations on Monday suggests the Obama administration's deficit consolidation plan is based on growth assumptions, instead of actual cuts in spending. The Office of Management and Budget projects the US economy will grow +4.4% in 2013 and +4.3% in 2014, compared with consensus market forecasts of +3.0% in 2013 and +2.8% in 2014 during the period. If consensus forecasts are used in budget calculations, the government will have to cut $1.75 trillion more to achieve the same result it desires.

If the budget plan fails to alleviate deficit problem, the status of USD as a major reserve currency will once again be threatened. The IMF urges the US to derive a 'credible strategy' to stabilize its public debt as the country is the only large advanced economy where 'the cyclically adjusted fiscal deficit is expected to increase in 2011 compared with 2010 despite the ongoing economic recovery'. Deteriorating fiscal conditions in the US benefits gold as investors lose confidence in fiat currencies and prefer owning hard assets as a store of value.

A survey done by Central Banking Publications indicates that reserve managers no longer view that sovereign debts are risk-free. More than 80% of respondents said sovereign risk fears had impacted their strategy. Another issue affecting investment strategies was Fed's expansion of QE2 in November last year. These 2 factors are probably the major reasons transforming central banks to net gold buyers, after being net sellers for 20 years. We expect if the US government fails to pass a feasible budget plan, gold may rise further as investors seek to diversify away from USD.

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