The Connection Between Gold Prices and Geopolitics
Gold has been on a meteoric rise since the start of 2022 – increasing an impressive 16% since January 2022.
However, what many investors may not realize is that this surge is not primarily being driven by consumer demand. Rather, a quiet yet colossal buyer has been rising steadily in the ranks: central banks.
As global uncertainty continues to shake markets around the world, central banks have been stockpiling gold as a way to protect their balance sheets from the fallout. Read on to take a closer look at the factors driving the surge in gold.
Who’s buying gold?
While the supply of gold is relatively stable, the demand for gold is on the rise, especially amongst the global central banks. In 2022, central banks bought 1,136 tonnes of gold, up from 450 tonnes in 2021, as reported by the World Gold Council.
But before we look at why central banks are buying gold, we need to understand the role of gold in a central bank’s balance sheet.
Why do central banks buy gold?
- Store of value – A store of value is an asset or commodity which tends to retain its value and can be exchanged in the future. Gold is a real asset with intrinsic value, limited supply and universal purchasing power, making it a reliable store of value. In economic crises, central banks can pledge gold to secure foreign currencies. For instance, in 1991, India’s RBI pledged 46.91 tonnes of gold with the Bank of England and the Bank of Japan to secure a $400 million loan during a severe balance of payment crisis.
- Inflation protection – Gold is a reliable hedge against inflation as it retains its value while paper assets like currencies can lose their value. As a result, investors and banks often look for alternative assets like gold that can hold their value during times of inflation. Since gold is a commodity which is limited in supply and cannot be controlled by one country, it does not lose its value easily. Hence, central banks also buy gold to secure their purchasing power during inflation.
The gold-buying spree of central banks can be linked with the Russia-Ukraine war
In response to the Russia-Ukraine war, the US imposed economic sanctions on Russia. One of these sanctions was freezing Russian assets held in US dollars (USD), which includes Russia’s foreign exchange reserves.
USD is the most widely used currency for international trade and financial transactions. So, many central banks hold USD reserves as part of their foreign exchange reserves. They hold foreign exchange reserves to stabilise the currency exchange rate, facilitate international payments, and manage the monetary policy.
When the US froze Russia’s USD reserves, it sent a signal to other countries that the USD could potentially be used as a tool for economic sanctions or political pressure. This phenomenon has been termed ‘the weaponisation of the dollar’.
The weaponisation of the dollar has made central banks across the world fearful of relying too heavily on the USD for their foreign exchange reserves, as it could leave them vulnerable to similar sanctions.
As a result, central banks are now diversifying their foreign exchange reserves by buying gold. By holding gold, central banks can reduce their reliance on any single currency, including the USD, and protect their foreign exchange reserves from potential political or economic disruptions.
In a nutshell
Central banks buying gold can be a contributing factor to the recent surge in gold prices. But it is also important to acknowledge the role of investors’ demand for gold as a safe haven asset amidst the current economic conditions. As interest rates and inflation continue to rise, it is possible that gold will remain an attractive option for investors seeking to hedge against market volatility. As market dynamics are ever-evolving, investors should keep an eye on the latest developments and make informed decisions about their portfolios.
Windmill Capital offers Asset Allocation versions of our most popular smallcases. Asset Allocation can significantly reduce the risk/volatility of our most popular model smallcases while maintaining the high returns. Invest in equity as per the underlying theme/strategy of the smallcases AND also invest some amount into other asset classes like debt, gold and cash.
Check out Windmill Capital smallcases
Disclaimer: Investment in securities market are subject to market risks. Read all the related documents carefully before investing. The content in these posts/articles is for informational and educational purposes only and should not be construed as professional financial advice and nor to be construed as an offer to buy /sell or the solicitation of an offer to buy / sell any security or financial products.
Users must make their own investment decisions based on their specific investment objective and financial position and using such independent advisors as they believe necessary.
Windmill Capital Team
Windmill Capital Private Limited is a SEBI registered research analyst (Regn. No. INH200007645) based in Bengaluru at No 51 Le Parc Richmonde, Richmond Road, Shanthala Nagar, Bangalore, Karnataka – 560025 creating Thematic & Quantamental curated stock/ETF portfolios. Data analysis is the heart and soul behind our portfolio construction & with 50+ offerings, we have something for everyone. For more information and disclosures, visit our disclosures page here –https://windmillcapital.smallcase.com/#disclosures