Somewhat lost amid the euphoria over the recent stock market rise, with the S&P 500 approaching a new record high, is the recent increase in gold prices. Gold futures settled at their highest levels in recent weeks, testing and occasionally breaking the psychologically important $1,300 barrier. The short-term reasons for the increase in gold spot prices are weakness in the U.S. dollar and concerns over global growth with unsettled trade and tariff negotiations with China and between the United States and its North American neighbors. Asia, the EU and UK are all showing clear signs of slowing growth, and even the recent stock market rise is getting long in the tooth, according to many market analysts.
Although rallying sharply from its 2018 lows, gold fell 1.1% in 2018 and notched a .85% rise in the first quarter of 2019. This was largely seen as a Pyrrhic victory. Although the rebound was impressive, it was another year of high expectations dashed by harsh reality. The one step forward, one or two steps back movement of gold over the past twelve months, and really for most of the last several years is growing tiresome. For investors, economists and analysts looking for catalysts for sustainable upward price movement – to $1500 per ounce or more over the next year, there may now be a glimmer of hope that gold is on the proper upward trajectory, thanks to the adoption of new bank capital requirements that now favor expanded gold holdings.
Basel III is a collection of international banking regulations established by the Bank for International Settlements (BIS) to promote stability in the international financial system. 28 countries participate in the Basel Committee on Banking Supervision (BCBS), which promulgates rules governing the appropriate level of capital for banks and international banking supervisory standards. The BIS is the trading agent for gold for the International Monetary Fund (IMF) and central banks around the world.
Following the international financial crisis of 2008 and the realization that many banks were undercapitalized and massively overleveraged, taxpayers and governments were forced to bail out the banks, and government regulators all around the world responded with an insistence on more and higher quality capital reserves. These directives became enshrined in post-2008 global banking regulations. The purpose of bank capital is to absorb losses, boost consumer confidence, limit disproportionate asset growth, and provide protection to depositors and insurance funds.
Under the Basel accord, a set of rules were originally established to set capital requirements for financial institutions, dividing assets into categories based on their perceived riskiness, with bonds and gold considered among the least risky assets. A banking institution has to maintain a minimum level of cash or liquid assets as a ratio of its risk-weighted assets, known as the capital adequacy ratio (CAR). Consequently, under Basel I rules, banks were required to hold a percentage of assets in these lower risk assets. With Basel II, bank assets were divided into three categories: Tier 1 assets representing the lowest risk and Tier 3 assets representing the highest risk. Tier 2 capital includes revaluation reserves, hybrid capital instruments and subordinated term debt, general loan-loss reserves, and undisclosed reserves. Under Basel II, gold could either be considered a Tier 1 or a Tier 3 capital asset.
For gold, the discount applied for calculating its liquidity buffer, known as the net stable funding ratio (NSFR) that all banks must hold, is increasing from 50 percent to 85 percent. “This change will make it far more attractive for central banks and banks to hold gold as part of their liquidity profiles and bolster the ‘gold rush’ we are already seeing from central banks and global financial institutions,” says Anthony Allen Anderson, VP of Sales and Marketing at GSI Exchange, a leading coin dealer and precious metals investment services company based in Calabasas, California, “the ability to count gold as a reserve asset, enabling gold preferred capital reserve status on the balance sheet of banks, along with a renewed, industry-wide focus on ‘financial soundness’ will set gold up for sustainable long-term growth.”
The Basel III rules are intended to represent a meaningful step forward in reducing global financial risk. Seeing gold as a historic safe haven during times of economic turmoil, and as a stable, secure asset with intrinsic value, central banks turned again to gold, from a regulatory perspective at least, as a preferred asset for banks to hold in reserve. Under Basel III, a bank’s tier 1 and tier 2 assets must be at least 10.5% of its risk-weighted assets, an increase from the 8% required under Basel II. These rules go into effect starting March 29, 2019, but the impact on gold prices should be felt for many years to come.
In January 2019, the World Gold Council reported that global central banks, responding to the Basel III rule changes and geopolitical uncertainty added 651 metric tonnes of gold to their reserves in 2018, the highest increase in fifty years, representing a 74% year-over-year increase in net purchases, with China and Russia leading the way.
According to a 2014 report by the World Gold Council it is estimated “that the amount of gold on China’s banks’ balance sheets has increased between 400 tonnes and 1843 tonnes since 2009.” In the five years since, and with liberalization of rules that now allow Chinese private investors to purchase gold bullion, China has become a major force in the global markets for gold. According to the IMF, Russia has tripled its gold reserves since 2005 and is holding the most gold since at least 1993.
“Russia and China have been some of the largest buyers of gold in recent years — exponentially increasing their gold reserves, and we are seeing a global currency shift away from the U.S. dollar. Whether this reflects a desire to establish an alternative international financial system returning to a gold standard or a strategic move away from Western hegemony in financial markets, only time will tell,” says Oksana Prysyazhnyuk, an international business strategist and policy consultant, “similarly, Russia and China have been actively involved in shaping the markets and pricing for oil and natural gas, where the two nations are trying to effect a balance of power shift in this valuable commodity as well.”
With a determined China and Russia entering the market, other central banks are likely to follow, especially following the introduction of the new Basel III rules, when banks are expected to strongly support, rather than suppress gold prices, as a way to boost their balance sheets without taking on added risk. For investors waiting for the long-promised gold breakout, Basel III and China and Russia’s aggressive buying may be exactly the triggers they’ve been awaiting.
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