2025 Public Sector Perspectives

Historical role of gold in monetary system Gold has played various roles in different cultures and societies. In ancient times, gold was used as jewelry and also carried significant symbolic meanings. In India and China, for example, gold represents wealth, prosperity and longevity. Even today it is a must-have at Indian and Chinese weddings. But gold’s role evolved with the external environment. The use of gold shifted from symbolic meaning to real economic value when the Egyptians and Romans were inspired by gold’s characteristics to use it as their currency for trading. After fulfilling that role for several centuries, gold began to be used as the base asset for issuing fiat currencies during the 1700s. The gold standard was first adopted by Britain in 1816. The Great Depression During the Great Depression, people converted fiat currencies into gold to protect the value of their assets. To encourage conversion of gold back to fiat currencies and to increase the opportunity cost of holding gold, central banks around the world raised interest rates. This only served to exacerbate the Depression. Many countries could not maintain their currency peg against gold and therefore left the gold standard in a bid to save their economies (this included the UK which abandoned the gold standard in 1931). In 1934, the U.S. passed the Gold Reserve Act that prohibited both dollar redemption for gold and ownership of gold in order tomaintain the dollar’s peg to gold. The U.S. and France were the only countries which maintained their currency peg against gold during this period. WorldWar II Prior to and duringWWII, a significant number of countries sent their gold holdings offshore for safe keeping, primarily to the U.S. and the U.K. To this day, a significant amount of some countries’ gold reserves remain held in the vaults of the Federal Reserve Bank of New York and the Bank of England. However, this is changing due to several factors discussed later. BrettonWoods System The BrettonWoods Systemwas set up in 1944 by 44 countries as the world sought to rebuild the stability of international financial system after WorldWar II. Gold became the heart of global monetary system as it, in effect, became the underlying asset for most of the world’s currencies. The majority of the world’s currencies were pegged to the dollar while the dollar was pegged to gold and was freely convertible. Due to a variety of factors, countries increasingly converted their USD holding for gold in the 1960s and early 1970s. This ultimately led U.S. President Nixon to suspend dollar redemption for gold in 1971, marking the abandonment of the currency peg and presaging the end of the BrettonWoods System. Reduction of gold holdings The Great Moderation from the mid-1980s to 2007 was a welcome period during which economies grew at almost their full potential rate with relatively low inflation and interest rates. In addition to the positive macro environment, the world order was characterized by an openness to trade, international cooperation, and the rise of globalization. Consequently, gold prices fell from a high of around $850 in 1980 in nominal terms to a low of $284 in 1990. 2 With the decline in global inflation and a perceived reduction in the need for safe-haven assets, particularly after the end of the Cold War, central banks began to re-evaluate the need and size of their allocation of FX reserves to gold. Central banks became net sellers of gold during the 1990s and early 2000s. This was highlighted by the decision by the Bank of England to sell more than half of its gold reserves in 1999. It was an attempt to diversify and invest in interest yielding assets particularly those that were denominated by the then newly-launched euro. While politics may have played a role in this instance, the sale also showed the change in sentiment towards gold. For the first time inmore than a century, gold appeared to have become peripheral in the monetary system. Role of gold from the global financial crisis to post-COVID era Beginning with the burst of dot-com bubble in 2000, sentiment towards gold began to shift. Gold prices began to rise sustainably after the 9/11 attacks on the World Trade Center as investors perceived greater geopolitical risk and grewmore skeptical about the sustainability of the strong global economy. The global financial crisis in 2007-08 completely shifted the outlook and price for gold. Investors, including central banks, clamored for the safe-haven characteristics of gold. Consequently, beginning in 2010, central banks once again became net purchasers of gold. During the 2010s therewere a series of crises and developments that sustained central banks’ consistent purchases of gold. Events including the Eurozone debt crisis (2010), U.S. sovereign debt downgrade (2011), US-China tradewar (2018), and COVID-19 (2020), prompted central banks around theworld to keep interest rates at very low levels for a long period of time. 3 Interest rates being at historical lows, and even nominally negative in some instances, made the opportunity cost of holding gold lowand easy to justify. Market dynamics added to the incentives to purchase gold. After reaching a lowof $1,049 in December 2015, gold prices continued tomove higher, creating returns that investment-grade fixed income assets could not match during the same period. Thismade gold an increasingly attractive and important part of central banks’ portfolio. 2 https://www.investing.com/commodities/gold-historical-data 3 https://sprott .com/investment-strategies/physical-bullion-trusts/the-case-for-gold-in-crises-2024/ 24 The Changing Role of Gold in Central Bank Reserve Management