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central banks of s. america loading up Central Bank of Argentina – a changed view on gold
By: Rhona O'Connell
Posted: '19-SEP-05 11:14' GMT

http://www.mineweb.net/sections/gold_silver/489001.htm




LONDON (Mineweb.com) -- At the precious and base metals seminar held in London on September 14th and organised by research group GFMS, Juan Basco of the Central Bank of Argentina gave an interesting insight into the thinking of central bankers and how Argentina has developed an increasingly flexible foreign exchange policy over recent years.

Having, some years ago, decided that gold was not worth holding in its portfolio and having reduced its holdings to less than one per cent of total (of which more below) it has now changed its philosophy and was a purchaser of gold during 2004 as it reshaped its portfolio. The Bank now holds 3% of its foreign exchange reserves in gold and may consider taking more in future, but is not currently committed to doing so. Responding to a question from the floor Mr. Basco stated that this may well also be the case with other Latin American central banks – which opens up an interesting vista for the future and clearly this area will be one to watch.

Mr. Basco described how in the period 1991 – 2001 the Argentine government was on a currency board, which meant that the peso had to be kept to a one-to-one parity with the US dollar. In 2002 a floating rate system was introduced and this initially led to a dual system and the banking system came under severe pressure; in 2003 the currency was stabilised and since then the central bank has become a net purchaser of foreign exchange in the international market.

The essential difference between the 1990s, during which Argentina ran down its gold reserves and now, when it has increased them again, is a direct result of the degree to which the Bank is allowed to (or has to) manage its foreign exchange reserves. In the 1990s, the whole of Argentina’s monetary base had to be backed by foreign exchange reserves, which meant that there was a passive monetary policy with no currency risk. The central bank was, at that point, forbidden by law from financing government debt.

The attitude to gold accordingly came under review. Gold had originally been seen as an important reserve asset for the central bank as it was used to protect the portfolio against the effects of inflation or financial crisis. Then, however, it lost its role a means of payment, holding costs were regarded as high and because it was deemed to be illiquid it was not available when intervention was required. Other assets, meanwhile, were offering higher rates of return. Because, also the central bank had to follow a passive policy with respect to the portfolio, any large drop in the gold price affected the currency’s dollar parity and left part of the monetary base unprotected.

The bank therefore put in place a zero-cost put/call options strategy to hedge the gold holdings (i.e., it identified the minimum gold price necessary to protect the monetary base and bought puts to protect that price, financed by the sale of calls). At this stage the holdings comprised roughly four million ounces in good delivery bars and a further 400,000 ounces in non-good delivery coins that had been minted during the 19th century. In 1996 and 1997 the options were exercised and the proceeds went into US bonds and foreign currency instruments from G-7 countries.

Working through the banking crisis that followed the changes in policy involved three stages. In the first half of 2002, heavy intervention was necessary and the peso dropped from 2.80 to the dollar to 3.80 to the dollar and the volatility in the exchange rate was high, resulting in a drain on the country’s foreign exchange reserves. In the second phase in the second half of the year the peso was stabilised at 3.50 to the dollar and volatility fell while intervention became more focused on the wholesale rate and temporary restrictions on capital flows were released. Since 2003 the peso rate against the dollar has appreciated and the central bank is, as outlined at the outset, a net buyer of foreign exchange in the international market. The country’s international debt restructuring was completed in mid-2005, covering more than 80% of its external debt and is now enjoying small capital inflows (Mr. Basco pointed out also that Argentina has never defaulted on any of its debts to international agencies).

Herein lies the change in attitude towards gold. Because the bank is now active in the market rather than passive, it is adopting a totally different portfolio management philosophy. The liquidity in the gold market has been proven ample for the bank’s requirements. With $25 billion reserve assets (likely to be $27 billion by the end of this year and compared with nine billion in 2002), the government needs to control the volatility of its portfolio and has introduced gold as part of the diversification necessary to achieve that aim. The bank takes the view that gold is recovering its role as an asset that protects a portfolio from crisis and also that, following the recent decoupling from the euro, its role as portfolio diversifier has been further enhanced. When asked from the floor why the bank had decided that gold was a liquid asset, his response was that they had proved that it is – they sold a lot and bought a lot without any disruption to the market.

Part of the decision to take gold into the portfolio rests on the fact that the bank holds 30% of its reserves in non-dollar assets and it therefore wants to use gold to reduce volatility. It will not go above that of non-dollar assets percentage because of its need for dollars for international trade.

The latest figures from the IMF show that during 2004 Argentina acquired 54.9 tonnes of gold (equivalent to five days’ global fabrication and bar hoarding demand). It is not a lone voice in the wilderness, but it does make a change for headlines to concern a central bank acquisition as opposed to constant talk of official sector selling. On which note, a reminder that the second year of the Central Bank Gold agreement goes into force on September 27 and we should expect heavier sales in the fourth quarter of this year than we had in the third, by quite some margin.