London, July 2010

The World Gold Council (WGC) has published a research paper examining how gold can help a central bank meet its foreign reserve management objectives.  The study looks at gold in three contexts: strategic asset allocation and the maximisation of risk-adjusted returns in the investment portfolio; as a tactical overlay to hedge against current global macroeconomic risks; and as a high-quality liquid asset in periods of distress, the time when central banks most need their reserves.

In the former, portfolio optimiser models are used to show that the efficient frontier of a typical developing or emerging market central bank can be enhanced by adding gold. How much gold depends on a central bank’s risk appetite: an allocation to gold of between 2.4% and 8.5% is optimal for a bank with around a 5% risk tolerance. At a risk tolerance of 8.3%, the optimal allocation to gold increases to 29%.

Natalie Dempster, Director in the Government Affairs team at The World Gold Council, comments on these findings: “The results of this study are not intended as a strategic asset allocation recommendation for any specific central bank and are illustrative in nature, not least because central banks’ actual portfolios will differ from the one used in the example, as will their risk and return expectations, and investment constraints.

While the appropriate allocation to gold for a central bank will depend on many factors from investment policy to liquidity requirements, what the study revealed is that, given the way gold interacts with other assets, it stands out as a very effective portfolio diversifier within reserve portfolios, displaying a low average correlation with other typical reserve assets.

“Beyond the strategic case for gold outlined in the study, current global macro-economic risks, such as the European sovereign debt crisis and strong money supply growth make a strong case for an additional tactical overlay to gold in reserves. A sovereign debt downgrade to below investment grade reduces the pool of eligible investments for many central banks, while contagion risks lower the attractiveness of similar assets.

“Furthermore, the 2007/2009 financial crisis clearly changed what could be perceived to be markets which are deep and liquid.  Gold, which bears no counterparty risk and is permissible as a reserve asset, has remained highly liquid through the worst of the financial crisis, and hence becomes especially attractive in the current environment.”

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The importance of gold in reserve asset management, it is available from: www.gold.org