The World's Central Banks are Stockpiling Gold - And You Should Too

Today's comment is by Eric Roseman, Investment Director and editor of Commodity Trend Alert.

Dear A-Letter Reader,

The European Central Bank (ECB) has officially joined the chorus of influential central banks which are stockpiling gold bullion. With the ECB now growing its physical bullion reserves, gold-bugs are in some high-powered company.

It's no wonder the ECB has joined the parade of gold-bugs. The yellow metal is racing to surpass its nominal all-time high of US$850 an ounce it set in January 1980. Gold currently trades at a 27-year high - just US$105 dollars below its all-time high.

For gold to truly be in a secular bull market, it must rise against all major currencies, and that's exactly what's taking place now. In fact, spot gold prices have been rising against all major currencies since 2005. Over the last 12 months alone, gold has gained 29% in U.S. dollars, 19% in euro, 28% in yen and 18% versus the soaring Canadian dollar.

The latest statistics for September, courtesy of the ECB, show the Frankfurt-based institution accumulated €14.36 billion worth of gold (US$20.3 billion). This means they now have a total of €186.3 billion (US$263.6 billion) in their reserves. That's, an 8.2% increase compared to August 31 and a 3.2% rise in aggregate reserves since March (latest figures available).

Who Took all the Gold?

Bull markets, especially in raw materials, are predicated on supply and demand fundamentals. To a lesser extent, raw materials also follow the direction of the U.S. dollar and interest rates.

Over the last several years, severe commodity shortages have resulted in incredible gains for investors. Savvy investors have literally cleaned up on supply deficits in the base metals, the grains, lean hogs and other foodstuffs has resulted in incredible gains for investors. Gold bullion is next on the supply shortage list as production continues to decline.

Global gold production peaked in 2001 at 2,604 tons or 83.7 million ounces. In 2006, gold production stagnated to 2,467 tons. That's a 5% decline. It's predicted gold will post another single-digit decline in 2007 as production bottlenecks and strikes in South Africa, the world's largest gold producer, continue this year.

Annual gold mining supply has declined by 4.4 million ounces since 2001. Over the last six years, gold prices have risen from US$260 an ounce to US$745 an ounce - a 186% rise.

While the majority of central banks typically have the worst sense of market timing, several institutions in Europe, Latin America, Africa and especially in Asia, have been busy accumulating physical gold this decade.

But at the same time, many major market economies (namely Spain) and several producing nations, including Canada and Australia have been dumping gold this summer.

Despite Massive Central Bank Sales,
Gold Rockets Higher

But what's truly impressive about this gold bull market is the ongoing parade of central bank sales since 1999. Despite regular central bank dumping, the gold market has easily absorbed several million tons over the last eight years.

The first Central Bank Gold Agreement (CBGA), originally signed in 1999, covered a five-year period regulating the amount of central bank gold sales to 2,000 tons. The maximum sales quote permitted under the terms of the second CBGA is 500 tons annually, or 2,500 tons from 2004 to 2009.

Although statistics aren't available on cross-border sales, including central bank purchases, it's fair to assume that several large central banks in the emerging markets continue to recycle their devalued U.S. dollar exchange reserves into gold bullion.

Who's Buying All this Expensive Gold?

The emerging markets are an incredibly different asset class in 2007 compared to just 10 years ago. They're wielding enormous influence on capital markets.

Back in 1997 and 1998, most countries were either nearly bankrupt or suffering from a financial meltdown. But since 2002, many of these countries have benefited from the commodity bull market, and enjoyed record net trade surpluses and bulging foreign-exchange reserves.

Russia, China, Argentina, South Africa and several other smaller emerging market countries are the most significant buyers of gold since 2003. And in terms of fabrication demand, India is by far the largest consumer of gold jewelry, followed by China, Turkey and Russia. Even as gold prices have almost tripled since 2001, fabrication demand has not waned - in fact, it's actually soared!

The Power of Emerging Markets
and Sovereign Wealth Funds

In addition to emerging market purchases this decade, oil-rich countries and sovereign wealth funds continue to trade U.S. dollars for physical gold as an alternative investment amid a plunging dollar since 2002.

Sovereign wealth funds, created by governments to invest assets worldwide, seek higher returns on capital. These funds have increasingly sold staid U.S. Treasury bonds as the dollar has declined. These influential companies, overseeing an estimated US$1.3 trillion dollars, continue to assume stakes in public companies, private equity, real estate, the euro and gold.

The bull market in gold is now running on all cylinders in late 2007. In a testament to bullion's ultimate value as a store of monetary wealth, it is now regaining its importance as a strategic asset among many central banks tired of holding not only depreciated dollars, but other fiat currencies that have significantly declined vis-à-vis gold.

The current trend among central banks may also herald a return of the gold standard. We could see a future monetary regime similar to the now defunct Breton Woods agreement that would include the world's largest economic powers' currencies and commodities. If that is a possibility, then US$750 gold is extremely undervalued in nominal terms.

If gold is good enough for the ECB and other central banks, it's good enough for every investor. That's especially the case, if you're seeking to hedge paper money and protect your purchasing power in an environment of growing monetary and financial instability and ultimately, higher inflation.

ERIC ROSEMAN, Investment Director

P.S. Saying "invest in gold" isn't enough if you don't know how to invest in gold - a.k.a. the central bankers' favorite hedge against the falling dollar. So click here for my favorite gold plays to guard your portfolio in the months ahead.

Reader Response: What We Think of Nicaragua

I received a response to my offshore comment from Tuesday ("Stay Away from Nicaragua"). The reader who wrote me is an American real estate agent in Nicaragua, and the reader made some points worth considering...

"We can't argue with much of what you say here. It's an unfortunate situation that most Nicaraguans did not vote for. But here's another perspective: all of this could represent a window of opportunity...if you can stomach the elevated political risk. The fact is, Nicaragua was on the verge of being heralded widely - globally - as the "next Costa Rica" and the "next Panama" in the world press before Daniel Ortega's presidential victory earlier this year.

Our hope is that as real estate prices continue to escalate in both Costa Rica and Panama and as Ortega approaches the end of his five-year presidential term, that'll happen again. Ortega 2.0 can't be Ortega 1.0 if he wanted to. He has even less support now - including less support among his own Sandinistas - than he did after the election, and he was elected as a minority president to begin with. He faces a hostile legislature that has opposed him on a number of significant issues. Nicaragua is more dependent financially than it has ever been on the U.S. and the European Union. It will never receive as much support from Chavez, Iran or Cuba as it does from the U.S. and the European Union in both government aid and private investment - and most Nicaraguans know this.

It is our view (and yes, hope), that apprehension created by Ortega's minority government has opened a window of opportunity for smart, forward-looking investors with a five-to 10-year time horizon to get in "before the herd" - before the end of Ortega's term and before what we anticipate will be the resumption of the real estate investment boom that preceded Ortega's presidential election victory.

We have seen estimates from global real estate analyses earlier this year that Nicaragua, as a whole, may be as much as 68% undervalued, given its level of economic freedom and its business climate (as measured by the Wall Street Journal Index of Economic Freedom). In other words, adjusting statistically for what Nicaragua offers investors compared to other countries - as far as property rights, tax burden, transparency, government spending (as a share of the economy), inflation, trade, labor, financial and business regulation policy - Nicaragua is only 32% of the average cost of countries offering similar business climate characteristics.

This isn't to take anything away from what you've said. We are not apologizing for Ortega. We're only providing broader long-term perspective. We only wish to point out that Nicaragua now may represent the same investment opportunity that Mexico in 1994, Argentina in 2001 and Eastern Europe in the early 1990's represented - that Nicaragua itself represented in the early 1990's - during and after political and financial crises in those regions. Those crises eventually gave way to fantastic real estate booms.

And the political risk in Nicaragua now may be far less than it was back in the early 1980's. Ortega just doesn't have as much support now as he did back then - nowhere near it. Wishful thinking on our part? Maybe. Just some food for thought. For all the political heartburn, it's still a beautiful country with beautiful people - a great place to live with enormous untapped investment potential."

Thanks for your comments. I always welcome reader feedback to any of my articles.

BOB BAUMAN, Legal Counsel

Wealth & Investments

Agribusiness Reaps a Rich Harvest
with U.S. Taxpayers' Handouts

With the NFL football season in full swing, a different kind of political football is being tossed around on Capitol Hill right now. It's the 2007 version of the U.S. farm bill - a federal government boondoggle if ever there was one.

The Bush administration and Congress just love to bash China for "manipulating" its currency to boost global exports of cheap Chinese manufactured goods. But when it comes to farm policy, the U.S. is itself one of the biggest manipulators on the global stage.

Congress has enacted a vast array of agricultural subsidies and price supports to artificially prop up American crops, which costs taxpayers like you and me billions. The U.S. also places punitive tariffs on agricultural imports that might otherwise lead to lower prices for American consumers.

Fewer than 2% of Americans even work down on the farm, but the current farm bill in place since 2002 has averaged just over US$80 billion a year in support payments. And most of the handouts go to big businesses, and wealthy absentee landlords, not to the quintessential small-town American farmer.

In fact, from 2002 to 2007, the government spent US$72.9 billion on "commodity support" programs - essentially direct handouts. A whopping 75% of that money went to just 10% of American farms.

Payments are heavily concentrated on crops that reflect the structure of U.S. agriculture back in the Depression era of the 1930's. The big name crops like corn, cotton, rice soybean and wheat receive the bulk of price supports, which only encourages irrational overproduction.

For example, U.S. cotton growers sell their crops on global export markets for about half what it costs them to grow the stuff. The American taxpayer picks up the difference. This of course means that cotton farmers in the developing world can't compete. And nearly half of their population is dependent on agricultural exports for survival.

At the same time, America slaps high tariffs on imported crops. The average U.S. tariff on agricultural imports is 18% - much higher than the 5% average tariff on other imports. So not only are U.S. consumers subsidizing big agribusinesses who don't need the help, but at the same time, we're paying much higher prices for the food on our tables this Thanksgiving than we need to.

The U.S. Senate is currently debating the 2007 farm bill, which comes up for renewal every five years. Hope springs eternal for reform. But judging from the version of the bill passed by the U.S. House of Representatives, we may have to live with this boondoggle for another 5 years.

In July, the House version of the farm bill actually increased the overall size of potential support payments, eliminating some recent tax cuts to pay for the increased agricultural largess. Your tax dollars at work!

MIKE BURNICK, Senior Editor & Global Markets Analyst