Can gold replace financial assets?

Source-This post on Can gold replace financial assets? Has been created based on the article “Limits of the global gold rush” published in “Business Standards” on 24 May 2024.

UPSC Syllabus-GS Paper-3– Indian Economy

Context-The article discusses the limitations of gold as a primary reserve asset. The international gold prices have surged by over 30% in the past two years, driven by increased demand.

Why have international gold prices reached record highs recently?

1) Generally, it is believed that low-interest rates should cause gold prices to remain low because gold does not generate cash flow.However,prices have increased despite the rise in global interest rates.

2) Gold prices have risen despite a relatively strong US dollar, which is usually inversely related to gold prices.

3) The major reason for increasing gold prices is sustained buying by central banks. Central banks accumulated 290 tonnes of gold in Q1 2024, a record for the first quarter, led by China, India, and Turkey.

Why are central banks buying significant amounts of gold?

1) Gold has historically been an important component of central bank reserves, and many central banks are now buying gold for diversification purposes.

2) Some are also seeking to reduce their dependence on US treasuries due to geopolitical tensions and the risk of asset seizure. This was evidenced by the freezing of Russia’s reserves by Western countries after the Ukraine invasion

3) Gold, when physically stored within a country, poses no such risk of asset seizure and is free from any default concerns.

Read more- Gold drives trade deficit to new high

 What are the limitations of gold as a primary reserve asset?

1) Gold is at best a diversifier and unlikely to be a major driver against the US dollar’s dominance for large central banks. For ex- about 60% of global forex reserves and over 80% of global trade are still denominated in US dollars.

2) Increasing gold’s position in large central bank reserves can push prices and increase investment risk due to its limited supply.

3) The limited supply of gold suggests that even slight changes in demand can result in significant price fluctuations. When considering this factor alongside its emotional value and the potential market effects of major central banks selling their reserves, it indicates that gold is likely to maintain a minor role in the global economy during periods of geopolitical and financial instability.

4) Large transactions involving gold can disrupt central banks’ efforts to maintain currency stability and smooth capital flows, as they require liquid forex reserves for this purpose.

Question for practice

What are the reasons behind central banks acquiring substantial quantities of gold? What are the drawbacks of relying on gold as the main reserve asset?