Golden Avalanche

Nick from www.sharelynx.com shared some quotes with me that I'd like to pass on. They are from a book written in 1939 by Graham & Whittlesey called Golden Avalanche:

“Before leaving the subject of gold supply it is interesting to relate present gold reserves to the monetary circulation of this country and the world. The gold reserves of the United States are almost two and a half times the total of all ordinary money now in circulation in this country. We could replace at its present value every piece of paper money with a gold coin and would still have enough left over to do the same for every country in Europe. There is enough gold in the monetary reserves of the world to replace all ordinary currency of the entire world 100 per cent with gold coins. Never until the present decade was such a situation as this even approached.” p.15

"It has been estimated by a number of writers, on the basis of conditions prior to 1914, that the production of gold would have to rise by about 3 per cent a year in order to preserve approximately stable price levels. The best known of these calculations are those of the Swedish economist, Professor Cassel. This estimate tends to exaggerate the rate of expansion in the demand for basic reserve money. It is based on a period when population and production, and, therefore, the money-work to be done, were increasing at an exceptional rate, and when the non-monetary demand for gold was at its highest. During these years, moreover, the need for gold rose as rapidly as it did partly because of the extension of the international gold standard system to embrace a growing list of countries.

Even if the gold standard system were again established as it was in 1913 the need for gold could not be expected to increase as it did in the half century before the World War, simply because there would not exist the same possibility of extending the use of gold over a steadily widening area.

As was noted earlier, the monetary reserves of the world are today nearly three times as great as in 1929. If commodity prices were to return to the 1929 level, if business activity were to increase at an annual rate equal to that maintained in the sixty fat years prior to 1914, and if all the countries then on the gold standard should return to it, we should still have enough gold to meet all monetary requirements for many years to come, even though not one single ounce was produced during that time. If the gold standard is not restored on such a scale, then the world is long on gold to a corresponding degree. It is absolutely fair to say that, ignoring entirely the possibility of increasing the efficiency of our monetary and banking systems and making the most liberal assumptions as to growth in the monetary and non-monetary demand for gold, there is not the remotest prospect of the world’s needing to have another ounce of gold mined for several decades." p. 18-19

The King of Currencies

A reader has asked me to comment on these two recent GATA articles www.gata.org/node/7908 and www.gata.org/node/7911, which claim that London unallocated metal is a fractional reserve system.

Adrian Douglas’ assertion is that there is at a minimum four owners for each ounce of unallocated metal held in London. His support for this is to apply the ratio of average daily share trading in GLD (11.9m) to its shares outstanding (325m), rounding to a ratio of 1:30, to an estimate of the daily trading in gold in London to derive the amount of gold London should have. This is then compared to an estimate of what London does have, resulting in the 1:4 fractional ratio.

For his estimates of the London market, Douglas relies on a report by Paul Mylchreest. I haven't had time to review Mylchreest’s numbers in detail, but his report takes a very logical approach and is fact based to estimating of the amount of gold in London. His conclusion is that there is

"an aggregate pool of gold of just over 16,866 tonnes of gold to support an average of 2,134 tonnes of daily spot gold trade. On this basis, 12.7% of the pool of available gold is being turned over every day on average. … And the entire pool is turned over every 7.9 working days. In my opinion, this level of trade relative to the estimated pool of gold liquidity is excessive and doesn’t pass the smell test."

Firstly, he makes a series of assumptions to get to his figures. For example, his 16,866t figure relies on World Gold Council/industry estimates of above ground gold and the percentage that is investment. Being a trade organisation representing miners who want a high gold price one should expect that “stock” numbers will be estimated on the downside. When estimating what the real trading volume of gold is, then he steps into a more rubbery area because he is relying on only two guesses from some industry people - we need more than that.

As a result, one must consider his 12.7% turnover figure to have a fair margin of error considering all the assumptions and estimations used to derive it. This is not to say that it should be 1%, just that it is not a “hard” number.

Secondly, even if 12.7% is correct, I don’t think it logically follows that this “doesn’t pass the smell test", a conclusion he comes to by comparing gold to equity, other commodities and fiat currencies. The last one is probably the most relevant. In this he has to again make some assumptions about currency trading turnover to come to a figure of 2.6% for Sterling, conceding that when including forwards and swaps “daily Sterling turnover is only equivalent to 8.4% of UK broad money”.

Why stop at Sterling? If one does the same calculations for the Australian dollar, you get 4.1% for spot and 13.3% including forwards and swaps. Does gold’s 12.7% (which could be lower if some of Mylchreest’s assumptions are changed) now appear as an “excessive amount of gold trading relative to the likely pool of available gold”?

Mylchreest’s final conclusion is that either 1. there is “more than one ownership claim on each gold bar” or 2. “there is far more gold bullion held in private hands than is acknowledged by current industry estimates”.

I would suggest that there is another OR that Mylchreest has not considered: the very fact that gold is no one’s liability and cannot be printed means it attracts a disproportionate amount of trading and speculation. Why is it assumed that 12.7% is excessive and unreasonable? Could not the 12.7% figure be proof of the special monetary nature of gold, proof that it is the King of Currencies?

I have spent a bit of time on Mylchreest’s report because it is the key input into Adrian Douglas’ calculations. Before I move on to his numbers, I would like to say that I have a lot of respect for Mylchreest’s report and look forward to it being improved with more accurate data.

On that, I note Mylchreest’s statement on page 25 that “I haven’t a clue what COMEX inventories were in 1997, but let’s assume 200 tonnes …” That information is available at Sharelynx.com going back to 1975. A subscription is required but would be worthwhile as Sharelynx has a lot of other data that would be very useful for Mylchreest’s analysis.

Now on to Adrian Douglas’ calculations. He is basically applying GLD's turnover of 3.66% to Mylchreest’s turnover figure of 2,134t to come to an implied stock holding that London should have of 64,000t. This is then contrasted to Mylchreest’s estimate of 15,000t of non-leased physical to derive the 1:4 fractional ratio.

This analysis assumes that the behaviour of over-the-counter (OTC) players is/must be the same as those trading GLD. Let us consider each of Douglas’ statements in support of this.

“The purpose of buying investment gold is for it to store wealth. This necessarily implies that it is held for a long time.”

This is a very broad statement and one that I don’t think can be supported. Investors have all sorts of different time horizons. Remember we are talking about trading in unallocated and whether that is backed. The fact that it is unallocated rather than allocated bars would imply, if anything, that the investors have shorter time frames rather than long.

“If gold is bought and traded quickly it would destroy wealth, not store it, because there would be a large loss due to transactional fees.”

It is actually the other way around. The quicker you can trade something the less risk you have to changes in prices. Bullion banks have a spread between their bid and ask prices – they MAKE money from quickly trading gold. For those dealing with bullion banks in the OTC market, the tightness of those spreads combined with the volatility of gold mean it is entire reasonable for them to make money day trading gold.

“Considering these limitations [minimum trade limit of 1,000 ounces] it is likely that OTC participants would turn over a lot less than 1/30th of the inventory in a day.”

I do not see how the $1 million trade size must mean a lower turnover. That is not a big figure for wholesale market participants. With bullion bank spreads of $0.50 to $1.00, a 1000oz deal only means $500 to $1000 profit. This would mean that a spot gold trader would need to do a lot of trading to make a decent return on the capital employed, which means they would trade more frequently, rather than less.

As with Mylchreest’s comparisions to currency trading, I don’t think Douglas’ comparisions to GLD make any conclusive case that London gold turnover is suspicious.

For further support, Douglas notes that

“In the last 14 years the supply of dollars has increased from $4 trillion to $15 trillion (+275 percent) while the gold price has risen from $400 in 1995 to $1,000 in 2009 (+150 percent). How could this happen? … There has to be an alternative massive supply of gold to make the price rise slower than the influx of dollars.”

How it could happen is that those extra dollars were diverted into equities and house prices, rather than gold, pushing up their price more instead.

He also says that “If the OTC market traded only gold that was in the vaults on a 100 percent reserve ratio, there could never be a lack of liquidity.”

Lack of liquidity has nothing to do with stocks, backed or not. It has to do with a depth of buyers and sellers. If you have 100% backed unallocated, but few of the holders want to sell, then you have a lack of liquidity as well.

For some closing comments, I’ll quote Lawrence Williams from Mineweb:

“The big problem, though, with much of this kind of analysis is that the analysts and observers are working with a mixture of real and assumed figures. It thus tends to rely on statistics being manipulated, perhaps subconsciously, to support pre-conceived theories.”

Futures COT

Adam Hamilton of Zeal LLC is one commentator I have been following for many years. His latest one on the Commitments of Traders Report is essential reading:

"The bottom line is gold futures activity as chronicled in the CFTC’s Commitments of Traders Report is often misunderstood. A minority of analysts choose to interpret facts about week-to-week developments out of the illuminating context of bull-to-date behavior in similar situations. Thus their interpretations of this complex report are often misleading. And sadly many newer traders are swayed by this shoddy analysis.

It is critical to remember gold futures are a zero-sum game. For every short, there is an offsetting long. So if the feared commercial hedgers’ net-short position is surging and hitting records, then so too are speculators’ net-long positions."

SLV and Jeff Nielson

On Sep 17 Jeff Nielson posted an article on SLV. I took issue with his belief that ETFs' management fees were unrealistically cheap and thus another indicator they were a scam. Below is the exchange between Jeff and I on the matter.

Bron: You say "custodians of the vast majority of all the world's bullion-ETFs – a service which they are providing free of charge" but SLV has an expense ratio of 0.50%, some of which if I remember the prospectus correctly, is paid to the custodian. If SLV holders pay 0.50% how can it be considered "free". By what do you mean free?

Jeff: Hi Bron. Just look at all that is SUPPOSEDLY covered by this 1/2% fee:

1) Transaction costs. Purchases must be made CONSTANTLY, all day long - in order to buy the actual silver for unit-holders at the same price they bought their units at. Given the huge volatility with silver, it's not even feasible to restrict buying to once a day - since silver has had MANY daily moves of 5% or more.
2) Insurance/delivery costs
3) Storage/security costs.

Obviously BILLIONS of dollars of silver require significant security to guard such a hoard. The U.S. government has an entire military battalion guarding Fort Knox - so no one can find out how much gold is NOT there.If you think these costs are minimal, then answer this question: why do the small number of companies who hold their own bullion need to charge MANY times that premium for their own security/storage costs?

Bron: Before I comment, just want to state upfront that I work for the Perth Mint, but I am speaking here in a personal capacity. While I’m speaking personally, obviously the ETFs are competitors to my employer’s business, both in respect of physical coins and bars as well as our own storage facility, so I’m not any apologist for the ETFs. Taking each of your points in turn.

1) Transaction costs. I note that SLV’s average Bid Ask Ratio is 0.08%. This is very tight but is not necessarily unprofitable for a market maker. You are right that the market maker must be purchasing (or selling) gold constantly as it sells (or buys) SLV shares. My experience with the Perth Mint’s ASX listed product (code: ZAUWBA) is that the market maker will simply set their stock exchange price for an ETF higher than their cost on the wholesale over-the-counter market and adjust this constantly during the trading day. This way they always make a profit on transactions, it is not a cost to them. If individuals bid prices under this than the market maker misses out on a trade. It is only where there are excessive buyers or sellers that the market maker’s prices will get hit.

2) Insurance/delivery costs. Delivery costs are effectively zero, as the metal is most likely already in the vaults as sellers of physical need to bring their metal to London to trade it. Insurance is a real cost, but are easily covered by 0.50%. Important to note that the metal is not fully insured, just the first couple of billion (I don’t think the prospectus says anything about the first loss limit of the insurance). Once you get to a certain size therefore, the insurance cost is a fixed cost, not variable.

3) Storage/security costs. These are fixed costs, once you have a vault and have secured it, every additional ounce does not result in any change in costs. Once you get to the point that you have covered these fixed costs, every ounce above that is pure profit and this is where custodianship can be highly profitable. At 280 million ounces, SLV is definitely there in my opinion. Storage business is a classic case of economies of scale, which is why smaller companies have to have higher storage charges (eg Perth Mint allocated silver is 2.5% pa).

I have been a bit brief on explaining the above, but my view is that they are making money with a 0.5% expense ratio. That is why I think the “free of charge” line of attack is not supported and you are better off focusing on your other criticisms.

Jeff: Bron, at the time that SLV was created, there was only 200 million oz's of silver in GLOBAL inventories. Now SLV and others hold close to 450 million oz's. Obviously there MUST be both delivery AND insurance charges for AT LEAST 250 million oz's of silver - which could NOT have "already been in vaults".

As for security/storage costs, I'll happily concede (for purposes of argument) that no new storage space was created. This brings me back to my point about the ludicrous idea of a BANKER (holding a massive short position) SUBSIDIZING "longs" by providing free storage/security.

Even if you subscribe to that ludicrous fantasy, there is still the issue of the "opportunity cost" to banks. Precious metals are not the ONLY items in the world for which there is a demand for high-security storage. Will ANYONE suggest that banks will provide a FREE service for precious metals longs - rather than charge someone a fee for storing other valuable assets? Try asking JP Morgan to store YOUR OWN precious metals for free - and listen to how hard they laugh at you.

Bron: "Obviously there MUST be both delivery AND insurance charges for AT LEAST 250 million oz's of silver - which could NOT have already been in vaults"

You've missed my point. Lets assume the additional 250moz is real and was bought by bullion banks to back SLV & others. In that case, the bullion banks would incur no delivery charges as the seller delivers metal to London at their cost to be able to sell it on the spot market in London. Secondly, the additional 250moz has no insurance charges - as I said, they only insure the first $1b of holdings, not the entire holdings.

"the ludicrous idea of a BANKER (holding a massive short position) SUBSIDIZING longs by providing free storage/security" & "Will ANYONE suggest that banks will provide a FREE service for precious metals longs - rather than charge someone a fee for storing other valuable assets?"

Jeff, you keep on saying they are doing it for free when SLV charges 0.5%. Some of that 0.5% goes to the custodian, they are being paid. That is not "for free" - I don't understand why you keep on saying they are providing free storage.

The question is whether the 0.5% charge is realistic, profitable assuming the volumes of metal SLV and others hold is physical. As explained in my previous reply it is. Saying this does not mean that they have physical, but nor does it mean they do not.

Jeff: Bron, your assumptions about delivery cost are only valid if you're implying that silver (and gold) goes straight from refineries into bankster vaults - rather than having to be PURCHASED by the banksters (first) on the open market, and then transferred to their vaults.

When you mention the 0.5% fee charged by SLV, my understanding is that this also (supposedly) covers their OWN administrative costs AS WELL AS all the shipping costs, transaction costs, insurance costs, and storage/security costs.

You would be hard-pressed to find any ONE bankster service (in ANY of their business activities) which they are willing to provide for a 0.5% fee. Suggesting that they are willing to REDUCE their fees (to close to ZERO) to SUBSIDIZE the entry of longs into the market is simply nonsense.

Bron: "your assumptions about delivery cost are only valid if you're implying that silver (and gold) goes straight from refineries into bankster vaults - rather than having to be PURCHASED by the banksters (first) on the open market, and then transferred to their vaults."

No it doesn't. There is no difference between purchasing from refineries or on the open market - refineries are all in different countries just like existing stocks. If market makers cannot acquire metal from investors or sellers already holding it in London, they will actually be able to acquire it at a discount to London spot (which is the usual state of the market), the discount equalling the shipment cost into London. Even if they have to pay a premium (or pay shipment costs into London), then they just factor this into their bid and ask prices quoted for SLV. This is why delivery is not a cost that comes out of the 0.5% fee.

"When you mention the 0.5% fee charged by SLV, my understanding is that this also (supposedly) covers their OWN administrative costs AS WELL AS all the shipping costs, transaction costs, insurance costs, and storage/security costs."

The 0.5% does cover their administrative and compliance costs, but as I have discussed above and in my previous replies, any shipping and transaction costs are recovered via market making activities, so these do not come out of the 0.5%. As I have also replied, insurance and storage/security are FIXED costs, not variable, whereas the revenue of 0.5% is variable. This means that once you cover you fixed costs, the 0.5% on any additional metal is pure profit.

"You would be hard-pressed to find any ONE bankster service (in ANY of their business activities) which they are willing to provide for a 0.5% fee. Suggesting that they are willing to REDUCE their fees (to close to ZERO) to SUBSIDIZE the entry of longs into the market is simply nonsense."

0.5% is not "close to zero". On 280moz, 0.5% = $24 million, that is not anywhere near zero. The fact is that in the wholesale market storage is offered for much less than 0.5%. Do you remember David Einhorn's Greenlight Capital exiting his GLD in favor of physical bullion? He did this because it was CHEAPER, in other words he could get storage for less than GLD’s 0.4%. In fact, quoting http://www.hardassetsinvestor/:

“By contrast, a $400 million player in the bullion market has substantial room to negotiate. You can be sure his [Einhorn] bullion holdings are being custodied for less than 12 basis points.”

If you believe that 0.5% is an unrealistic fee, a subsidised fee and therefore proof that SLV is a scam, then logically you must also believe that Bullion Vault, with a 0.12% storage fee, is also a scam. This puts you in a bit of a spot, because Bullion Vault is one of the most transparent operations in the market, and favoured by many goldbugs and commentators. Your stepping out on a limb here.

The post above was on Sep 21, Jeff replied to another post on Sep 22 but ignored mine. I posted the comment below on Sep 27. No response by Jeff as at Oct 4.

Bron: You have replied to someone else's comment which appear after mine, but ignored mine. Does this mean you conceed on the issue of the reasonableness of the storage fee?

Canberra Trip

I have been busy preparing for two presentations I'll be doing at the Gold Standard Institute's seminar in Canberra. As a result my blogging will be infrequent.

On Sunday 1 Nov there is a free gold investor day and I will be explaining how London metal accounts are used to facilitate the flow of gold from mine to you. There is a great range of other speakers from Daily Reckoning, BullionMark, Global Speculator. If you are within driving distance of Canberra you would be crazy to miss it as it is a great opportunity to catch up with fellow precious metal investors.

2 Nov to 5 Nov is the formal seminar with Professor Fekete the key speaker. I'll have an hour session on COMEX stocks. Daily Reckoning will also be speaking and has a good explanation of what you can expect. Cost is $790 and a 4 day committment but if you have the time will be well worth it.

I have also forgottent to mention a new precious metals forum for Australians called Silver Stackers (they let gold investors in :). If you are tired of US centric discussions on forums like Kitco, it is worth a look.

Protecting yourself from World War III: Debtors vs Creditors

Steve Keen is an Australian Post-Keynesian economist credited as having "seen it coming" in this survey of research by economists or financial market commentators. Keen was one of only eleven researchers who qualified, which included Schiff, Roubini, and Shiller.

Steve Keen is a follower of Hyman Minsky’s “Financial Instability Hypothesis”, which he summarises as:

1) Capitalist economies periodically experience financial crises;
2) These are caused by debt-financed speculation on asset prices leading to bubbles in asset prices;
3) These bubbles must eventually burst because they add nothing to productive capacity while increasing the debt-servicing burden;
4) When they burst, asset prices collapse but the debt remains;
5) The attempts by both borrowers and lenders to reduce leverage reduces demand and causes a recession;
6) If the economy survives such a crisis it goes through the same process again, with another boom driving debt up even higher, followed by yet another crash; but
7) This leads to a level of debt that is so great that another revival becomes impossible since no-one is willing to take on any more debt;
8) Then a Depression ensues.

A plausible but dismal explanation. Consider this comment on Steve's latest blog post:

"This is one of the great questions for all of history, how to get out of this. For one thing, one persons debt is another persons asset or in many cases their money. ... It is clear that everyone that has something is going to take a haircut on it. Either by a systematic bankruptcy or by a natural one."

As Steve Keen says:

Some form of price chaos has to be expected though, whatever is done. One side-effect of the bubble has been an enormous dislocation in prices, not just with overvalued financial assets, but also with drastically overinflated incomes for the financial class, and concomitant price distortions all the way through commodities.

How do you protect yourself from this economic World War III? Simply swallow the red pill and step outside the Financial Matrix: bail out of your "has something"s into precious metals and sit by and watch the annihilation as everyone else takes "a haircut".

Scotiabank Certificates

The article Scotiabank and the Real Silver prompted me to have a closer look at their 2008 Annual Report. Two interesting quotes (note all dollars are Canadian):

“In Scotia Capital, revenue declined by 25%, due mainly to charges relating to the Lehman Brothers bankruptcy, valuation adjustments and generally weak capital markets. These were partially offset by record foreign exchange and precious metals trading revenues, and strong growth in corporate lending.” (p28)
and
“Precious metals trading revenue was a record $160 million, an increase of $44 million or 38% over last year, with higher revenues recorded in each of our major centres.” (p30).

Not surprising to see strong precious metal results from Oct 2007 to Oct 2008 (Scotiabank's reporting year). What I did find interesting is the observation by ispeakofpeak that Scotia's gold and silver certificates declined from $5,986m to $5,619m (p122), a 6.1% drop. This drop would reflect both changes in precious metal prices as well as changes in ounces held.

Unforunately, Scotia do not provide a breakdown of how many gold or silver ounces made up the certificate dollar total. But we do know that Canadian dollar gold prices were up 18% from 1 Nov 07 to 31 Oct 08 and that silver was down 14%.

If you think about it, assuming all the certificates were gold, then if the price was up 18% but Scotia's value dropped 6.1%, they must have lost a lot of ounces. On the other hand, if it was all silver, then as the silver price dropped 14% yet Scotia's value dropped only 6.1%, then they must have had an increase in ounces of silver.

Either of these would not be correct - there must be a mix of gold and silver. For sake of example and to put some numbers to it, lets assume for every $1000, $500 was gold and the other $500 silver. This is not unreasonable, I have seen many clients make this sort of "portfolio allocation" when buying precious metals. A 50:50 split by value works out as:

Gold Oz 2007: 3,996,336
Gold Oz 2008: 3,179,160
Change: -817,176

Silver Oz 2007: 220,173,903
Silver Oz 2008: 240,380,913
Change: 20,207,010

First off, some pretty impressive ounce totals, that would put them up there in my gold and silver league tables, if they were prepared to publish their actual ounce numbers.

What I do find interesting is that they lost gold at a time when everyone else (ETFs, GoldMoney, etc) were gaining. And it does not matter what you assume the split at. If you chose 75:25 gold:silver, or 25:75 it may change the amounts of gold and silver, but it still results in a loss of gold and a gain of silver.

Another interesting observation is that on their balance sheet they list Precious Metals at only $2,426m ($4,046m for 2007, p106). So dollar value precious metal liabilities only down $365m, but precious metal assets down $1,620m. This means that in 2007 they had 68% of their liabilities covered by physical but in 2008 only 43% cover.

If we look to their derivatives, p150 shows that “Foreign exchange and gold contracts, futures” with 1 year or less maturity were $2,602m out of a total of $4,239m. Gap between 2008 precious metal liabilities and physical assets was $3,193m. Conclusion: remaining 57% covered by COMEX futures and/or over-the-counter forwards.

Michael Pascoe - Gold Hater

Hat tip to Justin - Gold drops 25%! by Michael Pascoe:

So much for the rampant gold bugs wetting themselves about chart levels and such, never mind the overtime being worked in the mini-industry that exists around promoting gold.

As gold sceptics know, the yellow stuff occasionally has a day in the sun when there's fear and loathing in the financial system ...

But don't try to tell hard-core bugs that – they've long been inured to Shakespeare's warning that all that glisters is not gold.

I've created a new label called "Gold Haters" so I can keep track of them for future reference.

Alan Kohler - Gold Hater

One to bookmark and shove in his face when gold is $5000. From Gold fever looks incurable by Alan Kohler:

But underlying demand is weak and getting weaker, and supply is on the rise – big time.

Gold is the commodity of craziness.

... gold investors are that unique breed of incurable optimists who don’t want to be paid any income on their capital

... it is not a currency. I can’t go into JB Hi-Fi with a lump of it and buy a TV.

It’s just a commodity they [central banks] got stuck with because it used to be a currency a long time ago and will never be again.

So gold is also the commodity of confusion: is it an investment safe haven or just a commodity? Answer: it’s whatever everyone thinks it is, and right now it’s a haven.

To roll or not to roll, that is the central bank's question

Yesterday I was dismissive of the recall of Hong Kong's gold as significant, but it is another bit of evidence of a shift in central bank attitudes towards gold. Far more significant indicators include (see this MineWeb article):

* China's announcement that it had moved 454 tonnes of gold into its reserves since 2003
* Central Bank Gold Agreement (CBGA) quota being reduced from 500t to 400t a year
* Russia's Prime Minister stating that it should hold 10% of its reserve assets in gold

It points to a renewed appreciation of the role of gold in turbulent times. Recalls of gold like Hong Kong may also indicate a reassessment of counterparty risk. Moves to return gold are eminently sensible, of course: what is the point of a country having its gold out of its immediate physical control if everything goes to hell. That is really the whole point of having gold reserves. In a time of war (not that I'm suggesting that is where we are heading) you ain't going to be able to buy guns or food from another country with your funny paper money.

Some have claimed that repatriation of gold by other central bankers following Hong Kong's lead will translate into higher gold prices. However, this depends on the extent to which that gold is actually sitting in a vault somewhere or has been lent out to bullion banks. If the former, then obviously there is no effect on the price – the gold is just changing location. If the latter, then it could be potentially explosive if Frank Veneroso's estimates of leased gold of between 10,000 and 16,000 tonnes are correct.

I would point out that central banks can't just recall gold mid-lease, they have to wait till it's maturity. Consider also that the leases will have been made over varying terms, from a few months to a few years, and all at different points in time. This means that all of the central bank leases will mature over a number of years. What the term to maturity of this global lease book is, is hard to say. I'll have a stab at most of it being 1 to 2 year leases, but am prepared to stand corrected.

So not all of Mr Veneroso's leases will be recalled immediately, or to be more accurate, declined to be rolled. Plus not all central banks will decline to roll their leases (although that may change depending on how bad things get).

Also, don't fall into the trap of assuming that all of this leased gold has to be bought back from the market to repay the gold loans. This sort of simplistic analysis is based on an ignorant view that “leasing = bad”. The reality is a bit more complex. To explain, I am going to have to be a hypocrite and be simplistic myself. There are three things someone can do with borrowed gold:

1) Manufacture it into jewellery, coins or bars. Sell these for cash. Use cash to buy replacement gold. Hopefully have left over cash = profit. Repeat many times.
2) Sell the gold. Use the cash to build a mine. Extract the gold from the ground. Repay your gold loan. Hopefully have left over gold. Sell this for cash = profit.
3) Sell the gold. Invest the cash to earn interest. Hopefully gold price drops. Use part of your cash to buy gold. Repay your gold loan. Left over cash = profit.

All of the above are ultimately promises to repay gold, but not all of these have the same risk profile. I've ranked them in terms of risk and the first two are materially different to the third. In the first two the gold loan is backed by gold, either in inventory or below the ground.

In the current gold market, one would have to consider the risk of failure low for the coin/bar business – everyone wants the stuff – and I'm sure that central banks, through bullion banks, would not consider these leases high risk and necessitating recall. For jewellery, the increasing gold price equals less sales, so we could expect some business failures, so while these leases are backed by physical it would have to be considered at some risk.

For miners it is a bit more risky. Sure they have it in the ground, but lets not forget Bre-X or Sons of Gwalia. As long as any hedging is modest and loan maturities tied to production, these would also be considered lower risk by central banks.

In the case of the first two it ultimately comes down to the extent that the lease is secured: the first two are not risk free - business ventures do not always turn out as expected. To the extent that they are not secured in some way, central banks would have to be nervous, but not as much as our third category.

In the case of the short sellers, the gold is gone and only cash is left. To the extent that a miner has excessively hedged (did I hear someone say Barrick?), then they are also in this category. The crux of the issue is to what extent have the short sellers put up collateral and more importantly, have the ability to put up more (or the willingness to put up more)?

This collateral issue I will discuss in my next post. My point for the moment is to not get awe struck by the 16,000t figure (or whatever other figure is bandied about) and think it is all going to have to be bought back, and now, and therefore the gold price is going to the moon.

If central bank reassessment of counterparty risk results in requests for leases to be repaid, then it will occur over a number of years as those leases mature. This will manifest itself as a steady stream of short covers, not as a big bang, and be a source of solid "base" demand for gold for a number of years.