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BOK moving to revamp strategy by diversifying away from dollar
By Kim Jae-kyoung
 Korea’s central bank has been in the limelight among global investors and policymakers after it announced Tuesday the purchase of 25 tons of gold between June and July, joining a global wave of chasing gold as a guard against the collapse of the U.S. dollar.
The amount was small but the purchase has had large repercussions for the markets both at home and abroad as the move came amid growing disputes over whether ongoing gold rallies are the beginning, or the end, of the bubble.
The BOK’s purchase has supported expectations that the official sector (central banks) will continue to remain in favor of the yellow stuff on the back of debt crises in the U.S. and Europe.
It was the BOK’s first appearance in the precious metals market in more than a decade. The purchase has hiked its gold reserves from 14.4 tons to 39.4 tons. In dollar terms, its gold holdings now total $1.32 billion, around 0.4 percent of the total foreign reserves valued at $311.03 billion. It would also raise its global ranking in gold holdings to the 45th from the previous 56th.
The purchase in the central bank’s words was aimed at diversifying its foreign reserve investment and reducing risks caused by market volatilities.
“Although gold prices are surging lately, it seems the time is ripe to increase gold holdings. We expect the purchase to cut investment risks in managing foreign reserves due to the diversification effect,” Suh Bong-gook, head of investment strategy at the BOK, told Business Focus.
The central bank has not bought gold since the 1997-1998 financial crisis, claiming that it was not a desirable investment because it does not carry interests and dividends, as well as being difficult to cash out.
U.S. dollar credibility at stake
Following the announcement, most market observations and commentary on the purchase center on the timing of the investment, but it is important to figure out what’s behind the BOK’s shift in its stance toward the yellow metal.
Market experts point out that the move can be taken as a signal that the BOK is moving to reduce dollar holdings on expectations that the U.S. dollar will continue its downward spiral on the back of rising debt fears and renewed prospects of quantitative easing in the U.S.
“Most market participants and media are engaged in a debate over whether the timing was right, but it is not the real issue here. You have to focus on whether dollar assets are still safe,” SC First Bank senior economist Oh Suk-tae said.
“There is a growing doubt among investors about whether U.S. dollars are still assets they can trust as it is widely believed that the U.S. economy has received incurable damage due to the ongoing debt fiasco,” he added.
Bernard Dahdah, a commodities market analyst at Natixis London Branch, echoed the view, saying, “South Korea’s latest move joins a trend which is occurring in emerging countries which have high currency reserves mainly denominated in dollars.”
“This is a trend in which central banks are trying to increase gold holdings as a percentage of total reserves, trying to diversify away from the dollar currency.” The BOK holds 64 percent of its reserves in dollar denominated assets. For diversification, it also plans to invest in Chinese yuan.
Suh of the BOK, who is in charge of managing the BOK’s funds, however, remains cautious about the speculation, saying, “Our purchase does not signal a change in our investment strategy. The latest purchase of gold has been planned as a long-term holding, and we believe that gold holds an investment value in terms of diversification.”
Was it too late?
Analysts both here and overseas said in unison that the purchase of gold was the right move in terms of asset diversifications but they were split into two different camps over whether the timing was right.
Precious metals prices have rallied across the board in the past week, gaining support from a weaker U.S. dollar. Financial markets have been crashed by the U.S. raing downgrade and worries about a double-dip recession in the world's largest economy. Credit agency Standard & Poor's (S&P) lowered the rating Saturday from AAA to the next lowest level, AA plus, citing the absence of a credible plan by the U.S. government to lower its fiscal deficit.
In the second quarter of 2011, the average gold price reached $1,507 an ounce and $1,550 in June. It reached a record high of $1,661.2 last Wednesday. Given that the BOK’s latest gold purchase of 25 tons was valued at $1.24 billion, the purchase price is estimated at around $1,540 per ounce.
In fact, the BOK became the latest official sector buyer. Central banks of many emerging economies have already purchased a large amount of the precious metals over the past years.
According to a report by Natixis, Russia and Mexico were the main purchasers this year, having bought 19.5 tons and 5.7 tons, respectively, during the second quarter only. The trend of central banks’ gold chase really began in 2009, when China purchased 454 tons and India 200 tons.
“It is extremely difficult to time the market. Hence, it is equally hard to say that the BOK is buying into gold at too high a price. In Korea, gold holdings of $1.32 billion does not suggest that it makes up an excessively large part of the portfolio,” Standard & Poor’s (S&P) analyst Kim Eng Tan said.
“Portfolio diversification is an established practice among investors to reduce the volatility of the value of their assets. The benefit of this practice is that it prevents price volatility of any single type of asset from causing similar volatility to the value of the investment portfolio,” he added.
Gold bubble
Globally, the BOK’s gold purchase has reignited debate over whether gold prices will continue on an upward trend. Nobody can be sure of the future course of the precious metal but many experts are seeing a bubble forming in the market, meaning that gold prices will take a nosedive sometime in the future.
“The fact that investors, including central banks, are flocking to gold is yet another sign of how much uncertainty there is in global financial markets,” said Mauro F. Guillen, director of the Lauder Institute at the Wharton School.
“I have no doubt that there is a gold bubble, and someday it will burst. But for now, it seems to be a good store of value. Obviously, those who bought at the peak will lose the most when the bubble bursts,” he added.
Dahdah of Natixis said, “As a holding on a long-term basis we do view this purchase (by the BOK) as being too late. Our view on gold is that it is a bubble in which people are buying out of fear and concern.”
“Once the global economy gets back into shape a sharp withdrawal from gold will occur as global investors seek yield earning investments that actually also do not have holding costs, such as insurance and storage. We can only but agree with the BOK that it needs to diversify away from the dollar, but not necessarily in gold.”
Mixed forecasts
There is a wide spectrum of forecasts for the course of the precious metal, with analysts focusing on different variables.
Standard Chartered forecast gold prices will reach as high as $5,000 by 2020. Deutsche Bank predicts the prices will hit $2,000 next year. On the other hand, JP Morgan and Citigroup expects that the value of the yellow stuff will fall to somewhere between $1,300 and $1,400.
Those betting on price rises cite production bottlenecks and Chinese and Indian buying as key factors to drive the prices.
“While gold prices are currently supported by flight-to-quality flows as a result of continued uncertainties in developed markets, there are structural factors that could keep prices high in the medium term,” Tan of S&P said.
“China, India and Vietnam are sizeable economies that are projected to show strong growth in the coming years. In these countries, accumulating gold is a popular way of storing wealth,” he added. “Consequently, if current medium-term growth projections are realized, demand for gold from these countries could provide strong support for gold prices.”
Pessimists counter that demand for gold will fall in line with rising opportunity costs of holding the metal once interest rates rise in earnest.
“On a short term basis, prices of gold might go further up on the back of problems faced in Europe, the U.S. and the inflationary issues in emerging countries — hedge against inflation which is creeping up,” Dahdah of Natixis said.
“However, in 2010 around 36 percent of global demand for gold came from investors, historically those purchases have only represented around 12 to 15 percent. A withdrawal of this investment demand will create an imbalance in the supply-demand equilibrium leading to lower prices,” he added.
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