The primary reason central banks buy gold is for diversification. Gold is an excellent asset for diversification, thanks to its inverse relationship with the dollar. When the value of the dollar decreases, the price of gold often rises. Therefore, by holding gold in their reserves, central banks can mitigate the risk associated with a declining dollar. This form of diversification can contribute positively to the central bank’s balance sheet, especially during times of economic recession or instability.
Secondly, central banks buy gold to hedge against inflation. Gold has traditionally been viewed as a strong hedge against inflation. In periods of high inflation, the real value of most major currencies tends to decline, while the price of gold typically rises. For example, during the high inflation years of the 1970s, the price of gold increased significantly. Thus, by accumulating gold, central banks can somewhat protect their nation’s wealth from the damaging effects of inflation.
Thirdly, gold is used as a form of currency support. Gold reserves can provide a measure of reassurance to the markets that the central bank has sufficient reserves to protect the value of their national currency. In addition to this, central banks can also use their gold reserves to intervene in the foreign exchange market to stabilize the local currency value.
Another reason for central banks to buy gold lies in its properties as a safe-haven asset. In times of geopolitical tension or economic uncertainty, investors tend to flock to gold as an asset that will maintain its value. This can be particularly important for countries that are vulnerable to such circumstances, as it can help to maintain stability in their financial systems.
The fifth reason is related to de-dollarization. With ongoing global economic shifts, there is an increasing trend among central banks, especially those of China, Russia, and Turkey, to diversify away from dollar-dominated assets. These central banks are building gold reserves as a means of reducing their dependency on the US dollar.
Lastly, central banks also purchase gold to gain returns on their investment. Despite being non-yielding, gold can offer a capital gain opportunity to central banks. This is because the price of gold can increase, and when it does, the central bank can make a profit by selling the gold it bought at a lower price.
Thus, it is evident that the decision of central banks to buy gold is informed by a mixture of factors including diversification, hedging against inflation, supporting the national currency, safeguarding against geopolitical and economic uncertainty, de-dollarization, and earning potential investment returns. The relative importance of each of these factors can vary depending on the individual central bank and the prevailing economic and geopolitical conditions.
