Gold Leasing – Conspiracy or Economic Reality ?

The leasing of gold is simply gold being used as money. Like all money, there is a large above ground stock of gold that increases over time (although the rate of increase in the quantity of gold is generally much lower and more stable than the rate of increase in the quantity of fiat currency). This means that the current year's supply of gold is far less important to the gold price than the supply that can potentially come from the existing above ground stock. As such, gold leasing cannot be likened to the leasing of apartments or cars (when you lease an apartment you cannot return a different apartment at the end of the lease). It also cannot be likened to the leasing of soybeans or oil or any other commodity (other commodities are consumed, whereas all mined gold remains in existence and is therefore a potential source of supply). It can be likened, however, to the lending/borrowing of Dollars, Yen, Deutschemarks and Euros. In fact, the mere use of the word 'lease' conveys the wrong impression when we are discussing the gold market. Therefore, for the remainder of this article let's dispense with this word and use terms that correctly reflect gold's use as a form of money.

The essential pre-requisite for the large-scale lending/borrowing of gold is a bear market. The reason is that, irrespective of how much gold is made available for lending and how low the interest rates are, if there is a general perception that the price of gold will be higher in the future than it is today then gold borrowing will be minimal.

As the bull market in credit and financial assets progressed during the 1980s and accelerated during the 1990s, investment demand for gold correspondingly reduced. Since the primary long term driver of the gold price is investment demand, the gold price continued to move downwards throughout this period. As the belief that this trend would persist indefinitely became firmly entrenched in the investment psyche, so the perceived risk of borrowing and lending gold became less. Gold producers became eager to 'insure' their future earnings and obtain cheap financing through forward sales, secure in the knowledge that gold interest rates would remain low for many years to come. Speculators were keen to take advantage of the low gold interest rates, secure in the knowledge that they could borrow gold today and repay the loan at some future time with gold that had dropped in price. The entire situation was made possible by the willingness of central banks to lend a large amount of gold at low interest rates.

Why have central banks made a large amount of gold available at low interest rates? This cannot be known for certain, but there are two theories. The first possibility is that central bankers, like any other bankers, need to generate a return on their assets. The interest rate that can be earned through the lending of any money, including gold, is determined by the supply of the money, the demand for the money, the perceived inflation risk associated with the money, the perceived repayment risk associated with the borrower, and an opportunity cost. In the case of gold we have a large supply in the vaults of central banks, no inflation risk since the purchasing power of gold remains constant over the long term, minimal perceived repayment risk since it is believed that the price of gold will continue to trend lower, and a zero opportunity cost since the gold would otherwise be sitting in a vault earning no income. It could therefore be argued that interest rates for gold in the range of 1 – 2 percent, about 4% lower than official US Dollar rates, constitute a reasonable return (particularly when you consider that the rate of increase in the supply of US Dollars is 10 percent per annum greater than the rate of increase in the supply of gold). The major assumption here is, of course, that the repayment risk for gold is approximately zero.

The second possibility is the conspiracy theory, that is, central banks are making large amounts of gold available for lending into the market at unreasonably low rates in order to suppress the gold price. Food for the conspiracy theorists was provided last year by Alan Greenspan when he stated that central banks stand ready to lend gold in ever increasing amounts should the price rise. Greenspan was, of course, talking about the ability of central banks to foil the attempts of anyone who sought to profit by creating a short squeeze in the gold market. He wasn't referring to a coordinated approach by Central Banks to restrict a normal rally in the gold price, although many analysts have made this interpretation.

We cannot know for certain whether or not central banks are deliberately generating a below market return on their gold reserves in order to keep a lid on the gold price. Although the Greenspan statement does appear on the surface to be such an admission, this may be a misconception. If there really is a coordinated effort by central banks to restrain the gold price by facilitating low cost gold loans, then is it likely that the world's number one central banker, a man who is noted for his careful choice of words, would openly confirm such a strategy?

Whatever the reasoning behind the large scale lending of gold by central banks, we do know the following:

• Gold lending/borrowing (often called gold leasing) is simply gold being used as money.
• Gold cannot be lent (irrespective of the interest rate offered) unless there are willing borrowers.
• The borrowing demand for gold will only remain strong as long as gold is perceived to be in a bear market and gold interest rates remain significantly below US Dollar interest rates.
• Gold interest rates will only remain at the current low levels as long as those who lend gold fail to account for any counter party risk (repayment risk). After all, no head of state would relish the task of publicly announcing something along the lines of: "You know all that gold that backs our currency? Well, we have lent a large portion of it to some bullion dealers and hedge funds in order to generate a 1% return and they've defaulted, so it's gone. Sorry about that."
   

One final note: Andy Smith, the much quoted perennial gold bear, has often reminded us that gold is a market which is perpetually in surplus. However, so are the US Dollar, Yen and Euro markets. The difference is that the gold money cannot be printed to overcome any short term reduction in lending and/or the failure of any highly leveraged parties to a gold loan transaction.

Milhouse
Hong Kong
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