Why Foreigners Are Buying Gold

11/23/2009 10:36 am EST

Focus: GLOBAL

Lawrence Roulston

Editor and Publisher, Resource Opportunities

Bullion is benefiting from the falling dollar and the recent legacy of US wars and scandals, writes Lawrence Roulston in Resource Opportunities.

The announcement that the Indian central bank purchased 200 tonnes (6.43 million ounces) of gold from the International Monetary Fund ignited a rally in bullion. With the price now firmly above $1,100 for the first time, opinion is divided as to where it will go from here.

The knowledge that the IMF was intending to sell more than 400 tonnes of its bullion reserves had put a damper on the gold market. Finding a ready buyer for half of the gold that the IMF planned to sell removed that overhang from the market.

[Also,] India’s conversion of dollars for more gold in its official reserves may be a signal that other central banks could do the same, removing the balance of the [IMF’s] overhang. China is at the top of the list, although their official position is that [it] will continue to buy domestically produced gold. With China now the world’s largest gold-producing nation, they have ample supply.

The thinking that other central banks would exchange a larger portion of their US dollar reserves for hard assets was escalated by some commentators to a belief that central banks will make a wholesale switch out of dollars and into gold.

That thinking needs to be evaluated carefully. First, the 6.43 million ounces purchased by India boosted gold from 3.7% to 6% of their total reserves. India has a long history of having a strong affinity for gold. China had stated some years ago that it intended for gold to represent 2% of its total foreign exchange reserves. [Its] purchases over the last year merely saw gold keep pace with their ballooning foreign currency reserves.

The growing interest in holding gold by central banks is being augmented by other purchasers, including sovereign wealth funds, hedge funds, and a broad range of other professional investment managers, some of whom are buying gold for the first time. Individuals, in all parts of the world, are also buying gold in record amounts.

The American dollar, the undisputed global currency of choice for decades, is now seen by many as being on a long slide. The trillions of dollars pumped into the economic system to keep it afloat are in demand in this moment, but that situation is already beginning to reverse.

At the height of the crisis, investors around the world bought dollars in the form of Treasury bills and other short-term instruments as a safe haven. Now, with economic activity in Asia and other emerging economies outpacing the developed world, those dollar instruments are being sold back to invest in more vibrant economies. It will be at least a year or two before the US gets back to the kind of growth that would again draw international investment money back in a big way.

There is another, sometimes overlooked, reason to expect further declines in the dollar. The financial crisis that engulfed the world over the past year originated on Wall Street. There is a degree of bitterness and distrust around the world toward the ratings agencies and the banks that peddled toxic [mortgage] waste.

Following soon after the dot.com bust, it may take some time for international investors to regain confidence in the American business system. A series of other embarrassments, including Enron and the Madoff mega-fraud, have deepened the distrust of American investments. Investors can deal with a business failure. But a $50-billion Ponzi scheme that operated undetected for more than a decade brings the entire system into question.

Longer term, I am certain that gold is going higher. In the near term, a correction is a very real possibility, but not a certainty.

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