Central banks hold the answer to "How high can gold go?"

09/29/2010 2:02 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Bet you didn’t know that Sunday, September 26, marked the end of the year.

Well, it did for the world’s central banks that participate in the Central Bank Gold Agreement, which lays out quotas for how much gold central banks can sell in a year. The agreement was put in place after a 1999 announcement from the Treasury of the United Kingdom that it would sell half of the country’s gold set off a wave of selling by other European central banks that drove the price of gold to a 23-year low of just $250 an ounce.

The Central Bank Gold Agreeement restored order to the gold markets but it certainly didn’t stop the selling. In the last decade central banks sold 442 metric tons of gold on average each year. Selling peaked at 497 metric tons in the “gold year” that ended in the fall of 2005.

This year? The central banks subject to the agreement sold just 6.2 metric tons, a 96% drop from the previous year. Other central banks not part of the agreement have been net buyers. China almost doubled its gold reserves in calendar 2009 to 1054 metric tons. India, Saudi Arabia, Russia, the Philippines, and Sri Lanka have been buying to build up their gold reserves.

As a whole, central banks are projected to be net buyers of gold for the first time since 1988.

And you were wondering why gold has climbed to near $1300 an ounce? The shiny yellow stuff is trading at $1311 an ounce as I post this.

So how long does this trend last and how far can it drive gold?

I think gold buyers can expect that central banks will stay net buyers for a while yet—but the balance between developed economy central banks and developing economy central banks is tricky.

Central banks in developing economies are under-reserved in gold. The BRIC economies, for example, of Brazil, China, India, and Russia show just 5% gold on average in their official reserves. Gold investors can reasonably expect that these countries will be careful buyers—from current domestic production in the cases of China and Russia.

Central banks in developed economies are over-reserved in gold. On average the countries that use the euro hold 58% of their official reserves in gold. Portugal tops the list at 80% in gold. As gold prices continue to rise, these countries will be tempted to sell part of their reserves. (Central banks have proven to be really, really bad market timers, selling much of their gold near the market bottom. So we’ll see how good they are at calling a top.)

And the balance between developed country selling and developing country buying will be critical for the future price of gold.

So where does that balance come down?

As long as global financial uncertainty remains high, developed country central banks will be reluctant to sell and that will keep the balance on the side of higher gold prices.

No brilliant insight that, I’d readily admit. Fear drives gold prices higher—especially when it keeps potential sellers of gold on the sidelines.

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