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Finance & Development, March 1978
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Gold market developments, 1975-77: The supply effects stemming from gold sales by the Fund and the U.S. Treasury have not been a major factor affecting the wide swings in the price of gold in recent years; a report on market trends

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
March 1978
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Michael Galen Martin

In August 1975 the Fund’s Interim Committee of the Board of Governors on the International Monetary System (Interim Committee) agreed that 25 million ounces of gold should be sold by the Fund for the benefit of developing countries, and that another 25 million ounces should be distributed (“restituted”) to Fund member countries. It was also agreed that the official price of gold would be abolished upon ratification of the second amendment of the Fund’s Articles of Agreement. These agreements, in conjunction with sales of monetary gold holdings by the U.S. Treasury in 1975, represented a significant change in the monetary role of gold. Contrary to market opinion, however, they played only a contributory role in the sharp decline in bullion prices since 1975.

The highly volatile movement of gold prices over the last few years (see Chart 1) was due in large part to abrupt variations in the speculative demand for gold and the fluctuation in supplies from communist countries. Moreover, since the gold market is very sensitive to actual and expected changes in currency values and interest rates, the generally unstable economic conditions of recent years have also contributed to the market’s movements.

For an analysis of earlier events which did much to lay the basis for the current volatile nature of the gold market, see David Williams’ The gold market, 1968-72, in the December 1972 issue of Finance & Development.

Chart 1.London gold prices January 1972 - December 2, 1977

(Weekly high and low, in U.S. dollars)

The speculative demand for bullion is intrinsically unstable. Gold is not an interest-earning asset, and holders only earn a return if its market price rises. Thus, speculators tend to buy only if they expect gold prices to increase more than anticipated returns on other investments. Rising prices on the gold market tend to create expectations of further price advances while falling prices tend to lead to expectations of further declines. Movements in gold prices, therefore, tend to be self-reinforcing and may encourage excessive price variations.

Another factor in the volatility of gold prices is that speculators tend to use gold as a hedge against inflation—to buy when inflation is expected to increase and sell when it is expected to decline. The sharp changes in the rate of inflation during the 1970s have consequently contributed in large measure to the large variation in bullion prices.

In addition to the instability of demand for gold, private and official reserves are large relative to current production—official holdings are probably about 35 times larger. As a result, the gold market is quite different from that of most other commodities in that only slight changes in expectations concerning adjustments in stock levels can have profound effects on the speculative demand for bullion.

The other key feature distinguishing gold from other commodities is its monetary function. The monetary role of gold has in fact now largely been eroded, but expectations that it will yet be resurrected persist, particularly in periods of currency turmoil. The changing value of the metal in the marketplace partly reflects the waxing and waning of such expectations. Thus, the gold sales of the Fund and the U.S. Treasury were a factor in the initial decline in gold prices, not only because of supply effects, but also because they contributed to a fall in demand.

On the supply side, sales from communist countries fluctuated markedly be tween 1970 and 1976 (see Table 1). Sales from the Union of Soviet Socialist Republics, the major supplier in this group, tend to vary with its agricultural output and are often related to its needs for foreign exchange. In 1976 in particular, poor agricultural harvests forced the Soviets to increase considerably the amount of gold they marketed to bridge a widening balance of payments deficit.

To understand why bullion prices declined in 1975 and 1976, it is also important to consider the historical context. The price of gold rose sharply in the early 1970s from around $45 an ounce at the end of 1971 to almost $200 an ounce by the end of 1974. A multiplicity of factors contributed to this rise. Perhaps foremost was the serious inflation prevailing in the industrialized countries. Speculative demand for the metal was also fueled by uncertain currency values, apprehension about the so-called energy crisis, and weak equity markets. Demand for gold was further boosted by the prospective liberalization of gold ownership in the United States and a worldwide boom in commodity prices—involving an 83 per cent increase in world metal prices in 1973 and 1974 and a 180 per cent rise in silver prices. This marked rise, however, could also be seen as a reaction to the suppression of price increases which had existed since 1934. In fact the real price (in constant dollars) of gold fell by 75 per cent from 1934 through the early 1970s because the nominal price of gold remained steady at $35 an ounce while other prices rose.

Decline in prices

The price of gold fell sharply from almost $200 an ounce at the end of 1974 to almost $100 an ounce in August 1976. This abrupt price decline happened partly as a correction to the overvaluation which had evolved over the preceding three years, and partly because the boom in commodity prices peaked in 1974, world inflation began to abate, and the market estimate of U.S. demand for gold proved to be overstated. The decline occurred despite an 11 per cent reduction in the amount of bullion supplied to the market between 1974 and 1975, which was due to a fall in the mine output of Western countries and lower sales by the U.S.S.R.

Net official monetary sales were small—about 15 tons in 1975 compared with 20 tons in 1974. Many observers attributed the fall in gold prices to the decisions of the U.S. Treasury and the Fund to sell gold from official holdings in 1975. These sales, however, accounted for only 3 per cent of all the gold supplied to the market in this period. The gold sales made by the U.S. Treasury and the Fund did, of course, curtail speculative demand insofar as they altered expectations about the future disposition of official gold.

Table 1.Estimated supply of gold bullion, 1950-76(In metric tons)
195019601970197119721973197419751976
World production 17551,0491,2741,2361,1831,1211,010957966
Net trade with CMEA countries2177-354213275220149412
Official purchases or sales3-288-262-23696-1516201570
Total supplies (net of official purchases)4679641,0351,3861,2451,4021,2501,1211,448
Source: Based on data from Gold 1977, Consolidated Gold Fields Ltd., London, June 1977.

Excluding CMEA countries

Members of the Council for Mutual Economic Assistance (CMEA) are Bulgaria. Cuba, Czechoslovakia, the German Democratic Republic, Hungary, Mongolia, Poland, Romania, and the Union of Soviet Socialist Republics

The definition of official sates includes activities of government-controlled investment and monetary agencies in addition to central bank operations. This category also includes Fund sates and distribution (“restitution”) to member countries. Minus sign indicates official purchases.

Source: Based on data from Gold 1977, Consolidated Gold Fields Ltd., London, June 1977.

Excluding CMEA countries

Members of the Council for Mutual Economic Assistance (CMEA) are Bulgaria. Cuba, Czechoslovakia, the German Democratic Republic, Hungary, Mongolia, Poland, Romania, and the Union of Soviet Socialist Republics

The definition of official sates includes activities of government-controlled investment and monetary agencies in addition to central bank operations. This category also includes Fund sates and distribution (“restitution”) to member countries. Minus sign indicates official purchases.

The drop in gold prices in 1975 was entirely due to reduced demand (see Table 2). Speculative and investment purchases of gold dropped to only 164 tons in 1975 from 519 tons in 1974. A 226-ton increase in fabrication demand, prompted largely by the attractiveness of lower bullion prices, only partially offset the market decline. The drop in prices was to a large extent a reaction to the poor response of investors in the United States to the removal of the ban on private ownership of gold. Investors made large-scale sales from gold holdings built up in 1974 in anticipation of strong U.S. demand for gold, and these sales led to the largest recorded fall in gold prices over a short period of time. In London the price of gold fell $30 an ounce in the first seven days of January 1975.

A number of factors apparently contributed to the unexpected weak demand for gold by U.S. residents. Most important perhaps was the absence of an established tradition of private gold holding in the United States. Moreover, a single 400-ounce bar, then valued at about $75,000, was too expensive for personal trading. The sharp price increase in 1974, too, had made gold seem high-priced and unattractive for investment, especially compared to other commodities which had declined in price in 1974. The fall in gold prices immediately after ownership became legal may also have been discouraging.

The weak demand also contributed to a relatively poor response to the U.S. Treasury’s gold auction on January 6, 1975. At the auction, bids were received for less than half the 2 million ounces offered. In addition, bid prices were considerably below the prevailing market price; the cutoff price set at $153 an ounce compared to a morning fixing price in London of $173 an ounce. As dealers worked down inventory positions, gold imports into the United States fell close to zero early in 1975, a sharp decline from a monthly average of almost 200,000 ounces in 1974. In fact, the inventory surplus caused the customary premium of gold in New York over London to move at times to a discount.

On the supply side, restrictions on the purchase of gold coins, too, meant an increase in the amount of gold the market had to absorb in the form of bullion. The United Kingdom banned the import for domestic sales of gold medals and gold coins minted after 1837, effective April 15, 1975, and discontinued the sale to residents of new sovereigns. In 1974, the United Kingdom had absorbed about 29 per cent of the production of South African Krugerrand gold coins. (Each Krugerrand has one troy ounce of fine gold which makes it easy for buyers and sellers to negotiate its price in relation to the market price for gold at any time.) The declining premium of the Krugerrand over the price of bullion had already prompted the South African authorities to consider reducing the output of Krugerrands. Thus, South African coin production, which had absorbed about 30 per cent of its total output before the imposision of the measure, fell to only about 15 per cent of gold output for the remainder of 1975 and 1976.

The U.S. Treasury held its second gold auction at the end of June 1975, offering 500,000 ounces of gold. Bidding interest at the U.S. gold auction in June was strong, contrasting sharply with weak demand at the January auction. Almost all of the gold on offer was sold on June 30 and at a rate only slightly below the prevailing market price. The cutoff price of $165.05 appeared to serve as a consolidation level, and the price of gold subsequently fluctuated around this for several months. The increased confidence of leading dealers who had been able to absorb the U.S. Treasury’s sales led to some broadening of the market demand for gold.

Further decline

After stabilizing at around $160-170 an ounce from April through August, gold prices declined sharply in September 1975 when the Interim Committee of the Fund agreed to sell 25 million ounces of gold and distribute (“restitute”) another 25 million ounces to member countries. In addition, for a specified period, the Group of Ten and other participating nations agreed to further changes in the monetary role of gold: (1) there would be no action to peg the price of gold; (2) the total stock of gold then in the hands of the Fund and the monetary authorities of the Group of Ten would not be increased; (3) the parties to these arrangements would respect any further condition governing gold trading that their central bank representatives agreed to at regular meetings; (4) each party would report semiannually to the Fund and to the Bank for International Settlements (BIS) the total amount of gold bought or sold, and (5) these arrangements would be reviewed by the participants at the end of two years and then continued, modified, or terminated.

Table 2.Gold: fabrication, speculation, and investment demand, 1970-76(In metric tons)
1970197119721973197419751976
Purchased for fabrication:
In developed countries7678411,015745710704823
In developing countries61154933211121250536
Total demand for fabrication1,3781,3901,3478567319571,359
Of which:
Carat jewelry1,0631,059995510229511936
Electronics9188107127926472
Dentistry63697173616470
Other industrial and decorative uses62697071595661
Medals, medallions, and fake coins5452402151841
Official coins46546354285244178
Net speculation and investment demand1(343)(4)(102)54651916489
Total demand1,0351,3861,2451,4021,2601,1211,448
Source: Based on data from Gold 1977, Consolidated Gold Fields Ltd., London. June 1977.

Excluding coins, but including “identified bar hoarding.” Parentheses indicate net sales

Source: Based on data from Gold 1977, Consolidated Gold Fields Ltd., London. June 1977.

Excluding coins, but including “identified bar hoarding.” Parentheses indicate net sales

A number of reasons were advanced by market analysts why these official arrangements need not affect the market. First, they noted that it would be in the interests of the Fund, and in particular of its developing member countries, to secure as high a price as possible for the gold in order to permit a larger Volume of financing for the Trust Fund to provide balance of payments assistance to needy members. This, of course, suggested that the gold would be marketed gradually, Second, it was argued that some central banks might purchase gold disposed of by the Fund, and thus reduce the flow of gold to the private market.

These considerations, however, appeared to have been outweighed by the great sensitivity of market participants to any official sales of gold. Apart from sales of Fund gold—25 million ounces correspond approximately to one year’s output of newly mined gold by South Africa— there were rumors of a further gold auction by the U.S. authorities later in the year and additional sales by the U.S.S.R. to finance food imports. Investors, already disappointed by the weaker trend in prices during August, put substantial amounts of gold on offer. These sales increased around mid-September 1975 and were variously described as “self-enforcing” and “panicky” when they coincided with the sharp strengthening of the U.S. dollar in the exchange market and the announcement of a 17.9 per cent devaluation of the South African rand. The rand devaluation emphasized the importance of gold exports for South Africa’s balance of payments and consequently lowered expectations of the likelihood of a curtailment in these supplies.

During the remainder of 1975, market price movements moderated. Apparent differences in interpretation of the consensus reached at the Interim Committee meeting led to reduced expectations of impending official sales. An easing of the U.S. dollar in international exchange markets and lower interest rates on short-term investments in dollar-denominated instruments, which enhanced the attractiveness of a position in gold, helped to stabilize demand for gold. Concern over the potential effects of a financial default by New York City also tended to support the price of the metal. Moreover, the sharp fall in gold prices during the summer revived the interest of some of the more traditional purchasers of bullion. Market reports indicated a substantial increase in demand from hoarding circles in the Far East as well as an increase in the interest of industrial and artistic users in Europe.

Rising supplies

The decline in gold prices continued in 1976. Supplies, however, rose substantially and reached their highest level since 1968. Aggregate supply reportedly amounted to 1,448 tons in 1976, a 30 per cent increase from 1975. The increase stemmed principally from very heavy Soviet sales, the highest since 1965, and sales of holdings by the People’s Republic of China which, combined with sales from Eastern European countries, amounted to 412 tons in 1976 compared with 149 tons in 1975. The gold output of Western countries increased by about 1 per cent to 966 tons in 1976, marking an end to five years of consecutive decline in gold production (see Table 1). Net official sales accounted for 70 tons of supply in 1976. Total official monetary sales amounting to 144.2 tons (including 121 tons sold at the Fund auctions) were offset by official purchases of about 75 tons, largely by the Middle and Far East.

Demand also rose considerably in 1976, principally as a result of a sharp rise in imports of gold bullion and jewelry into the Middle East. Demand from the area accounted for about one third of total demand in 1976. Among the components of demand, fabrication of carat jewelry rose by over 80 per cent to 936 tons in 1976, accounting for about 65 per cent of total gold demand. Industrial and commercial demand, excluding carat jewelry, medals, and medallions, rose about 10 per cent. Speculation and hoarding demand accounted for only a small part of aggregate demand, declining to 89 tons from 164 tons in the previous year. The fabrication of official gold coins continued to decline, falling from 22 per cent of nonmonetary absorption in 1975 to 12 per cent in 1976 (see Table 2).

Chart 2.Estimated supply of gold, 1976

Source: Gold 1977 Consolidated Gold fields Ltd., London June 1977.

The rise in demand was nonetheless not enough to prevent the price of gold from falling until the end of August 1976. At the beginning of the year, gold prices declined further when the Fund confirmed the agreement of August 1975 regarding the disposition of the Fund’s gold. According to the agreement, Fund gold sales and distribution (“restitution”) were planned to start without delay and sales would be made in public auctions over a four-year period. Furthermore, the Fund would have the power to sell any part of the gold left after the distribution of the 50 million ounces already agreed upon.

A report indicating the likelihood of increased sales of gold by communist countries deepened the market’s apprehension. Although sales from the U.S.S.R. generally coincide with periods of strong demand and rising prices, a continued trade deficit of about $5 billion seemed to require financing either through borrowing on the Eurocurrency markets or through gold sales. Since the Euromarkets were unlikely to be able to supply financing of the order of $2.5-3 billion, gold sales were expected to expand. Essentially, the uncertainty regarding supplies of bullion rendered gold a less attractive short-term investment. In addition, political and military unrest in southern Africa contributed to the uneasy atmosphere Investor interest was also diverted by the strong recovery of the U.S. equities market and recent sharp rises in commodity prices, particularly for silver.

South Africa needed foreign exchange to deal with a worsening balance of payments situation and yet did not want to place additional pressure on gold prices through stepped-up bullion sales. Consequently, in March 1976, South Africa effected a swap, a spot sale of 5 million ounces of gold from reserves combined with a concomitant forward purchase. The transaction, similar to a loan collateralized by gold in its effects on the market, allowed South Africa to improve the liquidity of its reserves without increasing bullion supplies to the spot market.

The first auction of the Fund’s gold took place in June 1976 and was followed by regular auctions at six-weekly intervals. Gold prices, which fluctuated narrowly between $125 and $135 an ounce from February through June 1976 in light and nervous trading, dropped precipitously in July and August. From a technical point of view, it was not the increase in the supply of gold from the Fund’s sales but a sharp shift in speculative demand that created the abrupt decline in gold prices. In July, market participants put pressure on gold prices when they began selling in disappointment over the results of the Fund’s second gold auction held on July 14. Then in August, when reports from Zurich indicated that buying interest may be limited in the September auction and that the major Swiss banks would probably not participate, selling pressure increased. Although soon denied, these reports led to substantial offers of gold by way of liquidation of short-term holdings.

Under these uncertain market conditions, prices reacted sensitively to various news reports appearing to support a bearish outlook in the bullion markets. Speculation that monetary authorities might be more reluctant than had been hoped to stem sharp price declines in the gold markets also contributed to the pressure on prices. During July, France, which had acquired 79 million ounces of gold from the BIS following the first two Fund auctions, stated that it would not attempt to support the price of gold by intervention but would leave gold prices to be determined purely by the forces of supply and demand.

Recovery

After reaching a low of $103 an ounce on August 31, 1976, the price of gold entered a period of recovery. Several factors contributed to the stronger market conditions. Considerable new demand was reportedly originating from the Middle East and interest from the Far East remained strong. Reports of a record Soviet harvest suggested reduced U.S.S.R. gold sales for the purpose of financing grain imports. In addition, industrial and artistic users of the metal began to rebuild their stocks when the prices appeared to have bottomed out. The possibility of a more expansionary economic policy following the results of the presidential election in the United States and concern about an acceleration in inflation added to the demand for gold as a hedge against inflation. Finally, a U.S. Treasury study released in October projected that over the coming five years the industrial demand for gold would considerably exceed current production. According to the study, sales from official holdings could rise to 25 million ounces by 1985 without depressing the real price of gold. In the absence of such a large increase in monetary sales, gold prices would have to increase to balance supply and demand.

Gold prices continued to rise during the first quarter of 1977, reaching over $150 an ounce in mid-March, in spite of a considerable augmentation in the supply of gold to the market. The People’s Republic of China exported about 2.6 million ounces of gold to the United Kingdom in December 1976, the first exports to the United Kingdom for some years, most of which was apparently sold on the market early in 1977. In April, South Africa effected a new swap arrangement, with sales of probably just under 3 million ounces of gold.

The Fund’s first distribution (“restitution”) operation began on January 10 and ended near the end of the month, involving the transfer of 6 million ounces to member countries based on members’ quotas as of August 31, 1975. While little of the gold found its way onto the market, it did tend to dampen demand for the metal as apprehension that it might be offered nevertheless lingered.

Prices then drifted lower, fluctuating between the lower $130s and the upper $140s from April through August, before an upward trend reasserted itself toward year-end. The strengthening in prices, which took place steadily in September and October, appeared to originate in a re-emergence of speculative demand. By mid-November 1977 the price was around $168 an ounce. The recovery, which had begun in September 1976, had by this time offset almost two thirds of the price decline which had taken place since early 1975.

The gold market, then, has been marked by wide price swings over the last five years. Essentially, the gold market is composed of participants who tend to react sharply to new information, causing rapid price reversals. Sharp variations in the amount of bullion marketed by the U.S.S.R. has also added to price instability over the past few years. Contrary to some market commentary, actual supply effects stemming from gold sales by the Fund and the U.S. Treasury have thus far not been the dominant influence on the market, although it is true that the sales have increased instability of speculative demand. Over time the influence of these monetary sales on the market has diminished as investors have come to accept Fund auctions as an integral part of the current market situation at any time.

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