1. Central bank diversification strategies:Rebalancing from the dollar and euro

2. About the World Gold CouncilContentsThe World Gold Council is the market development organisation Executive summary 01for the gold industry. Working within the investment, jewellery Diversification of Traditional assets 02and technology sectors, as well as engaging with governments Signs of diversification are already apparent 03and central banks, our purpose is to provide industry leadership, Traditional vs Alternative reserve assets 03whilst stimulating and sustaining demand for gold.The role of Alternative reserve assets04We develop gold-backed solutions, services and markets basedPortfolio optimisation including Alternative reserve assets 06on true market insight. As a result we create structural shifts in Methodology, data, and assumptions07demand for gold across key market sectors. BlueSky: applying no restrictions to the analysis08We provide insights into international gold markets, helpingDrawbacks to Alternative reserve assets 09people to better understand the wealth preservation qualities of Market size and availability09gold and its role in meeting the social and environmental needs Adjusting optimisation analysis for market size10of society. Market scenario sesults: Accounting for market size11Based in the UK, with operations in India, the Far East, Europe Alternative assets positively correlated withand the US, the World Gold Council is an association whose other risk assets 12members comprise the worlds leading gold mining companies. Challenges with investing in the renminbi 15 Limited market access for foreigners15 Qualified Foreign Institutional Investors (QFII) 15For more information Hong Kong deposits 15Please contact Government Affairs: China liberalisation scenario 15Ashish Bhatia A renewed relevance for gold16ashish.bhatia@gold.orgSummary 19+1 212 317 3850Natalie DempsterDirector, Government Affairsnatalie.dempster@gold.org+44 20 7826 4707Scan with your mobile device toaccess our research app for investorsCentral bank diversification strategies: Rebalancing from the dollar and euro 3. Executive summaryCentral banks have begun to reduce reserve portfolioallocations to US dollars and euros in favour of alternativereserve assets. A portfolio optimisation analysis concludesthat gold, with its lack of credit risk and deep and liquidmarket, is one of the most attractive alternatives in thisdiversification process. Accordingly, building gold reservesin tandem with new alternatives is an optimal strategy asthese markets need time to develop and allocations to goldremain largely below optimal levels.The financial crisis and subsequent sovereign debt crisis have This analysis is premised on the assumption that central banksheightened reserve manager attention to the need for increased retain 65% of their reserve assets in dollars and euros and finddiversification, in particular, away from dollar and euro assets.the most optimal asset mix for the remaining 35%. The analysisFurthermore, while the dollar is still the primary global currency examines traditional assets like Japanese yen, British pounds, its long-term supremacy is less certain. As such, central banksand gold, all of which have been consistently held by mostare actively looking to diversify their reserve portfolios and central banks over the past several decades. It adds to thisspecifically reduce allocations to US dollars and euros. traditional list Chinese, Canadian, Australian, Swiss, and Danish denominated high quality assets that are among the preferredDespite limited availability and convertibility of its currency, alternative reserve assets for central banks. These assets haveChinas rise in the global economy has forced central banks to produced strong returns in recent years and are supported byseriously consider renminbi denominated assets. Meanwhile, in healthy economic fundamentals.a world of deteriorating credit, countries like Canada, Australiaand Switzerland, all with AAA credit ratings, stand out as Purely through portfolio optimisation analysis of these assets,potential reserve investment alternatives. renminbi, gold and Australian dollar assets emerge as the most important for diversification. However, given the limitedAgainst this backdrop, this paper examines the trend of size of Chinese and Australian sovereign debt markets, golddiversification in reserve asset management away from the emerges as the dominant asset for diversification with optimalUS dollar and euro in order to better understand how central allocations to gold of approximately 8%.banks should approach allocation decisions at the margin.01 4. Diversification of Traditional assetsIn recent years, emerging market central banks have been Given the rapid growth in reserves, emerging market centralaccumulating reserves at a record pace. The global statisticsbanks are increasingly questioning their large US dollar andcompiled by the IMF, also commonly referred to as the IMF euro allocations and exploring opportunities for diversification.COFER data, show that official reserves for all central banks Accelerating the drive for diversification are historically lowhave grown from US$2tn in 2000 to greater than US$12tn global interest rates, which translate to a higher cost ofin 2012, a span of only 12 years. Official reserves primarilymaintaining reserves, and the uncertainty over US and Europeanconsist of US dollar and euro denominated assets and gold. fiscal outlooks. Furthermore, emerging market central banksTo a lesser extent, central banks also hold allocations to other also recognise the growing role of emerging markets in globaltraditional reserve assets denominated in Japanese yen and growth and are interested in shifting investments toward theseBritish pounds. Chart 1 illustrates changes in reserve asset economies as they play an ever more important role globally.size and composition over time. While these aggregate figuresinclude reserve assets for both emerging market and developedeconomy central banks the vast majority of reserves andreserve growth are from the emerging economies.1Chart 1: Offical sector foreign exchange reserves and goldUS$bn14,00012,00010,000 8,000 6,000 4,000 2,000020002001 200220032004 2005200620072008 200920102011 Q2 2012 Gold USDEURJPYGBP OtherSource: IMF COFER, IFS statistics, World Gold Council1Data on reserve composition is not available for emerging market central banks; however, as they account for a significant amount of total reserves trends for the aggregate group of all central banks can still be a strong proxy.Central bank diversification strategies: Rebalancing from the dollar and euro 5. Signs of diversification are already Traditional vs Alternative reserve assetsapparent The remainder of this paper makes the distinction between twoBetween 2000 and 2012, global central banks shifted away categories of assets or currencies: Traditional reserve assetsfrom US dollar denominated assets as the US dollars share and Alternative reserve assets. Traditional reserve assetsof total reserves declined from 62% to 54% (Charts 2ainclude US dollar, euro, gold, British pound, and Japanese yenand 2b). Some of this shift, or rebalancing, has been into denominated assets. These assets distinguish themselveseuro denominated assets, which explains the rise in euro from the other currencies/assets as each of these assets hadallocations during this period. However, anecdotal evidencean allocation of greater than 1% of global total reserves oversuggests that euro allocations may have plateaued as the the past ten years and all have been core official reserves forEuropean sovereign debt crisis has encouraged reservemany years. These assets share the high quality attributes thatmanagers to reduce euro allocations. meet the safety, liquidity, and return requirements of central bank reserve managers. Furthermore, these assets are typicallyWith incremental euro allocations falling out of favour, central already approved in the investment guidelines for almost allbanks have been exploring various other assets. Supporting thiscentral banks.point, the IMF data shows that the share of other currenciesin reserve composition has tripled in absolute terms since 2008. Traditional reserve assets will be compared against AlternativeCanadian dollar (CAD), Australian dollar (AUD), Swiss francreserve assets that include Australian, Canadian, Chinese,(CHF), Danish kroner (DKK) and Chinese renminbi (CNY) areDanish, and Swiss denominated instruments. These assetsamong the currencies in which emerging market central bankshad less than 1% allocations or were not delineated in the IMFare increasingly investing.2 This development has prompted the COFER data as they have been less commonly held amongIMF to include CAD and AUD in its regular reporting beginningcentral banks. While CHF denominated assets have historicallyin 2013; 3 a measure that highlights the growing role of these had a presence in reserve asset management, allocations havecurrencies as reserve assets.4 In line with this diversification been minimal in recent years, averaging 0.2% since 1995 andtrend, central banks have also become net buyers of gold, as ofthus, Swiss assets were included as Alternative reserve assets.2010, after a period of nearly two decades of net sales.Chart 2a: Breakdown of total official reserves (as of 2000) Chart 2b: Breakdown of total official reserves (as of 2012) Gold 13% Gold 13% USD62% USD54% EUR16% EUR22% JPY 5% JPY 3% GBP 2% GBP 3% Other 2% Other 5%Note: Totals may not equal 100% due to rounding.Source: IMF COFER statistics, Q2 2012 Source: IMF COFER statistics, Q2 20122Reserve management data and publications from the central banks of China, Russia, Korea, South Africa, Malaysia, Hong Kong, India, Turkey,Hungary, Poland and Mexico were analysed for details regarding reserve asset allocation.3Wall Street Journal, IMF Mulling Inclusion of AUD, CAD in Official Forex Reserves, November 2012.4COFER data currently only includes the following currencies: USD, EUR, GBP, JPY, CHF and other. 02 _03 6. The role of Alternative reserve assetsAlternative reserve assets5 provide a variety of benefits for costs associated with official reserves. Meanwhile, rapid growthreserve managers, particularly in terms of relative safety andin China and other emerging markets is driving broad-basedreserve diversification. In a world of deteriorating credit quality,investor interest in higher yielding securities. In Australia andcountries like Canada, Australia, Denmark and Switzerland, allCanada, a strong commodity sector and healthy economicwith AAA credit ratings, stand out as countries with strong fundamentals support much higher yields than those availablepotential as reserve asset currencies due to their high quality.in the US and Europe. Returns are further enhanced by strongThese countries have long held top credit ratings and havecurrencies, with US dollar denominated returns in theserecently been reaffirmed by the major rating agencies.Alternative markets benefiting from foreign exchangeappreciation against the US dollar. Chart 3 illustrates returnsThe pool of Alternative reserve assets also brings prospectsfor these Alternative assets in local currency and US dollarfor greater returns than those available in US dollar and euroterms, illustrating the positive impact that foreign exchangedenominated assets. US and European long-term treasuryappreciation has had on total returns when measured inyields have averaged less than 3% over the past five years,US dollars.which suggests returns are unlikely to surpass the carryingChart 3: Annualised returns for alternative reserve assetsReturn (%)25201510 5 0 Canada Denmark SwitzerlandAustralia China Gold In local currency terms In US dollar termsNote: Weekly data from January 2005 to October 2012.Source: Barclays Aggregate treasury indices, Bloomberg, World Gold Council5 Defined as assets denominated in Canadian dollar (CAD), Australian dollar (AUD), Swiss franc (CHF), Danish krone (DKK) and Chinese renminbi (CNY).Central bank diversification strategies: Rebalancing from the dollar and euro 7. The Alternative reserve assets are also drawing attention dueto their low correlations with Traditional reserve assets. Table 1summarises the correlations between Alternative and Traditionalreserve assets and shows that there are no strong correlationsbetween these new assets and the Traditional ones addingto their diversification strengths. As these assets are not highlycorrelated to Traditional reserve assets, they can help to providediversification by remaining stable should Traditional reserveassets decline.Table 1: Correlation matrix of Traditional and Alternative reserve assetsTraditional reserve assets Alternative reserve assets USUSTreasuriesAgenciesGermany GoldUKJapan Australia CanadaChinaDenmark SwitzerlandUS Treasuries0.910.30 0.04 0.290.56 -0.09 -0.01 0.07 0.31 0.34US Agencies0.910.36 0.07 0.340.52 0.05 0.15 0.08 0.36 0.36Germany0.300.36 0.43 0.630.39 0.540.500.21 0.98 0.78Gold 0.040.070.430.300.17 0.380.380.17 0.40 0.42UK 0.290.340.63 0.30 0.210.47 0.440.11 0.62 0.51Japan0.560.520.390.170.21 -0.06 0.000.15 0.38 0.45Australia -0.090.050.54 0.38 0.47 -0.06 0.720.01 0.54 0.38Canada-0.010.150.50 0.38 0.440.000.72 0.02 0.49 0.36China0.070.080.210.170.110.150.01 0.02 0.21 0.14Denmark0.310.360.98 0.40 0.620.38 0.540.490.210.76Switzerland0.340.360.78 0.42 0.510.45 0.380.360.14 0.76Note: Based on weekly returns from January 2005 to October 2012.Source: Barclays Aggregate treasury indices, LBMA04 _05 8. Portfolio optimisation includingAlternative reserve assetsPrevious research by the World Gold Council6 has examined With the assumption that 65% of the portfolio must beoptimal allocations to Traditional reserve assets for emergingallocated to US dollars and euros (47% and 18%, respectively),8market central banks. This study expands upon the analysis by the analysis proceeds by examining the optimal assets for theusing portfolio optimisation to determine optimal allocations remaining 35% of the reserve portfolio. The assets that arewhen Alternative reserve assets are considered. available for this 35% consist of the remaining pool of Traditionalassets (gold, British pound, and Japanese yen assets) andThis analysis is premised on the assumption that central banksthe Alternative reserve assets. Under these assumptions, theseek to reduce allocations to US dollar and euro denominatedremaining non-dollar and non-euro assets are examined directlyassets as they may currently perceive themselves as over-against each other.allocated. It assumes central banks will reduce their combinedallocation to US dollars and euros from the current 74% downto 65%. Chart 4 shows that in 2000 allocations to US dollarsand euros amounted to 78% and declined to 74% by 2012.Assuming this trend continues, a typical emerging marketcentral bank may then seek to reduce its combinedUS dollar and euro allocation to 65%,7 leaving the remaining35% to be allocated to other reserves assets.Chart 4: Historical and estimated USD and EUR denominated reserve assetsTotal reserves (%)100 90 8078%74% 7065% 60 50 40 30 20 100 2000 2012 Estimated USD EURSource: IMF COFER, World Gold Council6RBS, RBS Reserve Management Trends 2012: Optimal gold allocation for emerging-market central banks, April 2012 and World Gold Council, The importance of gold in reserve asset management, June 2010.7There is no reference to a time period during which US dollar and euro allocations decline. Instead, the analysis only assumes that there is a desire by central banksto reduce these allocations over time.8 The split between US dollars and euros is based on the observed split between US dollars and euros in 2012 from the IMF COFER data.Central bank diversification strategies: Rebalancing from the dollar and euro 9. Methodology, data, and assumptions Asset volatility and correlations: Table 2 lists the return and volatility assumptions used for the assets in the study. WeeklyOptimisation method: In order to analyse this data, Newdata from Barclays Capital Aggregates from January 2005 toFrontier Advisors (NFA) patented portfolio optimiser, which isOctober 2012 was used to determine estimates for volatilitybased on a re-sampled efficiency optimisation technique, was and correlations between reserve assets. More current andused. The Michaud Re-sampled Efficient Frontier has beenfrequent data was selected in order to capture the more recentacknowledged by Harry Markowitz, founder of modern risk- experience of the Alternative reserve assets.adjusted return portfolio theory, to be more effective and robust Asset returns: As past performance of both gold and fixed-than classical mean-variance optimisation.9 In particular the income securities over the last 14 years would not bere-sampled portfolio results tend to be more robust and less appropriate forward looking measures (for example USreliant on the accuracy of return and volatility assumptions. Treasuries returned 5.2% during this period), this study insteadThe results presented in this analysis are those of middle-level used an average of the Yield to Worst values calculated byrisk, which reflect the mid-point of the lowest and highest risk Barclays Capital from the period August to October 2012, whichportfolios on the re-sampled efficient frontier, with risk defined was the time period during which this study was conducted.as volatility. Re-sampling was based on 1,000 simulations of the The return assumption for gold was conservatively reduced toefficient frontier.2%, with the assumption that it would at a minimum perform at the level of the long-term inflation target of the Federal Reserve.Table 2: Asset inputs and historical returns and volatilityAlternative assets Traditional reserve assets US USModel inputsCanada Denmark SwitzerlandAustraliaChina Gold Treasuries Agencies UK Germany JapanProjected returns(Yield-to-Worst)1.6% 0.9% 0.4% 2.9%3.3% 2.0% 0.9%1.0% 1.7% 0.9%0.6%Volatility 10.0%10.5%12.0% 13.6% 8.9%20.0% 4.4%2.7%11.1%10.3% 11.3%Information ratio0.20.1 0.00.20.40.10.20.40.2 0.10.1Alternative assets Traditional reserve assetsHistorical returns US USand volatilityCanada Denmark SwitzerlandAustraliaChina Gold Treasuries Agencies UK Germany JapanAnnualised averagereturn8.6% 5.6% 7.5%11.4% 7.6% 20.0% 5.3% 4.8%5.0% 5.2% 6.0%Volatility 10.0%10.5%12.0% 13.6%2.3% 20.0% 4.4%2.7%11.1%10.3% 11.3%Information ratio0.90.5 0.60.83.31.01.21.70.40.5 0.5Note: This analysis has added 6.6 percentage points of volatility to Chinese treasury returns, which assumes the currency would have at least the samevolatility as a developed economy currency. This figure was chosen as it is the average increase in volatility for Traditional reserve assets when translating theassets volatility from local terms to US dollar terms (See box on page 15 for more details). References to country name denote origin of reserve assets.9See Harry M. Markowitz interview with Richard O. Michaud, Journal of investment management, Volume 9, No. 4, 2011, 19. JOIM Conference SeriesSan Diego, 6 March 2011, Conference Summaries. 06_07 10. BlueSky: applying no restrictions toChart 5: BlueSky scenario: Optimal allocations givenno constraintsthe analysisThe results of the first optimisation analysis showed thatAustralian, Chinese, and gold assets played the most prominentroles in the remaining 35% of the optimal emerging market Denmark 1%central bank portfolio. This means that based on the return,Switzerland 1%volatility, and co-variance inputs, these assets emerged as the UK2%Japan 3%most important to include for reserve managers, with 13%Canada4%of the portfolio allocated to Chinese assets, 6% to AustralianGold5%assets, and 5% to gold. Australia 6%China13%In this BlueSky scenario, the only constraint applied was US and Europe65%to limit the US dollar and euro holdings to an aggregate 65%of the portfolio, with 47% fixed for US dollars and 18% fixedfor euros. Under this constraint, Alternative reserve assetsstood out in importance from the other reserve assets from* 65% allocation to US and Europe comprised of 48% USD and 18% EURa portfolio optimisation perspective. Observing the returndenominated assets.assumptions used for the analysis, as expected China andNote: Optimal allocations for median levels of risk given 65% allocationAustralia commanded the highest recommended allocations to USD and EUR.given their leading respective 3.3% and 2.9% yield inputs.Importantly, despite golds conservative yield input of 2%10and higher volatility (20%), the model suggested a significantallocation given golds strong portfolio diversification properties.Furthermore, allocations to Alternative reserve assets suchas Australian, Chinese and even Canadian treasuries receivedgreater allocations than Gilts or JGBs, their Traditionalasset counterparts. Finally, the Alternative reserve assetsdenominated in DKK and CHF had the smallest allocations inthe optimal portfolio. Chart 5 illustrates the allocations for eachasset class. Based on this first test, it is evident there is a clearrole for Alternative assets in the diversification process.10See box on page 7 for more details.Central bank diversification strategies: Rebalancing from the dollar and euro 11. Drawbacks to Alternativereserve assetsWhile thus far the analysis has provided both qualitative and markets with none larger than US$1.5tn. Moreover, the largestquantitative evidence that Alternative reserve assets have an of these, the Chinese treasury market, is difficult for foreignersimportant role in reserve portfolios, there are two aspects ofto access. Foreign investors must be part of the Qualifiedthese assets that may raise caution with many central banks.Foreign Institutional Investor (QFII) programme which currentlyIssues related to (A) market depth and size, and (B) the positive consists of approximately 13 central banks and sovereign relatedcorrelations these assets have with risk assets are examinedentities.11 Due to the limited availability of renminbi assets, aseparately in this section. US$180bn revised market size is assumed which is based onQFII availability and off-shore deposits in Hong Kong (See Chart 6Market size and availabilityand the box on Page 15 for more details).As central banks manage large pools of official reserves, largeand deep markets are required to avoid having significantmarket impact when transacting. Chart 6 depicts the individualmarket sizes of Alternative and Traditional reserve assets, andshows that the Alternative reserve assets are all quite smallChart 6: The market size of alternative reserve assets and goldUS$bn3,5003,0002,5002,0001,5001,000 5000 Switzerland China AustraliaDenmark Canada ChinaGold(QFII and offshore) (including covered)Note: Gold stock is calculated as gold held by private investors and the official sector as estimated by Thomson Reuters GFMS (62,500 tonnes)multiplied by the average 2012 London PM fix gold price (US$53.6mn per tonne).Source: BIS, CSRA, HKMA, J.P. Morgan, World Gold Council11 See box on page 15 for more discussion of limited availability of renminbi assets. 08_09 12. Adjusting optimisation analysis for market size assets of US$1.6tn and US$720bn respectively, both of whichIn the prior section, the first optimisation analysis examinedare greater than the actual market sizes of US$1.5tn andthe optimal allocation to both Traditional and AlternativeUS$460bn. Thus, the second optimisation analysis, which takesreserve assets with the assumption that 65% of the portfoliointo account market size, allows for a more realistic solutionwould remain dedicated to US dollar and euro allocations; the based on existing market factors.analysis conducted in this BlueSky scenario had no additionalIn order to calculate the constraint level applied to each asset,constraints. In order to improve the study, a second optimisationa size cap for each market was estimated based on the ratioanalysis constrained the Alternative reserve assets by theirof outstanding market size to total reserves outstandingindividual market size to adjust for asset availability.12(US$12.3tn), as outlined in Table 3.If the results from the first optimisation analysis were to beimplemented across all central banks, there would need to bea collective allocation to Chinese and Australian reserveTable 3: Market sizes and allocation constraintsAssetsMarket size (US$bn)CapNon-traditionalSwitzerland US$1345%AustraliaUS$460 5%Denmark (including covered)US$593 5%CanadaUS$1,134 10%China US$1,485 (US$180bn investable*) 5%TraditionalUKUS$1,524 15%GoldUS$3,437 30%EuropeUS$9,314 100%US US$10,521 100%JapanUS$12,143 100%*See box detailing the Chinese reserve asset market on page 15 for more details.Source: BIS, China Securities Regulation Commission, Hong Kong Monetary Authority, J.P.Morgan, World Gold Council12 The analysis continued to assume that central banks would reduce their combined USD and EUR holdings from 74% to 65%.Central bank diversification strategies: Rebalancing from the dollar and euro 13. Market scenario results: Accounting for market sizeThis second portfolio optimisation analysis confirms theThe results of this revised analysis, which will be referred to as important role of gold as an asset for diversification, as itthe Market scenario, confirm there is a role for Alternative commands a dominant position in the 35% allocation pool whenassets, with Canadian, Chinese, and Australian assets beingaccounting for market size. Its presence in the diversificationallocated at 3 to 5 percentage points of the 35% diversification portfolio was closely matched by JGBs at nearly 8% of theportfolio. However, these allocations are significantly lowerreserve portfolio. Thus, the constrained optimisation analysisthan the first analysis as they take into account actual marketsuggests that while there is a role for Alternative reserve assetsavailability of these assets. The size limitation of Alternative in the diversification process, it is tempered considerably byreserve assets actually re-emphasizes the role Traditional assetsmarket size constraints. Accordingly, the results suggest goldmay need to play in diversification. In the Market scenarioand Traditional reserve assets should receive more considerationoptimisation, there is a greater allocation to Traditional assetsfrom reserve portfolio managers.such as gold, JGBs and Gilts than under the BlueSky scenario(Chart 7). In fact, the Traditional reserve assets take centrestage in the diversification process with gold leading the way.Chart 7: Market scenario: Optimal allocations given marketsize constraints Switzerland1% Denmark1% Australia3% China4% Canada 5% UK 6% Japan8% Gold 8% US and Europe 65%Note: Optimal allocations given 65% allocation to USD and EUR.Total may not equal 100% due to rounding.10_11 14. Alternative assets positively correlatedthe underlying currencies as more data points are availablefor currencies than for reserve assets. Over the 13 years fromwith other risk assets January 2000 to October 2012, the Australian and CanadianAnother drawback to consider with these Alternative reserve currencies exhibited strong, positive correlations with the MSCIassets is the stronger correlation they exhibit with risk assets. World Index of 0.64 and 0.58, respectively (Chart 8a).Given part of the strength of the Alternative assets is related toMeanwhile, the Traditional reserve currencies illustrated ineconomic growth and commodity sector strength, these assets Chart 8b had no significant correlations with this globalalso carry risks that are associated more broadly with economic equity index. Furthermore, examining conditional correlationscycles. These pro-cyclical qualities are in large contrast to shows that when risk assets have experienced extremelyTraditional reserve assets that act as safe havens and are oftennegative events, these Alternative reserve currencies tend toconsidered countercyclical. move in tandem.In order to examine the behaviour that Alternative andTraditional reserve assets exhibit against other risk assets,this study examined the correlations of long-term returns forCentral bank diversification strategies: Rebalancing from the dollar and euro 15. Chart 8a: Correlation between MSCI World Index and reserve currencies (January 2000 October 2012)Against the USD CNY Gold CHF DKK CAD AUD-1.0-0.8 -0.6 -0.4 -0.2 00.20.40.6 0.8 1.0 CorrelationNote: Calculations based on returns from weekly data.Source: Bloomberg, World Gold CouncilChart 8b: Correlation between MSCI World Index and reserve currencies (January 2000 October 2012)Against the USDUSD indexJPY Gold EUR GBP-1.0-0.8 -0.6 -0.4 -0.2 00.20.40.6 0.8 1.0 CorrelationNote: Calculations based on returns from weekly data.Source: Bloomberg, World Gold Council12 _13 16. Examining instances when the MSCI World declined by two Finally, Australian and Canadian assets are also susceptiblestandard deviations or more, the study found that there was a to commodity cycles. The correlation between both of thesecorrelation between the MSCI World and the Canadian dollarcurrencies and the SP GSCI commodity index is approximatelyand Australian dollar of 0.58 and 0.80, respectively. As such,0.55, which is higher than all the other reserve assetswhen markets are rapidly declining and central banks may find including gold (a commodity itself). In fact, a research reportit necessary to sell reserve assets, they might expect to incur conducted by the World Gold Council illustrated that whilelosses. This is in direct contrast to gold, the price of which tendsgold is technically a commodity, its financial characteristics areto rise when the MSCI World is declining in one of these more considerably different from most other commodities.13extreme events, as indicated by its -0.22 correlation (Charts 9aand 9b).Chart 9a: Correlation when MSCI World Index declines by two standard deviations (January 2000 October 2012)Against the USD AUD CAD DKK CHF Gold CNY-1.0 -0.8 -0.6 -0.4-0.2 0 0.2 0.40.60.8 1.0CorrelationNote: Calculations based on weekly data.Source: Bloomberg, World Gold CouncilChart 9b: Correlation when MSCI World Index declines by two standard deviations (January 2000 October 2012)Against the USD EUR GBP GoldJPYUSD index-1.0 -0.8 -0.6 -0.4-0.2 0 0.20.4 0.60.8 1.0CorrelationNote: Calculations based on weekly data.Source: Bloomberg, World Gold Council13 World Gold Council, Gold: a commodity like no other, April 2011.Central bank diversification strategies: Rebalancing from the dollar and euro 17. Challenges with investing in the renminbiChinese authorities announced that the quota for total participation by foreigners would be raised to US$80bn fromWhile there is little question regarding Chinas growing role in the US$30bn.15 Participation by individual institutions is furtherglobal economy, there is also significant uncertainty regardinglimited to US$1bn. In order for central banks and sovereignits foreign exchange policies. There are two elements to thiswealth funds to participate in the QFII programme, they mustuncertainty. First, while the currency has gradually been made have been in existence for over two years, and assets undermore flexible since 2005, it remains tightly controlled and is management must be in excess of US$500mn. QFII investorsallowed to fluctuate in a narrow range only. Thus, Chinas fixed may invest in stocks, bonds and warrants traded on exchanges,exchange rate policy leads to uncertainty regarding the currencys fixed-return products traded in the inter-bank bond market,outlook. Investors in CNY must consider the possibility that the securities investment funds, stock index futures and othercurrency appreciates or depreciates meaningfully should Chinafinancial instruments permitted by the CSRC.16move toward a more flexible exchange rate policy. Hong Kong depositsExamining only the historical data without an appreciation ofInvestors interested in acquiring renminbi denominated assetsthis policy would lead reserve managers to be attracted to these may also turn to the offshore market in Hong Kong. Hong Kongassets for their low volatility.14 Moreover the steady appreciationhas been at the forefront of RMB internationalisation, offering aof the renminbi since 2005 has magnified returns in US dollarfully-deliverable offshore renminbi (referred to as CNH) marketterms, adding to its attractiveness. However, a more flexiblethat gives foreign investors access to renminbi assets. The Hongexchange rate policy would at a minimum have an impact onKong Monetary Authority estimates the CNH deposit base isthe volatility of Chinese assets. In dollar terms, the volatilitynearly US$100bn (CNH600bn) and growing rapidly.17of Chinese treasuries is just 2.3% since 2005, comparedwith an average of 8% for Traditional reserve assets. If morecurrency volatility is introduced, the question remains whetherChina liberalisation scenariothe volatility of CNY-denominated assets will rise to levels The analysis in this paper also considered a scenario in whichsimilar to those of Traditional reserve assets or even those ofChinese markets became more accessible to foreigners. Underemerging market assets, which are higher at 15% to 20%. This this scenario the cap of 5% applied to allocations to Chineseanalysis has added 6.6 percentage points of volatility to Chineseassets was lifted to 15% to account for complete availabilitytreasury returns, which assumes the currency would have at of the US$1.5tn in government bonds. The results of thisleast the same volatility as a developed economy currency. Thisoptimisation analysis show that Chinese treasuries become thefigure was chosen as it is the average increase in volatility fordominant asset in the optimal portfolio due to their low volatility,Traditional reserve assets when translating the assets volatility appreciation against the US dollar and low correlation withfrom local terms to US dollar terms. Traditional reserve assets (Chart 10). Gold would continue to have a strong presence at nearly 7%, exceeding all other assetsLimited market access for foreigners in this scenario.The second source of uncertainty pertains to the accessibility ofthe market for Chinese reserve assets. As of September 2012, Chart 10: Allocations for diversifying assets in Chinathere was US$1.3tn outstanding in Chinese treasury bonds and liberalisation scenarioanother US$241mn in central bank bonds. This study assumedthat only US$180bn of the approximately US$1.3tn total marketis available publicly, which is the sum of the US$80bn availablethrough the Qualified Foreign Institutional Investor programmeand Hong Kong offshore deposits. This resulted in a maximum Switzerland 1%Denmark 1%allocation to Chinese treasuries of 5% in the optimal allocationAustralia 2%analysis in this paper. The investable Chinese treasury marketCanada4%is small as the Chinese government does not have as muchUK4%outstanding debt as the US or Japan, but it is effectively even Japan 5%smaller due to restrictions on foreign investors. Gold7%China11%Qualified Foreign Institutional Investors (QFII)US and Europe65%Foreign investors, including central banks, may participatedirectly in Chinese markets through the Qualified ForeignInstitutional Investor (QFII) programme. As of October 2012,there were 192 institutions in the programme, includingNote: Barclays Treasury Aggregates.13 central bank or sovereign-related entities. In April 2012,Source: World Gold Council14 As was confirmed by the optimisation study in this analysis.15 China Securities Regulatory Commission, QFII Investment quota to be increased by 50bn US Dollars, April 2012; available from http://www.csrc.gov.cn/ pub/csrc_en/OpeningUp/RelatedPolices/QFII/201212/t20121210_217805.htm16 China Securities Regulatory Commission, Provisions on issues concerning the implementation of the administrative measures for securities investment made in China.17 Hong Kong Monetary Authority, Hong Kong: The Premier Offshore Renminbi Business Centre, March 2012. 14 _15 18. A renewed relevance for goldThis analysis is premised on the basis that central banksGold has a long history as a reserve asset for central banks.are looking for alternatives to diversify portfolios that areDuring the days of the gold standard, gold was the reserve assetoverwhelmingly allocated to US dollars and euro assets.backing a nations fiat currency. Since the end of the classicalThrough portfolio analysis, this paper shows that Alternativegold standard and the subsequent gold exchange standard, goldreserve assets that previously had a limited role should behas remained an important part of reserve portfolios for centralconsidered by central banks as part of this diversificationbanks, but quietly fell out of favour as interest bearing sovereignprocess. The paper also illustrates the renewed relevance of debt in the US and Europe took on greater importance in theseveral Traditional assets in particular gold. 1990s and 2000s. More recently, central banks have become net buyers of gold as of 2010 (Chart 11).Chart 11: Net official sector transactionsTonnes6004002000-200-400-600-800 2002 2003 200420052006 2007 20082009201020112012Source: Thomson Reuters GFMS, World Gold CouncilCentral bank diversification strategies: Rebalancing from the dollar and euro 19. This paper has highlighted reasons why central banks have This study did not factor in several important qualities of gold,turned to gold in reserve portfolios. Gold is statistically namely its lack of credit risk and its liquidity as measured byuncorrelated with Traditional and Alternative reserve assetstrading volume. While reserve assets tend to be of high credit(Chart 12), which allows it to provide significant diversityquality, they still represent an obligation of a sovereign and carryto a portfolio and which is the primary reason it is one of the some measurable level of default risk. In fact, as central banksmost important assets that central banks should consider when have long investment horizons, the marginal sovereign defaultdiversifying out of the US dollar and euro. risk that does emerge over time is relevant for them. On theother hand, gold has no credit risk when held in an allocatedThis paper also illustrates that due to the large size of thebank account or in physical form in a central bank vault. Thisgold market, at approximately US$3.2tn, central banks havequality has not been taken into consideration in the quantitativesufficient access to gold for large investments.models presented thus far.Chart 12: Correlation of weekly returns between gold and reserve assetsAssets JapanGermany UK US AgenciesUS Treasuries-1.0 -0.8 -0.6-0.4-0.20 0.20.4 0.60.8 1.0CorrelationNote: Weekly return data measured in USD from January 2005 to October 2012.Source: World Gold Council 16_17 20. Furthermore, with regard to liquidity, golds average daily trading when measured against the size of its market is even morevolume is estimated to be US$240bn, as measured by a dealer robust with roughly 7% turnover, which exceeds all othersurvey conducted by the LBMA18 (Chart 13). In comparisonreserve assets (Chart 14). Golds deep liquidity is attributedto other large assets and currencies, gold emerges as one ofto its global nature and its role as both a currency and an assetthe most frequently traded, following only major currency pairs,with multiple uses.US Treasuries and Japanese government bonds. Golds liquidityChart 13: Average daily volume in US dollars for various assetsDow Jones (all stocks) German BundsUK gilts US agenciesSP 500 stocks EUR/JPY GoldUSD/GBPJapanese government USD/JPYUS TreasuriesUSD/EUR 0 200 400600 8001,000 1,200US$bnSource: BIS, German Finance Agency, Japanese MOF, SIFMA, Thomson Reuters GFMS, UK DMO, World Gold CouncilChart 14: Average daily turnover (average daily trading volume/market size)Turnover (%)876543210ChinaAustralia German Bunds UK giltsUS agencies Canada JGBs US TreasuriesGoldSource: Asian Development Bank, Department of Finance Canada, German Finance Agency,Japanese MOF, SIFMA, Thomson Reuters GFMS, UK DMO, World Gold Council18 LBMA, Loco London Liquidity Survey, April 2011.Central bank diversification strategies: Rebalancing from the dollar and euro 21. SummaryAs central banks look to reduce dollar and euroexposure, Traditional reserve assets such as gold canplay an important role alongside alternatives such asChinese, Canadian, Australian, Swiss, and Danishdenominated assets.Chinese assets, gold, and Australian treasuries emerge as the liquid market, is one of the most attractive alternatives in thismost important assets for diversification when conducting a diversification process. The study results suggest it would beportfolio optimisation exercise focused on optimising Alternative prudent for reserve managers to build gold reserves alongsideassets outside of the US dollar and euro. However, when marketAlternative reserves, as Alternative markets need time tosize and access constraints are considered, gold emerges as develop and allocations to gold remain largely belowthe dominant asset for diversification with a median suggestedoptimal levels.optimal allocation of 8% in US dollar terms. Overall, the studyconcludes that gold, with its lack of credit risk and highly18_19 22. DisclaimersThis report is published by the World Gold Council, 10 Old Bailey, LondonThis report contains forward-looking statements. The use of the wordsEC4M 7NG, United Kingdom. Copyright 2013. All rights reserved. This believes, expects, may, or suggests or words of similar import,report is the property of the World Gold Council and is protected by US andidentifies a statement as forward-looking. The forward-looking statementsinternational laws of copyright, trademark and other intellectual property included herein are based on current expectations that involve a number oflaws. This report is provided solely for general information and educational risks and uncertainties, These forward-looking statements are based on thepurposes. It is not, and should not be construed as, an offer to buy or sell, or analysis of the World Gold Council. 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