Why does a country need foreign exchange reserves

Why states still need gold reserves

Gold as Europe's trump card: a rising price benefits the euro and harms the dollar. The common currency is backed by gold, but not linked to it. In the case of the dollar, however, it is the other way round.

Vienna. The gold standard has long been history - so why do states and central banks still hold gold these days? And why is the whereabouts of gold reserves being debated in many countries (including Austria and Germany)? The answer can be found in the balance sheet of the European Central Bank (ECB), the guardian of the euro.

At the beginning of October the time had come again: at a level of 1377 euros per ounce, the ECB unpacked an imaginary camera and made a “snapshot” of the gold price - just a little below the previous record high. Then the central bank made a relatively simple calculation: The Eurosystem has around 10,800 tons of gold at 32,150 ounces - times 1377 that results in almost 480 billion euros.

And that is the first item on the Eurosystem's balance sheet: € 480 billion in the form of gold. The ECB evaluates this item four times a year according to the market price. The foreign exchange reserves (mainly dollars) follow in second and third place on the balance sheet. And although these paper money reserves are increasing in quantity, their qualitative importance is decreasing. When the euro started, gold made up around 30 percent and foreign currency around 70 percent of the reserves. Today it is the other way around: gold represents more than 65 percent of the reserves (tendency rising), foreign exchange for less than 35 percent (tendency falling).


Gold strengthens the euro

The Eurosystem's balance sheet perfectly illustrates the difference between gold and paper money: the latter can be increased as required. The currencies on the balance sheet are not valued “according to market price” - that would not make sense. Only the quantitative changes are given. This also happens with gold - when a central bank buys or sells gold. The true meaning of gold, however, results from the qualitative assessment of the reserves according to the gold price.

This is no coincidence either, but rather a neglected component in the often criticized architecture of the euro. The common currency is backed by gold, but not linked to it. It is the other way around with the dollar. It is (theoretically) still tied to gold, but not covered - because the roughly 8,000 tons of US gold on the Federal Reserve's balance sheet have remained unchanged at just $ 42 an ounce since the dollar was no longer exchangeable for gold in 1971.


The Fed in a bind

That is the reason why a rising gold price is currently a problem for the dollar, but not for the euro: the ECB could (theoretically) buy gold with freshly printed euros and let the gold price rise in euros. That would weaken the exchange rate between the euro and gold. The ECB could also sell gold to strengthen the euro. Such operations are still carried out today mainly with foreign exchange reserves.

The Fed is in a bind: If it buys gold, it weakens the dollar because the price of gold rises. And if it sells gold, it still does not strengthen the dollar - because foreign central banks are sitting on tons of dollars that are currently outside the system. The central banks would be only too happy to convert these dollars into gold.

These central banks still hold the dollar in reserve because there was no real alternative for a long time. Since 1999, however, the importance of the euro has grown with the rising gold price. And four times a year the ECB documents this fact with a “snapshot” and in its balance sheet. Next time in January 2013.

("Die Presse", print edition, October 24, 2012)