Gold reserves and exchange rate management

Gold bugs sometimes claim that central banks should own more gold as part of their reserve holdings. One (of several) reasons is that when the Fed makes unexpected changes to monetary policy (and under the new Fed Chair that seems increasingly likely), gold reserves can protect against currency devaluation and dollar devaluation alike.

A team of researchers looked at central banks, particularly in emerging markets, that try to stabilise their exchange rate vs the dollar. The hope is that if a central bank has larger foreign reserve currencies, it can use these to sell them and buy its own currency to stem devaluation trends and stabilise the exchange rate against the dollar.

The charts below show the impact of higher foreign exchange reserves on exchange rates in response to a 10bps surprise rate hike by the Fed. The way to read the charts is as follows: The chart on the left shows that central banks with a one standard deviation higher FX reserves (roughly 20 percentage points higher) experience 0.04 percentage points less exchange rate depreciation for every 10bps of rate hikes by the Fed. The chart in the middle shows that one standard deviation higher US dollar reserves reduces devaluation by more (0.1 percentage points), while non-dollar reserves have a much smaller and statistically insignificant impact.

Effect of FX reserves on exchange rates

This result makes intuitive sense. If a central bank has more dollar liquidity, it has more firepower to defend its currency against the US dollar, and correspondingly, there should be a smaller reaction of the exchange rate.

So, how does gold come into the picture? Gold is an asset traded in US dollars, so it is essentially an indirect dollar exposure for the central bank. The charts below show the same analysis but split between all FX reserves and gold, FX reserves only and gold only. Note that gold doesn’t really add protection against Fed monetary policy shocks. The dampening effect of gold reserves on the exchange rate is similar in size to FX reserves in general, but the uncertainty around it is higher, and thus the effect of gold reserves is statistically not significant.

Effect of gold reserves on exchange rates

There aren’t really any hard and fast conclusions one can draw from this analysis except maybe two: It seems that gold is counted by FX markets like an indirect dollar asset that can be sold to generate dollar liquidity when needed. And it seems that gold reserves don’t really increase FX stability compared to holding dollars directly.