This is the share of assets that the world’s central banks hold in gold. Right after the second war, central banks held over 70% of their assets in Gold. But, in just a few decades, this declined to just under 10% in 2010. However, now, that trend is reversing, with central banks all over the world racing to buy gold, and … carefully, slowly, central bankers are now EVENconsidering to add Bitcoin to their reserves.
If this trend continues, it could cause the prices of Gold and Bitcoin to skyrocket. But, it could also be a major blow to the United States, as the thing that previously replaced gold as the central bankers choice of reserve asset happens to be the US Dollar. If, the US Dollar is replaced by something else, this will make the US significantly poorer and weaker.
So, that raises the question, is this central bank gold buying spree just a small uptick, or the start of a major trend?
And, if it is a trend, what does that mean for the price of gold, Bitcoin, and the global power of the US? To find out, I did a deep dive into what central bankers THEMSELVES SAY that they are looking for in a reserve asset and what researchers have found what assets THEY ACTUALLY BUY.
But, of course, these types of reports are pretty dense, with a lot of jargon, which is why I’ve boiled it down to just the important bits, without the jargon. So let’s starting with a quick refresher on
What reserve assets are used for
If you boil it down to the basics, reserve assets are assets that central banks use to defend the value of their OWN currency. This is useful in two types of situations.
The first is to defend your currency. For example, last year, when the value of the Yen suddenly dropped. The Bank of Japan defended the Yen by selling billions worth of reserve assets in exchange for Yen. In doing so, it generated extra demand for Yen, thereby stabilizing its price.
So, why do central banks interfere in markets to change the price of their currencies?
First, central banks defend their currency in times of crisis to prevent ultra rapid inflation, to prevent the price of crucial imports from skyrocketing. To underscore how important this is, consider the case of Sri Lanka’s currency crisis in 2022, during which the central bank ran out of reserves. To prevent hyperinflation, the government felt it had to ration imported fuel, brining large parts of the economy to a standstill.
The second reason central banks fear a rapid currency depreciation is that it will get foreign currency borrowers in a lot of trouble. For example, during Mexico’s 1994 Tequila crisis, a lot of companies and banks got into big trouble because they had borrowed a lot in Dollars while their revenues were in Peso. Therefore, when the Peso was suddenly worth far less a lot of Mexican companies could no longer pay their foreign debts, which made the crisis even worse.
So, to prevent sudden currency drops from turning into full-blown economic crises, central banks all over the world increasingly hold reserve assets, which they can sell to support their currency in times of crisis.
On top of crisis prevention, a lot of central banks use reserve assets for currency control, or if you put it in less flattering terms, currency manipulations. Many central banks choose to fix their currency to that of another nation to encourage trade. For example, Hong Kong’s Monetary Authority keeps the Hong Kong Dollar tied to the US Dollar by buying reserve assets if there is too much demand for Hong Kong Dollars and selling reserve assets if there is not enough demand them, relative to the US Dollar.
So, okay with that refresher out of the way, we can now answer
Why the US Dollar is the best reserve asset, right now
by ranking it against potential challengers such as Bitcoin, Gold, and other Fiat currencies like China’s Renminbi or the Euro.
To do this ranking, we are going to rely on research by the World Bank, where they asked 191 central banks all around the world, EXACTLY WHAT THEY LOOK FOR in a reserve asset. This report reveals that central bankers essentially care about three things, (1) safety, (2) liquidity AND, finally, making some money.
So, to see why central bankers are increasingly turning to Gold, and perhaps even Bitcoin, AND to determine whether or not that trend is likely to continue, let’s go over each of these factors for each type of money.
Let’s start with the least important priority, making money, which works completely different for Fiat currencies compared to Gold & Bitcoin. You see, if a central bank holds Dollar assets, like US government debt, it will effectively get an interest rate of about 4.4% on that. For similar Euro bonds, that is 2.4% and for Chinese bonds 1.7%. Meanwhile, gold is just a piece of metal. Therefore, it COSTS money to store it. That is a negative interest rate of about, 0.5%. Finally, Bitcoin, is a data entry in a ledger. It does not pay an interest rate either.
So, here the Dollar clearly wins while Gold and Bitcoin are not attractive at all.
However, compared to Fiat currencies, Bitcoin and Gold, often go UP in price a lot. This means that central banks could potentially make more money than they would on US government debt, just by holding Gold or Bitcoin. Indeed, this potential to make money is exactly what the Czech central bank governor mentioned when he proposed buying Bitcoin as part of its reserves. But, of course, gold and Bitcoin are not guaranteed investments. They CAN and often DO go down in price, limiting their scores in this category.
But, of course, central banks are public institutions, making money is not their primary motivation.
Instead, as we discussed, central banks primarily use reserve assets to defend their currency. And, for that to be effective, the ideal reserve asset is highly liquid. If a central bank sells it, to buy back their own currency, they ideally do not affect the price of that asset while selling. This makes Bitcoin not suitable for most major central banks right now, as they would crash the market just by selling the massive quantities that they would sell in a crisis. This is a lesser problem for gold and Renminbi. It is hardly a problem for the Euro, and not at all of the US Dollar, which is traded on the U.S.’s gigantic financial markets.
But, there’s another part of liquidity that people don’t often talk about: buying liquidity. That is, central banks need to be able to easily accumulate reserve assets. It cannot be too expensive. This is especially important for emerging market central banks, who tend to hold less gold than rich central banks.
Indeed, what many people think is Gold and Bitcoin’s biggest strength, may actually be their biggest weakness. That is, unlike Fiat currencies, which governments can create in large quantities, the quantity of gold, and especially Bitcoin, is finite. Sure, central banks can always buy it, but buying a lot of it makes it more expensive. That is great for investors. But, not great for poor countries.
In contrast, the US has been relatively generous in opening up its markets to the world, allowing poor countries to accumulate US Dollars by exporting to the US.
This, along with its massive financial markets which make selling reserve assets painless, makes the US Dollar the most liquid reserve asset in the world by far. Other fiat currencies like the Euro come second, while gold, and especially Bitcoin score poorly in this category.
Finally, the US Dollar is still BY FAR the best when it come to the last and most important factor for choosing a reserve asset: safety. When it comes to reserve assets, safety can mean two things. The first meaning is about price stability. Here again, the relatively fixed quantity of gold and Bitcoin is a major weakness. After all, if you fix the supply of something, while demand may vary due to rapid economic growth or big crises, then OF COURSE you get a very volatile asset. So, not surprisingly, as you can see here, Gold has been very volatile historically. Similarly, despite crypto enthusiast calling 10% inflation hyperinflation, Bitcoin essentially experienced over 50% inflation in 2022 alone.
Of course, this was offset by massive Bitcoin deflation starting in 2023, to today. So, central bankers would have recouped previous losses if they held on to Bitcoin. But, that is not the point. Central bankers are not investors. They are crisis fighters. A volatile asset like Bitcoin has so far been unacceptable as a reserve asset because its volatility may prevent central bankers from defending their own currency when they need it most.
Here, Bitcoin enthusiast like the writer of the book the Bitcoin Standard, will argue that as Bitcoin gets more accepted, it will become less volatile. But, that is not what we have seen with gold, which remained a very volatile asset even in times that it was the world’s money. In fact, I suspect Bitcoin will forever be more volatile than gold, precisely because its supply is restricted far more than that of gold, which is more likely to be mined more if the price is high.
So, when it comes to price volatility, or rather stability, major fiat currencies have so far been FAR superior to BOTH Gold and Bitcoin.
However, on top of safety from volatility, for many central bankers, US Dollars were also more physically safe than gold after the second world war, when many of them feared a Soviet invasion. After all, during the second world war, countries like Belgium and the Netherlands lost big chunks of their gold reserves to the Nazi’s. Therefore, it became common practice to store gold in London or New York, far away from advancing armies. So, if you trust America to hold your gold, it makes sense you trust them not to confiscate your U.S. Dollars. Meanwhile, while Bitcoin may be very safe to hold in theory, there are plenty of stories of people getting hacked by holding them at third parties, or losing passwords or hard-drives if they tried to secure access to them locally.
So, the dominance of the Dollar today, and the decline of gold, and non-acceptance of Bitcoin, can for a large part be explained by these factors. Gold was less profitable holding than Dollars for years. But, more importantly, Dollar markets were far more liquid as the American economy grew, and finally gold was less safe to hold, mainly due to its inherently higher volatility.
So, then, fast forward to today, what changed? Why are we now seeing THIS uptick in gold reserves by central banks, which actually looks way bigger if we simply look at the quantity of gold in ounces.
In other words,
Why are central banks racing to buy Gold again?
and, perhaps a bit of Bitcoin as well in the future.
When, IMF researchers studied recent central bank gold purchases they found that
“both the volume and value of gold reserves increases with the imposition of sanctions from the U.S., UK, Euro Area, and Japan in the current or immediately preceding years. “
In other words, sanctions, and even reserves being frozen by the issuers of the most liquid and safest reserve assets caused central bankers that believed they could be at risk of sanctions to turn to the only real safe asset they knew, gold.
Therefore, for some central bankers, like those in Russia, gold that is kept locally, now looks more safe than Dollars and Euro’s. However, Gold still has some massive downsides in that it is expensive to store and, actually, really difficult to sell in global financial markets in London or New York, if you don’t want to hold it in a vault there, but rather in Beijing or Moscow.
This is where Bitcoin could actually play a role, since unlike gold, it is digital, and while slow and expensive to send to others for people like you and me, who can’t afford much Bitcoin, it is much easier and cheaper to send than Gold for central banks, who send it in large quantities. However, so far, that is just in theory, because World Bank researchers found last year that central bankers still think Bitcoin is way too volatile and is not liquid enough.
This can explain why instead of fully turning to gold or Bitcoin, Russia’s central bank for a larger part just shifted from so-called ‘unfriendly’ fiat currencies, to so called ‘friendly’ fiats like the Renminbi, or Indian rupee.
But, that is today. What about tomorrow? Is there ANY CHANCE at all that central banks will continue buying more gold, and potentially even Bitcoin? And, if they do, will that push gold & bitcoin prices up further? And, even more interestingly, will it lead to the demise of the US Dollar, and potentially even Fiat currencies in general?
In other words,
What will be the reserve currency of the future?
Well, given that reserve currencies typically only change slowly, due to network effects, I don’t expect a big move away from the Dollar anytime soon. That is, despite Trump’s economic advisors having indicated that if countries want to keep using the Dollar as a reserve currency, they may need to pay for it, the US Dollar is just still SO FAR AHEAD in the categories that matter to central bankers most: liquidity and safety that this will likely not lead to a collapse of the Dollar.
This can explain why last time around, when the world’s reserve currency changed from British pounds to Dollar, it took well over 60 years after the US passed the UK as the biggest global economy.
So, a demise of the Dollar looks far away. And, given that fiat currencies are so much more stable due to their flexible supply, I don’t think it makes sense to expect central bankers to fully switch to gold or Bitcoin, unless the world completely turns to anarchy.
Still, in this increasingly fragmenting global order, I do expect that the gold buying trend will continue as more and more central bankers want to insure themselves against potential geopolitical moves from America, the EU, or China.
And, yes, in this world, if Bitcoin becomes a bit more mainstream, and therefore more liquid, it may actually earn itself a small place in the central banker’s portfolio, as a digital alternative to gold that is easier to transfer across borders in large quantities.
But, to learn more about what increased adoption of both Bitcoin and other cryptocurrencies will look like in detail, I’m not the guy to listen to. So, instead, I highly recommend that you attend the Frankfurt School of Finance’s Crypto Assets Conference on the 26th of March. This is a serious conference that has an amazing line-up of industry insiders, government officials, and academics AND has kindly agreed to sponsor this video.
All Money & Macro viewers can attend the conference on-line for free, and, on location, in Frankfurt, with a 10% discount, if you use the link below.
So, go check out the specifics about the speakers and program of the conference on www.crypto-assets-conference.de
And, attend it, either in person on on-line for free, using the link in the description of this video or top comment below.