Central banks' gold with BIS?

When Reserve Bank of India bought 200 tonnes of International Monetary Fund (IMF) gold in November last year, the bullion market received one of the biggest boosts ever and the gold prices soared in the subsequent weeks to new record heights. Reason for this was that all central banks across the globe have been increasing their gold holdings fearing the recession looming large over the world.

But, things have changed again. Now it has come to the light that several central banks, which had increased their gold reserves, have pawned their gold with Bank for International Settlements at a record rate, taking advantage of the precious metal's historically high value to raise cash.

It is not clear whether India's Reserve Bank has pawned its gold with the BIS but many banks have already done it.

According to reports appeared in Wall Street Journal and Financial Express, a report released last week by the BIS shows the international agency has taken 349 tonnes of gold since December - allowing central banks to raise a record $14 billion.

The number surprised the market, which had assumed most central banks had retained their holdings of gold. Instead, the BIS data show that they have been entering these gold swaps - exchanging their gold with the BIS in return for cash, agreeing to repurchase the gold at a later date.

The RBI also may have pawned its gold for cash as it has become a normal practice this year.

The increase in the use of gold swaps is particularly surprising because central banks have rarely used them for decades, and the amount of gold at the BIS has remained stable for years.

Central banks of developed countries have relatively easy access to capital and capital markets, while emerging countries have generally been increasing their foreign reserves.

While the use of swaps has no practical implications for the gold market, the report helped weigh on gold prices, which have already come under pressure since reaching a peak last month.

The prospect that the gold isn't locked up in central bank vaults as investors thought - and that it may, in an extreme case, be seized and sold on the open market by the BIS - gave some investors pause.

The BIS report could change investors' perception of gold as an asset to protect against the impact of global sovereign-debt woes.

Originally sovereign financial troubles were taken as unambiguously bullish. But some are now rethinking this if the gold that sovereigns hold has been pledged as collateral to someone else who has more ability to liquidate those holdings.

If the central bank that lent the gold is for some reason unable to make good on the loan, the BIS could opt to sell the gold in order to get its money back, which would amount to flooding the market with an unexpected boost to the global supply.

The BIS annual report covers the 12-month period through March. April data show that an additional 32 tonnes of gold were put up as collateral that month, suggesting further loans were taken out with the BIS.

At this rate, the BIS holdings represent the biggest gold swap in history.

Central banks probably chose to swap gold for cash with the BIS - which is known as the central bank for central banks - because it is less visible to the market and probably cheaper than a syndicated loan from commercial banks.

Gold is often regarded as a protection against inflation and is thought to benefit from the inflationary impact of governments' economic stimulus packages. It has also been used as a haven against another financial meltdown.

The news of the swaps comes as the World Gold Council is trying to persuade central banks to buy more gold. The group sent a 28-page report to more than 800 central bankers and fiscal policy makers around the world, laying out the argument for increasing their bullion holdings.

Many central banks in rapidly growing countries have less than 2% of their reserves in gold, including China, Brazil, South Korea and Malaysia. By contrast, the US has 72.8% of its reserves in gold.

Many developing countries are reluctant to increase their gold holdings significantly. Gold's volatility and its inability to generate income have long been cited as reason why central banks don't want to enhance their gold holdings. Countries also fear that it could become difficult to liquidate their holdings in a pinch.