Russian gold.

Photographer: Andrey Rudakov/Bloomberg

Russia Can't Help Being a Gold Bug

Leonid Bershidsky is a Bloomberg View columnist. He was the founding editor of the Russian business daily Vedomosti and founded the opinion website Slon.ru.
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The dramatic drop in the price of gold makes Russia look like a classic sucker: As the price went down, it expanded its gold reserves. The Russian central bank is getting punished for betting on gold rather than U.S. assets as the Cold War seemed to restart last year. But it's not that simple -- the gold that Russia's buying is domestically produced and paid for with devalued rubles.

Russia has the fifth-biggest gold reserves in the world, after the U.S., Germany, Italy and France. It got there by steadily buying gold from domestic producers, and the woeful price trajectory since the September 2011 all-time peak has not stopped that activity, as the graph below shows.

From an investing point of view, this was stubborn insistence on a losing bet. In early September 2011, Russia's 27.2 million ounces of gold were worth $52.3 billion. At the end of June 2015, the country's gold reserves almost reached 41 million ounces, but they were worth just $48.1 billion, and that's down to $44.9 billion now. Not a great way to manage reserves.

One reason Russia's otherwise highly competent central bankers did this was political. Last year, after the Crimea invasion, the fear of Western financial sanctions made them dump U.S. treasuries, reducing holdings to $86 billion in December from $126.2 billion in February, and seek a safe haven in neutral, albeit unfashionable gold. It bought 171 metric tons, or 5.5 million ounces, in 2014.

QuickTake The Rise and Fall of Gold

That, however, doesn't explain why Russia was buying so much gold before it became an internationally recognized threat, and why it kept expanding reserves this year, after the fear of stringent sanctions -- such as an Iran-style cutoff from the Swift payment system -- subsided.

Russia is no longer dumping U.S. securities. According to the U.S. Treasury, after keeping its investment below $70 billion in February, March and April, the Russian central bank increased it to $70.6 billion in May. Yet gold purchases continue. After a hiatus in January and February, the central bank acquired almost 2.2 million ounces over the next four months.

The reason for this strange behavior lies in the dependency of Russia's gold industry on central bank purchases. Last year, according to the Moscow-based Gold Mining Union, Russia became the world's second-biggest producer of the precious metal, extracting 288 tons. Producers are not allowed to export their output directly. Instead, they have to sell it to banks, which are authorized to deal with foreign buyers and the Russian central bank. Last year, European banks bought 76 tons -- they have long-standing trading arrangements with state-owned Russian banks, the biggest buyers on the domestic market -- but the central bank dwarfed that, snapping up 59 percent of all output.

At the end of February, the Gold Mining Union, worried that its members' biggest customer was showing no interest, wrote a letter to the central bank, asking it to expand purchases by 30 percent this year compared with 2014 as compensation for sharply increased interest rates (the key rate had gone up to 17 percent in December to prop up the free-falling ruble) and to balance the domestic market. In response, deputy governor Dmitri Tulin promised to keep buying but said the central bank "considers it impossible to replace all domestic market buyers including domestic industries."

Now that the oil price, which Russia depends on to fill its coffers with export revenues, is weakening again, the central bank needs to be mindful of the size of its international reserves, which stood at $358.2 billion last week. In recent months, the central bank has been buying foreign currency to keep the ruble relatively weak and stimulate consumption of home-produced goods, but on July 28, it announced that it would suspend the purchases because of increased volatility. It wouldn't do to have the ruble plunge too much.

Buying gold, however, is a safer bet than intervening in the market, as it doesn't affect exchange rates. The central bank can print as many rubles as the gold producers need without causing a market panic or even boosting inflation all that much. It makes sense to play gold bug despite the falling global price, because that way the top-line number for Russian international reserves (which includes gold, foreign currency assets and IMF Special Drawing Rights) can be kept from slipping too much and sending distress signals to speculators. 

Of course, with the current panic, the gold stockpile is having an adverse effect on the reserves data -- it loses value faster than the central bank can print more rubles and buy more gold. There's nothing to be done about that, however; now would be a bad time to sell off the gold reserves. That in itself is a worry for Russia. If the oil price tanks again and the gold market doesn't recover, 13 percent of its reserves will be illiquid.

Other countries, however, are bigger gold bugs: Apart from the U.S. and the euro-zone countries, which print major reserve currencies and so are not particularly concerned about the size of their international reserves, countries like Lebanon, Egypt, Laos, Pakistan, Kazakhstan and Turkey all have a bigger share of gold in their reserves than Russia does, and so face bigger problems from the price collapse.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author on this story:
Leonid Bershidsky at lbershidsky@bloomberg.net

To contact the editor on this story:
Therese Raphael at traphael4@bloomberg.net