The governor of the Dutch central bank said the gold revaluation account guarantees the solvency of its central bank in a television interview about the potential losses. The significance of this statement is that if a European Central Bank will cover the losses by fully using its gold revaluation account, the ECB must put a floor under the price of gold. And if more losses need to be covered than the current gold revaluation accounts of European central banks allow, the ECB will have to revalue gold.
Gold monetary reserves of the Netherlands. Source: DNB
A discussion started in the Netherlands after Klaas Knot, Governor of the Dutch Central Bank (DNB), wrote a letter to Sigrid Kaag, Dutch Minister of Finance, on September 9, 2022. The letter is titled: “DNB plans a deterioration of the capital position.” Knot warns Kaag of the losses of the DNB due to the increases in interest rates, decided by the European Central Bank (ECB) but applied by all the national central banks (NCBs) of the Eurosystem. years, quantitative easing (QE) caused the DNB, and all the other NCBs, to create an abundance of bank reserves to buy government bonds Now that the ECB is raising interest rates, the DNB must pay increasing interest to banks on their excess reserves.These expenses cause DNB to suffer losses to the detriment of its capital position (equity).Note that all NCBs in the Eurosystem face similar challenges.
For this year, DNB expects a small loss, but for the years 2023 to 2026 a loss of 9 billion euros is expected. However, it could be more. DNB’s equity currently stands at 11.3 billion euros. If losses exceed €11.3 billion, DNB’s equity will become negative. While it is possible for a central bank to operate with negative equity, it hurts credibility, a central bank’s most valuable asset. And once the credibility is lost, people will get rid of the currency issued by said central bank.
For this reason, Knot wishes to discuss with the Dutch State (DNB’s sole shareholder) the possibilities of financing a recapitalization of DNB. In other words, if taxpayers can bail out their central bank.
The gold revaluation account as a guarantee of solvency
A Gold Revaluation Account (GRA) is essentially an accounting item that records unrealized gains on gold from a central bank. Because most of Europe’s monetary gold was accumulated during Bretton Woods at $35 an ounce, the respective GRAs are substantial. Monetary gold in the Eurosystem is valued at market price, and the price of gold today is well above $35.
Below is a simplified central bank balance sheet. On the asset side, there are international reserves (gold and foreign exchange), a bond portfolio and discount loans to commercial banks. On the liability side, there is the monetary base (reserves and currency), a deposit account for the government, a GRA and equity.
Like commercial banks, a central bank’s balance sheet includes assets and liabilities.
Interestingly, there is no limit on a GRA as gold is the only international reserve asset that cannot be printed. Denominated in fiat currencies, which can and are printed, the price of gold has no cap and can also inflate balance sheets.
The GRA can be considered equity, but technically it is not at this point because it is prohibited to use it. Current laws in the EU state: “there shall be no set-off of unrealized losses on a given security, or in one currency or gold holdings, against unrealized gains on other securities or currencies or gold”. At this point, the GRA just swells and shrinks in sync with the rise and fall of the price of gold. But all that could change.
On Sunday, October 30, 2022, Knot was interviewed by Buitenhof on DNB losses. When the solvency of DNB’s balance sheet came into question, Knot brought up the GRA.
To interview: So what you’re saying is that the higher the European Central Bank interest rate, the more it costs us…Tie: Yes that is correct …To interview: …and the more money it takes. Wait, I want to finish my question, so we all understand. And the higher the probability that the Dutch taxpayer will have to pay to repair the balance sheet of the Dutch central bank, which I always thought, “it’s solid, it can’t fail”, is high. This story is new to me.Tie: The balance sheet of the Dutch central banks is strong because we also have gold reserves and the gold revaluation account is over 20 billion euros, which we may not count as equity, but they are there.To interview: But you don’t want to sell the gold?Tie: No, we are definitely not going to sell.
Using the GRA to cover losses does not require selling gold, it requires changing accounting rules. The reason why it is now forbidden to use it is that once completely depleted, the fall in the price of gold will cause the GRA to fall, which will eat away at the net worth of DNB. The very thing DNB is trying to avoid. In the interview, Knot thus refers to the GRA as a solvency backstop, but this implies putting a floor under the price of gold.
In February, I published an article on the possibility of European central banks revaluing gold and then using their GRAs to cancel sovereign bonds as government debt relief. My analysis was based on an email exchange between me and the German central bank in which they stated that they did not exclude this possibility. In October, I revealed that European central banks have equalized, proportionally to GDP, their gold reserves among themselves over the past decades. This was done so that all benefit from the same relative gain in their GRAs when gold revalues. According to my assessment, the revaluation of gold will only take place in an insurmountable crisis. After the reversal of the gold revaluation, sovereign debt would have stabilized the price of gold and the Eurozone would effectively be heading towards a new version of a gold standard.
By the 1930s, GRAs had been used for several purposes. After devaluing against gold, central banks eventually pegged their currencies to gold at a higher price, leaving GRAs to be used as they saw fit. As far as I know, no central banker has openly discussed the use of a GRA – to cover their own losses or write off sovereign bonds – since Bretton Woods. Remarkably, in Buitenhof it wasn’t the interviewer who brought up the GRA, it was Knot! Since the word got out, central banks in Europe are officially ready to change the rules and use their GRAs to secure their own solvency. Also, once the rules are changed, it allows them to revalue gold and bail out their governments as well.
Ultimately, the current trend is clear: financial challenges, caused by unconventional monetary policy, lead to greater emphasis on the role of gold in overcoming these challenges. And I will follow these developments closely.
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.