A Golden Solution for Europe's Sovereign-Debt Crisis

Using countries' gold reserves to lower the borrowing costs of euro-zone governments

 By STEPHEN FIDLER

Central banks of the 17-nation currency union are sitting on more than 10,000 metric tons of gold. At northward of $1,740 a troy ounce, that's a chunk of change. (There are 32,151 troy ounces in a metric ton.)

From the point of view of Europe's debt crisis, most of it is in the wrong place. Nearly a third of it belongs to Germany and almost a quarter of it is in France, neither of which is struggling with high debt-interest costs. For some countries burdened with debt—Spain, which holds 282 tons, Greece with 112 tons and Ireland with just six—their holdings are too small to make much of a difference.

But two countries have enough gold to make a difference to their financing costs. Italy, which has flirted with unsustainably high borrowing costs, is sitting on the second-largest holding of gold reserves in Europe: 2,450 tons. The small economy of Portugal, which is in a bailout program after it lost access to affordable government finance, has reserves of 382 tons.

The idea is not to sell the stuff. Instead, the proposal is to bring down borrowing costs by using gold to guarantee the partial repayment of bonds to investors in case of a default. Italy's gold reserves would cover 24% of its estimated borrowing needs over the next two years and Portugal 30%. If the two countries could issue some unsecured debt at the same time, they could bridge an even longer period.

First, some perspective on an idea that could hypothetically help Italy to avoid asking its neighbors for a bailout and aid Portugal to regain access to the bond markets.

It is not from a disinterested party: The World Gold Council exists to promote the use of gold on behalf of the world's gold miners.

It is not in the current mix of ideas being discussed by senior policy makers, though it has been the subject of presentations in Brussels, for example to European parliamentarians, and has been put forward by Romano Prodi, the former Italian prime minister.

Moreover, a continuation of the current bond-market respite—inspired by the European Central Bank's pledge to buy the bonds of governments that request an official credit line and meet the conditions attached—would render it of only academic interest.

There are precedents for using gold as security. Ansgar Belke, an economist at the University of Duisburg-Essen in Germany, points out that in the 1970s Italy and Portugal both used gold reserves as collateral for loans from other central banks and the Bank for International Settlements. In a paper commissioned by the WGC, he calculates that gold bonds could cut Portugal's borrowing costs for five-year bonds from 10% to 6%, if a third of the bonds' face value was guaranteed in gold, and to 5%, if half was guaranteed.

Such bonds, he said, would "surely attract investors such as emerging-market governments and sovereign-wealth funds."

Using gold to back government debt could not happen overnight. For one thing, the gold reserves are not in the government's coffers but in those of the national central banks. Though the reserves in question are separate from the gold these countries have placed with the ECB, the governing council of the ECB must agree to any transfers of gold to governments.

Second, national central banks in the euro zone are meant to be independent. A transfer of gold to the government raises questions, says Mr. Belke, about whether such transfers breach the prohibition on central banks providing monetary finance to governments.

Third, euro-zone central banks are among those world-wide that have agreed to limit their collective gold sales to 400 tons a year, an agreement that persists until 2014. It's not clear whether using gold as collateral would be considered inside or outside the scope of this agreement.

Mr. Belke points out that current ECB operations—providing finance to banks which then buy their own governments' debt, and the ECB's government-bond-buying operations—are also viewed by some as breaking the prohibition against monetary financing, objections that have not proved an obstacle to the operations' going ahead.

In another paper for the WGC, Andrew Lilico of Europe Economics, a London-based economics consultancy, says the use of gold-backed bonds wouldn't be a case of central banks gearing up the printing press to bail out their governments.

"As a real asset, the use of gold as collateral is not inflationary, any more than would be the use of historic buildings or military equipment or islands or any other of the forms of collateral that have been proposed for distressed sovereigns," he argues.

Justin Knight, a European bond strategist at UBS, says some investment institutions might struggle to buy gold-backed bonds because they 
invest according to bond indexes, some of which include only unsecured debt. Other investors may have rules forbidding them from holding asset-backed securities.

"Bonds would need to be issued under international, rather than domestic law, and one could envisage a situation in which bonds secured against gold held outside of the country… might be seen as more valuable than that held in a central bank's own vaults," he said.