ACHIEVING VALUE FOR MONEY
Restructuring the reserve asset portfolio to reduce
its exposure to risk
6. The Treasury concluded in the late 1990s that
the amount of gold held in the reserves represented too great
an exposure to an individual asset, particularly as the gold price
had been declining for many years, the price was volatile and,
unlike foreign currency assets, there was virtually no return
on gold holdings. Against a background of increased gold sales
by central banks and a downward trend in the market price of gold,
the Treasury identified some potential benefits in managing the
risks to the reserves portfolio more actively.[8]
At the time of the sales announcement in May 1999 715 tonnes of
gold, valued at some £4billion, were held in the UK reserves.[9]
The Government had not previously sold large quantities of gold
from its reserves, only small quantities of gold coins.
7. When asked to clarify the purpose of the policy,
the Treasury said that it wanted to diversify the reserves portfolio
in the medium-term to reduce the riskiness of the portfolio by
decreasing the proportion of the net reserves held in gold from
44 per cent to closer to 20 per cent. It aimed to do this in a
way that maximised value for money but transparently, openly and
accountably.[10]
8. The Treasury measures the riskiness of the portfolio
by a "value at risk" calculation which includes consideration
of the maximum loss that might be incurred under certain circumstances.
Value at risk is a single summary statistical measure of possible
portfolio losses taking into account the probability and magnitude
of the likely losses in a given portfolio over a given time horizon.[11]
9. The Treasury illustrated the potential change
in the riskiness of the portfolio following the gold sales using
a portfolio worth $14 billion, similar to the size of the UK's
reserve portfolio, and on the assumption that the non-gold assets
were invested in US dollars, euros and yen at a benchmark ratio
of 40:40:20. The euro is less volatile than gold, and is more
independent of variations in the value of the yen than gold. This
key factor underlies the expected improvement in the risk characteristics
of the portfolio following the gold sales.[12]
The 40:40:20 benchmark ratio is reviewed periodically to ensure
that it is still appropriate, given changes in macroeconomic conditions
and in currency volatilities and correlations.[13]
10. On the basis of historical data on the movements
in the asset prices of euros, yen and gold the Treasury calculated
the value at risk—that is the maximum amount that could
be expected to be lost over a 10-day horizon, using a 99 per cent
confidence level—for two portfolios. The value at risk for
a portfolio containing 50 per cent gold is $459 million, compared
to $338 million for a portfolio containing 20 per cent gold. The
lower gold holding portfolio therefore had a 26 per cent lower
value at risk than the portfolio with a higher proportion of gold.[14]
11. Asked whether the UK would pass the UK's gold
reserves to the European Central Bank, should the UK join the
Euro the Treasury said that members contributed a share of their
reserves to the European Central Bank according to a pre-announced
formula, although they did retain ownership of them. Fifteen per
cent of the reserves contributed are in the form of gold. In the
case of the UK, these would be worth about $1 billion. The Treasury
confirmed that, in line with its policy of investing the proceeds
of the sales in the ratio of 40 per cent in US dollars, 40 per
cent in euros and 20 per cent in yen, 40 per cent of the proceeds
had been used to purchase euros (about 900 million euros). In
terms of the daily flows into and out of the euro this was insignificant.
It had not been an attempt to support the euro by the back door.[15]
12. At the conclusion of the sales programme the
UK's gold holdings will have been reduced to around 300 tonnes.[16]
The Treasury emphasised that gold would remain an important part
of the portfolio - about 20 per cent of the net reserves.[17]
Transparency
13. Influenced by its experience in selling bonds,
the Government decided to sell the gold in a transparent manner
on the basis that transparency should enhance value for money
for the taxpayer in the long run by reducing the risk premium
priced into bidders' valuations. There was also a growing commitment
amongst leading central banks to provide more timely and open
disclosure on reserve fund movements.[18]
14. The Treasury said that transparency had enhanced
the UK's reputation, especially as a big operator in foreign exchange
reserves and that the benefits of operating in an open, transparent
and predictable fashion could spill over into other areas. For
example the UK could borrow money from the markets more cheaply
than any other country - with the possible exception of Japan
and Switzerland. It was important to the UK's reputation to be
seen to be selling gold in a transparent way.[19]
15. The London Gold Fix is recognised internationally
as providing the best available indicator of the market price
for gold at any one time. References to market prices for gold
are therefore references to prices achieved in the London Gold
Fix.[20]
The price of gold fell sharply—by about 10 per cent—after
the UK's May 1999 announcement to sell gold was made, reaching
a 20 year low of $252 per ounce shortly after the first UK gold
auction. The price increased sharply to $325.50 an ounce in October
1999 following an agreement by European central banks to limit
gold sales over the next five years. Since then the price of gold
has mainly remained under $300 an ounce.[21]
16. The impact on the price of gold following other
international gold sales has generally been less than the impact
of the UK's announcement. In the case of the Swiss programme of
sales, which is substantially larger than the UK's, the price
impact had been less, mainly because that country went through
a more protracted process including a referendum to approve the
sale. The Treasury explained that it had expected there to be
a fall in the price following its announcement, although it had
not been clear by how much. The Bank of England said that a factor
in the softening of the gold price after the UK's announcement
was knowledge that the Swiss also intended selling gold.[22]
17. Asked about the sharpness of the fall in the
gold price after the UK announcement compared to the relatively
small amounts at stake, the Treasury said in evidence that there
would have been an even greater price response had it tried to
sell covertly in the market, rather than announcing the sales.
IMF guidelines on disclosure of reserve holdings meant that sales
would have become quickly apparent and raised concern that all
the UK gold reserves were going to be sold.[23]
18. Other countries have disclosed less information
about their gold sales. Some countries have sold discreetly and
without prior announcement of the decision to sell gold. Many
central banks do not publish the gold prices achieved in individual
sales and are often unwilling to disclose such information.[24]
The Treasury itself has a reserve price for each auction below
which it will not sell, but does not announce that price because
it would set a floor to the auction price. After the auction has
taken place, not information is given on prices bid in the auction
to avoid facilitating collusion between bidders.[25]
19. The Treasury said that, in its view, there was
no cost in acting transparently as best value was achieved by
opening up the sales to the maximum number of buyers as had been
done in the auctions. Comparison of the prices achieved in the
auctions with the best available benchmark, the London Gold Fix,
demonstrated that gold was sold transparently without losing value.[26]
Flexibility
20. The Treasury considered that greater flexibility
could not be expected to lead to better revenues than current
market expectations. The market viewed a more flexible approach
as an option that would only be exercised if it benefited the
seller. The Treasury had to trade off the market's desire for
predictability against the advantages of a degree of flexibility.
It accepted that it was not easy to judge how much could be gained
by predictability. It had moved towards being more flexible by
only announcing one auction in advance rather than two as it had
done at the start of the sales programme.[27]
21. Asked whether announcing the date of the second
auction (21 September 1999) so far in advance had left it unable
to take advantage of the significant strengthening of the gold
price when the European central banks' agreement was announced
(26 September 1999), the Treasury said that cancelling the second
auction would not have been an appropriate response. It would
not have been right for the UK to be opportunistic and rely on
insider information. Delay or cancellation would have raised questions
in the market and might have put the European central banks' agreement
at risk. As to whether speculation about delaying the auction
would have resulted in higher prices, the Treasury said that essentially
it had been concerned to preserve its reputation for future sales.
It would also have been difficult to know what impact the European
central banks' agreement would have on the gold price.[28]
22. A review by the Bank of England found some support
from market participants for smaller, more frequent auctions.
Many favoured the use of the London Gold Fix which they saw as
a logical extension of smaller more frequent sales.[29]
In response to a question on whether use of the London Gold Fix
would have had advantages over the auctions because it would not
be such a focus for adverse sentiment, the Treasury and the Bank
of England agreed that the London Gold Fix was a viable alternative
to auctions, and that the market preference was for smaller amounts
to be sold each day in the Gold Fix. They agreed that the London
Gold Fix was indirectly available to all market participants and
that it would be feasible for the Government to be transparent
about sales it made using the London Gold Fix by announcing how
much it intended to sell and over what period.[30]
23. The Treasury and the Bank of England confirmed
that they valued the greater transparency of auctions including
the ability to release the bid cover ratio, which showed the extent
to which the volume of gold bid exceeded the volume offered. Witnesses
also confirmed that they were concerned about fairness in the
sense of the sales being open to all participants on the same
terms. Auctions had the advantage of opening up the process directly
to a large number of potential buyers, who would otherwise have
to ask a London Gold Fix member to bid on their behalf; but some
of the non-members would be competing banks who would not necessarily
want to disclose their orders to competitors. In addition London
Gold Fix members charged a commission to outsiders on orders they
execute.[31]
The prices achieved
24. Between July 1999 and September 2001 335 tonnes
of gold were sold in 14 auctions every other month. Bids at the
auctions could be submitted by the members of the London Bullion
Market Association, by central banks and by other international
monetary institutions holding gold accounts at the Bank of England.
25. The average price achieved was $273.01 per ounce.
That price was 37 cents above the average of the London Gold Fix
prices on the day of the auctions. It was equivalent to less than
one per cent below the average of the London Gold Fix price of
$274.86 per ounce over the period of the auctions. Interpretation
of these figures is a matter of judgement since none of them is
statistically significant, given the small size of the sample.
The potential impact on the London Gold Fix price of the sales
cannot be gauged and would depend on whether the auctions attracted
more demand for gold than would be achieved in the London Gold
Fix. The Treasury expected to achieve the average price of gold
as measured by the London Gold Fix price over the course of the
whole programme.
26. The Treasury had analysed the apparent propensity
of the market price to rise sharply shortly after the auctions.
It had analysed price movements (in US$ and percentage terms)
for each of the ten auctions at 15, 10, 5 and 1 day(s) before
the auctions and could find no consistent pattern in price movements
up to or following auctions. Prices have tended to fall slightly
before the auctions, but they have also tended to fall after the
auctions.[32]
Figure 1 shows the variations in the London Gold Fix prices during
the period of the fourteen auctions.
Investment of gold sale proceeds
27. The proceeds of the gold sales were received
in US dollars and were re-invested in foreign currency interest
bearing assets at a ratio of 40 per cent US dollars, 40 per cent
Euros and 20 per cent Yen, a formula which is consistent with
the composition of the net currency reserves. The return on gold
is around half of one per cent compared to about 6 per cent for
interest-bearing foreign currency assets. By November 2000 that
reinvestment had generated an additional return to the taxpayer
of US $52 million, or £35.5 million.[33]
28. The Treasury said, in relation to how it had
determined the composition of the foreign exchange portfolio,
that it had determined the portfolio ratio by considering what
it wanted the foreign currencies for, the proportions of UK trade
with different parts of the world, and the ease with which these
currencies could be used for intervention purposes. It aimed to
keep a small number of highly liquid currencies that roughly reflected
the UK's trade patterns. The Treasury took the view that, at times,
the 40:40:20 split would work better than others, but that over
the medium term it gave a reasonable balance.[34]
29. Asked about the impact of any changes in prime
factors, such as the UK's trade weighting, the Treasury provided
details of the factors that it took into account when making a
judgement on the balance of assets to be held (Figure 2). It periodically
reviewed the appropriateness of these and also discussed the long-term
strategic issues relating to the overall foreign exchange account
at six monthly meetings with the Bank of England.[35]
| Figure 2: The components and weights of the net reserves currency benchmark
|
| Benchmarks | Determinants of the benchmark
|
| Intervention | To be able to intervene in the foreign exchange markets. This points to investing in relatively liquid assets—i.e. US, Europe and Japanese currencies.
|
| | Most readily usable for intervention—suggests holding larger proportion of dollars and euros.
|
| Macro economic factors | Required to finance outflows of trade and capital account without selling sterling in the event of a period of financial instability.
|
| | To provide protection against shocks to the UK macroeconomic policy objectives—suggests a case of investing in yen as a currency which is less likely to be weak at the same time as the other two currencies.
|
| Risk and return | Minimising the market risks on investment grounds—suggests holding dollars (30% to 50%) euros (40% to 70%) and yen (0% to 10%).
|
| | Analysis of historic returns on currencies. Recent data suggest that the dollar has been the highest yielding.
|
Source: Evidence, Appendix 1— determination of the composition
of the UK's net foreign currency reserves
Impact of the gold sales programme on the value
of the portfolio
30. The impact of the gold sales programme on the
value of the portfolio can be calculated by comparing the value
that will arise as a result of selling the UK gold with the portfolio
that would have existed had the sales not taken place. The Treasury
considered that a meaningful assessment of the financial benefits
could only be undertaken over the medium to long-term, and that
in the short term wide fluctuations in the gold price, exchange
rates and short-term interest rates could significantly impact
on the results.[36]
31. At 18 December 2000 there was a small gain of
US $34 million (£23.1 million) in the value of the portfolio
taking into account the interest gained from the foreign securities
bought with the proceeds of the gold sales. By 23 January 2001,
after the tenth auction had taken place, this gain had increased
to around US $100 million (£68.1 million).[37]
The Treasury said that it was nevertheless prepared to face up
to the prospect of losing money to achieve its main aim of lowering
the risk of the portfolio.[38]
Conclusions
32. In order to secure and maintain the reduction
in the riskiness of the reserves portfolio it will be important
for the Treasury to continue to monitor the appropriateness of
their foreign currency benchmark of 40 per cent in US Dollars,
40 per cent in Euros and 20 per cent in Yen, having regard
to the fluctuations in gold prices, exchange rates and interest
rates.
33. The Treasury decided to sell the gold through
auctions in quantities and on dates announced in advance, as part
of a process that would be seen as transparent, and so would increase
value for money in the long run. There can however be a trade
off between transparency and flexibility. For example the Treasury
does not announce the reserve price and following the auctions
does not disclose information on prices bid; and the Treasury
has decided to announce only the date of the next auction and
to reduce the amount to be sold in each auction from 25 tonnes
to 20 tonnes. In managing such programmes the Treasury should
continue to keep these trade offs under review, as its experience
develops, in order to maximise the benefits of both transparency
and flexibility.
34. The first two auctions (6 July 1999 and 21 September
1999) were preceded by a sharp fall in the price of gold, following
the announcement of the proposed sales. They were followed by
an even steeper increase in the price of gold when the European
central banks (including the Bank of England) reached agreement
(26 September 1999) on the overall size of their gold sales programme
for the subsequent 5 years. It would have been preferable if this
agreement could have been concluded and announced before the announcement
and start of the UK sales programme.
35. Analysis of the prices achieved in the auctions
so far indicates that they are in line with the prices that would
have been achieved if the London Gold Fix had been used, although
interpretation of the figures entails judgement because of the
sample size and the uncertainty over the possible impact of the
sales on the London Gold Fix price.
36. The Treasury considers that the outcome of the
sales programme in relation to its objectives of reducing the
riskiness of the portfolio can only be assessed meaningfully in
the medium to long term, because in the meantime temporary fluctuations
in asset prices could mask the benefits of risk reduction. The
Treasury is also prepared to face a loss as the price of diversifying
the portfolio to reduce the risk. At the end of the gold sales
programme a reasonable spread of data will be available on the
components and weights of the currency benchmark, including the
ability to provide protection against shocks to UK macroeconomic
policy objectives and minimising market risks.
37. We recommend that the Treasury should evaluate
the programme at that stage, to determine the extent to which
the riskiness of the portfolio has been reduced, and at what price
or profit by comparison with not selling the gold, on stated assumptions.
CHANGES TO THE SALES PROGRAMME
38. The Treasury has undertaken three formal assessments
of the options available to sell gold: the first, three months
before the first auction; the second, in February 2000 and the
third in the first quarter of 2001. In undertaking these assessments
the Treasury received technical advice from the Bank of England
as its agent and looked at the experience of gold sales in other
countries.
39. The Treasury accepted that there could be ways
in which the programme could be improved which was why it and
the Bank of England were in the process of reviewing it again,
taking into account the issues raised by the National Audit Office.
The review examined all aspects of the gold sale programme including
the alternative methods of selling gold, particularly use of the
London Gold Fix, the possibility of retaining more flexibility
in selling gold, the information provided to the gold market and
the management of the sales programme.[39]
It also took account of the experience of the auctions that had
taken place and involved discussions between the Bank of England
and market participants, analysts and other interested parties.
40. As a result of the review, and following the
hearing with our predecessors, the Treasury announced in March
2001 that the gold sales to take place in 2001-02 would consist
of six auctions and, that each auction would be smaller - 20 tonnes
rather than the 25 tonnes previously sold, and that sales would
continue to be held bi-monthly using the uniform price auction
format.[40]
These sales would complete the UK's gold sale programme.
41. The market participants canvassed by the Bank
of England, as part of the review of the auction process, were
roughly evenly split between continuing with bi-monthly auction,
moving to more frequent smaller auctions and using the London
Gold Fix. The review concluded that auctions continued to be the
most fair and transparent form of sales, while, in value for money
terms, auctions and the London Gold Fix were likely to deliver
broadly similar outcomes.[41]
42. The National Audit Office identified some of
the key forms of flexibility that could be introduced into the
process and the potential implications of these. They included
deciding on the amount to be sold only shortly before the auction,
announcing a range for the amount to be sold or publishing a supply
schedule in advance showing how much the Treasury was prepared
to sell at different prices. The benefits of these forms of flexibility
relate mainly to stabilising price volatility following the auction.
They would not necessarily lead to a higher expected return.[42]
43. The Treasury review of the auction process found
little support from market participants for announcing a range
for the amount to be sold and/or deciding the amount sold when
allocating the bids. There was more support for more frequent
sales and selling into periods of temporary demand. A large number
of market participants were, however, against all forms of flexibility
with some feeling that opportunistic sales would lead to a more
jittery market and potentially worse prices in the sales. Some
thought that flexibility would be inconsistent with a transparent
approach and that the reputational risk was not worth taking.
In the light of these views and the Bank of England and Treasury's
own views about the potential implications of retaining flexibility
in the sale process, the Treasury decided to continue selling
gold on the basis of fixed amounts announced in advance.[43]
44. There was some support in the market for smaller
auctions. Market analysts advised that, since the programme had
been announced, volumes traded had become lower, making 25 tonnes
a relatively larger amount to absorb. The Treasury had regard
to that fact in announcing in March 2001 that the individual auctions
would be of 20 tonnes in future.[44]
45. After each auction the Treasury disclose to the
market details of the price achieved, the total proceeds and the
bid-cover ratio. While the majority of the market was satisfied
with the level of information provided, the usefulness of the
bid cover ratio had been questioned by some market participants.
There had also been a call for more information on the bids received.
46. The Treasury review found little support among
market participants for the publication of more post-auction information.
Some considered that other measures would be open to manipulation,
while publishing more information was seen as potentially risky
because it might be over-analysed and viewed as negative by the
market. The Treasury also considered that publishing more detail
of bids could increase the risk of collusion between market participants.
It decided to continue publishing the bid cover ratio and not
to increase the disclosure of post-auction information.[45]
Conclusions
47. Since the sale programme began, the Treasury
have carried out three assessments of the options available to
sell gold, consulting market participants in the process. We endorse
the Treasury's decision, as a result of these reviews, to sell
smaller quantities of gold in each auction.
48. We also endorse the Treasury's decision to consult
market participants as part of their series of reviews of the
on-going sales process, because it is important in such programmes
for departments to develop as close an understanding as possible
of market sentiment and the concerns of other interested parties.
1 C&AG's Report, HC 86 Session 2000-2001, The Sale
of Part of the UK Gold Reserves, paras 1-2, 12 Back
2 ibid,
para 2.5 Back
3 ibid,
para 4 Back
4 Q116 Back
5 C&AG's
Report, para 2.9 Back
6 ibid,
paras 2.4, 2.22 Back
7 C&AG's
Report, HC 86 Session 2000-2001 Back
8 C&AG's
Report, paras 2.2-2.3 Back
9 ibid,
para 1.6 Back
10 Qs
2, 9, 30 Back
11 Evidence,
Appendix 1, pp 18-29 Back
12 ibid,
pp 26-29, Value at risk: A worked example Back
13 ibid,
pp 18-21, Determination of the composition of the UK's net foreign
currency reserves Back
14 Evidence,
Appendix 1, pp 26-29, Value at risk: A worked example Back
15 Qs
16-17, 24-29 Back
16 Q55 Back
17 Q30
Back
18 C&AG's
Report, paras 13, 3.4-3.5 Back
19 Q128 Back
20 C&AG's
Report, para 3.10 Back
21 ibid,
paras 2.7-2.8; Q96 Back
22 C&AG's
Report, para 2.8 and Appendix 4, Qs 96-97, 140 Back
23 Qs
4, 140 Back
24 C&AG's
Report, para 2.17 Back
25 Qs
45-47 Back
26 Qs
5, 11, 38, 116 Back
27 Qs
11, 37 Back
28 Qs
6, 97, 99-100, 103 Back
29 C&AG's
Report, para 4.3 Back
30 Qs
7-8, 13 Back
31 Qs
7, 13-14, 88-92 Back
32 Q133
and Evidence, Appendix 1, pp 18-29 Back
33 C&AG's
Report, paras 2.22, 2.24 and Qs 65, 125 Back
34 Qs
51, 71, 114, 136 Back
35 Evidence,
Appendix 1, pp 18-29 Back
36 C&AG's
Report, paras 2.22-2.23, 2.26 Back
37 ibid,
para 2.26 and Q36 Back
38 Q9 Back
39 C&AG's
Report, para 3.17 Back
40 Qs
15, 34 Back
41 Evidence,
Appendix 2, pp 30-31 Back
42 ibid Back
43 ibid Back
44 C&AG's
Report, paras 4.6-4.7 Back
45 ibid,
paras 4.3, 4.20, and Evidence, Appendix 2, pp 30-31 Back
