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“Can central bank gold reserves reduce sovereign credit risk?” – A study by the India Gold Policy Center of the IIMA
Posted on October 1, 2021
~ First of its kind international market study conducted in 48 advanced and emerging economies ~
In an era of rising public debt and the detrimental effects of COVID-19, a study by the India Gold Policy Center (IGPC) of the Indian Institute of Management Ahmedabad (IIMA) found a silver lining for countries that have diversified their foreign exchange reserves by increasing their holdings of gold.
The study reveals that high levels of central bank gold reserves have a significant impact on reducing the sovereign credit risk of that country in international markets. In the current scenario, therefore, the findings appear to have positive implications for India.
The first of its kind, this study of world markets was carried out by the team of Sawan Rathi, doctoral student in economics, Professor Sanket Mohapatra, Faculty of Economics at IIMA, and Professor Arvind Sahay, President of India Gold. Policy Center (IGPC) and a Faculty of Marketing and Economics at IIMA.
The researchers took into account five-year sovereign credit default swap (CDS) spreads for 48 advanced and emerging economies over a 20-year period from 2000 to 2020 to measure the economy’s risk of default. The data was compared with information on central bank gold stocks obtained from the World Gold Council database.
I. Hedging risks for central banks:
The study finds that increasing central bank gold reserves reduces future uncertainty and restores the confidence of investors as well as policymakers. Research reveals a negative and significant association of sovereign CDS spreads with the gold holdings of an economy’s central bank. The researchers noted that the likelihood of a downgrade in credit ratings decreases as central bank holdings of gold increase, reducing future uncertainty and reassuring investor and policymaker confidence.
ii. Stronger impact of central bank gold during turmoil in global financial markets and country-specific crises
The study examines the variation in the negative relationship between central bank gold reserves and sovereign CDS spreads, especially during times of high volatility in global financial markets and country-specific crisis. This variation is even greater during periods of high global volatility, as well as in the event of a country-specific debt and inflation crisis. In times of high global volatility, a 10% increase in aggregate central bank gold is associated with a 4.0% decline in sovereign CDS spreads, compared to a 3.1% decline in other periods. During the sovereign debt crisis, a 10% increase in aggregate central bank gold is associated with a 13.3% decline in sovereign CDS spreads, compared to a 3.0% decline in other periods . During the inflation crisis, a 10% increase in aggregate central bank gold is associated with a 16.0% decline in sovereign CDS spreads, compared to a 3.2% decline during the others. periods.
iii. Growth-oriented macroeconomic policies can also reduce country risk
Higher GDP growth, greater fiscal strength and larger foreign exchange reserves may lead to a reduction in sovereign credit risk as expected, while higher indebtedness is associated with an increased risk of debt default. a country. A better institutional environment, represented by the rule of law index compiled by the World Bank, is associated with lower sovereign risk.
Sharing his views on the political relevance of the findings, Professor Arvind Sahay, Chairman of the India Gold Policy Center, IIMA, said: Ratings from advanced and emerging market economies have come under pressure. In 2020, Moody’s downgraded India’s sovereign rating to Baa3, highlighting its weak fiscal position as the main cause of credit crunch.
The results of this cross-country study suggest that higher central bank gold reserves may help stem further deterioration and support the credit ratings of countries like India.
There has been a general increase in the stock of RBI gold reserves since 2018. In stating this, Professor Sanket Mohapatra, states, âCentral bank gold reserves are known to aid in the diversification of global international reserves and can increase returns when international interest rates are extremely low or negative. Our study shows that they can also have a positive impact on sovereign solvency, especially in times of financial market volatility and crisis episodes.
Professor Mohapatra argues that a more active involvement of gold can diversify India’s overall international reserve portfolio and is optimistic about gold playing the role of a stabilizing agent in India’s external position.