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Gold Prices Biding Time Until 2011

Since the second quarter of 2009, central banks from emerging market countries have transitioned into net buyers.

One of the biggest buyers is China. Over the past five years, the country secretly increased its gold holdings from 600 tons to 1,054 tons. China currently holds only 1.6% of its reserves in gold. Dempster says that if the continent were to reallocate its holdings to 3%, it would need to buy 1,000 tons of gold. Compare this with the U.S. and Portugal, which hold 70% and 80% of their reserves in gold, respectively.

China has said that it will not be buying additional gold for its reserves, but is encouraging its citizens to buy and is opening up the gold trading market to spur demand. China, however, is unlikely to announce if it is buying gold for risk of triggering a rally in the price.

"Some banks," says Dempster, "have been rebalancing as the percentage of gold in total reserves has fallen over time. Others are looking to diversify away from dollar-based assets, and with sovereign debt concerns continuing to grow around the world, gold's attractiveness as a reserve asset that bears no credit risk continues to grow."

Central banks, in general, regard reserve allocation as an ongoing government policy. Although the governments consider fundamentals like dollar weakness and the sustainability of gold as money, they don't trade gold, they buy it as an investment.

In the third quarter, purchases by central banks outweighed sales by 21.9 tons according to the World Gold Council. Eurozone banks held on to their gold while Russia bought 46.2 tons, Philippines bought 4.2 tons, Thailand added 15.6 tons to its reserves and Sri Lanka increased its holdings by 6.9 tons.

Inflation headlines should also help support gold prices. According to Reuters, the Reserve Bank of India said that inflation is not slowing as quickly as it wants. U.S. investors heard tell of similar issues when ConAgra (CAG) reported its quarterly results on Tuesday, citing higher costs.

Gold becomes appealing during times of inflation as a hard asset that retains more monetary value as fiat currencies are devalued. This thesis hasn't really panned out for investors in the United States as the inflation rates stay very low, but emerging market countries like China and India are seeing consistent high inflation. China's recent inflation reading puts prices 5.1% higher vs. a year ago. India is projecting inflation will be 5.5% in March 2011.
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