The Case for Gold as a Reserve Asset in the GCC

This paper focuses on some key aspects of the Gulf Monetary Union and specifically on the new central bank policy in the area of reserve management policy. It will address whether holding a substantial part of reserves in gold would enhance the stability of the new currency and in general how a reserve management policy which includes gold fares against the alternative strategy relying exclusively on holding assets denominated in fiat currencies.The original deadline of January 2010 for the Gulf Monetary Union (GMU) has been missed and a new deadline has not been set. Despite this setback the process has not halted and actually, away from the limelight, technical committees are working, with the plans for the inception of the GCC Monetary Council expected to be finalized by Fall 2010. Once the forerunner of the Gulf Central Bank is in place with the appointment of the Governor, one can envisage steady progress both in the institutional framework and in the technical aspects.Credibility will be the key issue for the new currency and therefore an important task for the Gulf Central Bank would be to set in place conditions that brace the trust of international markets. It is likely that the Gulf currency will initially be pegged to the US dollar, but once the initial phase in which the technical aspects of monetary policy conduct will be tested it is logical to expect that the exchange rate rule will be more flexible with a peg to a currency basket, either similar in composition to the SDR, or reflecting trade shares.A linked issue is whether the composition of reserves could help in conferring the new currency credibility and whether it is possible to demonstrate quantitatively that including gold would help to achieve better macroeconomic stability. We conduct a series of simulations based on past data to calculate the return on a portfolio of reserves assets with and without gold.Our results indicate that if a relatively conservative central bank should hold gold as an asset class, its potential returns for any given level of risk (i.e. at any threshold of standard deviation) increase by several points more per year than when excluding gold from its optimal portfolio. Similarly, a dollar invested (in January 1987) by a fictional conservative central bank in an international reserves portfolio with gold would have grown to $6.6 by May 2010 – which is about 1.5 times more than an international reserves portfolio without gold