Central Bank Case Swiss

7/29/2019 Central Bank Case Swiss

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C E N T R A L B A N K S C A S E S T U D Y

R E P O R T I I : Switzerland


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SwitzerlandThis report, prepared by GFMS for the World Gold

Council, is the second one of a series of publications

intended to investigate the practice of a select group

of countries, with respect to the management oftheir gold reserves.

Specifically, the objective is to examine the variety

of factors that have influenced the reserve manage-

ment decisions of the institutions involved.

Moreover, the aim of these reports is to consider

the broader economic and political backdrop of

the respective countries that has influenced the

decisions taken by central banks and other relevant

decision makers. Finally, these reports provide an

outlook on further developments that might occur

within the countries under review in the short to

medium term.


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Switzerland

1: Country background

Political background

Switzerland is a federal republic consisting of

26 cantons and a parliamentary democracy,

with the Federal Council of Switzerland thehead of government. The government exercis-

es executive power while legislative power is

shared among the parliament, comprising thetwo chambers of the Federal Assembly of

Switzerland, the Council of States and theNational Council, and the electorate directly.

With regards to the direct participation of the

electorate, the Swiss legislative system operatesunder a form of direct democracy. Specifically,

changes in the countrys constitution require a

referendum to take place, while any citizen canrequest a constitutional amendment by collect-

ing the signatures of 100,000 voters within aperiod of 18 months. Furthermore, citizenscan challenge a law that has been passed by

the parliament, by simply collecting 50,000

voters signatures within 100 days from thepassing of the law. As discussed later in this

report, this bore great significance in the mat-

ter of the Swiss gold sales that took place overthe first few years of the millennium.

Economic background

Switzerland enjoys a sound and stable economy

providing its citizens with a high standard of liv-ing. The countrys GDP per capita is higher than

that of most European Union (EU) countries.

The chart below provides a comparisonbetween the GDP per capita of Switzerland and

those of the top five EU countries (based on

their per capita GDP), illustrating that, from this

group, only Luxembourg and Ireland enjoy higherfigures than Switzerland.

Although the country is neither a member ofthe EU nor of the European Economic Area

Agreement (EEAA), Switzerland maintains a

close relationship with the EU, defined by aseries of bilateral agreements, dubbedBilaterals, in place since June 2002. It is worth

noting that since then Switzerland has enteredinto a second round of negotiations calledBilaterals II, intended to further enhance links

between the country and the EU.

Industry and trade/services are the two most

important components of the Swiss economy.Exports of goods and services overall in 2007

accounted for nearly 57% of the countrys GDP1.

With the exception of agricultural protection-ism, the country overall operates under very lib-

eral trade and foreign investment policies.

Finally, the stability and high level of privacy of the

banking regime in Switzerland make it one of the

most secure investment havens in the world.

Switzerland has thus established itself as theleading offshore money manager worldwide.

1Source: Eurostat - Structural Indicators database (forecast), Feb 2008

*

*The volume index of GDP per capita in Purchasing Power Standards (PPS) is expressed in relation to the European Union (EU-27) average setto equal 100. If the index of a country is higher than 100, this country's level of GDP per head is higher than the EU average and vice versa.


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2: Historical Structure ofSwiss Official Reserves

Switzerland has long been a major holder of

bullion. IMF data dating back to 1948 indicate that

from then until the second half of 2007 holdingsremained above 1,200 tonnes peaking at 2,745

tonnes in 1967.

In addition to having always been of significant

volume in absolute terms, Switzerlands gold

reserves have also historically accounted for amajor portion of the countrys overall reserves. The

accompanying graph features a breakdown of the

different components of Swiss reserves, and the

percentage of overall reserves gold accounted forat market prices, on an end-year basis since 1970.

After rising somewhat during the 1970s, driven by

a concurrently rising gold price, golds percentagepeaked at 82% towards the end of 1980. Since

then golds share of reserves has fallen, partly as

the price declined and more recently due to thefirst Swiss gold sales programme that commenced

in May 2000. In March 2005, which marked the

end of the sales programme, gold accounted for24% of total reserves, although since then it has

risen to 41%, in spite of the second sales pro-

gramme. This increase has been driven by both therelease of proceeds from the sales of gold bullion

from official reserves, so they are distributed

among the federal government and cantons, andthe effect of a rising gold price on the value of

remaining gold reserves.

With regards to Switzerlands foreign exchange

and other reserves, it is worth noting that, at

$45 billion (at end-2007, source: IMF), theserepresent a significant volume, taking into

account the size of the country and its status as

a healthy developed economy with a solidcurrency. For instance, comparing the size of

Switzerlands reserves excluding gold to those

of the EU-15 countries, only the United

Kingdom and France have larger absolute hold-

ings than Switzerland, even though Switzerland

ranks ninth in GDP terms and 12th in popula-tion terms among the 16 countries examined.

3. The Swiss NationalBank as an Asset Manager

With regards to its asset management guide-

lines and activities, the Swiss National Bank (SNB)

is one of the most flexible entities within theofficial sector. Where other banks reserves

include little more than gold and a limited selec-

tion of currencies, the SNB is allowed to trade ina wide range of assets. Specifically, according

to the Investment Policy Guidelines of the Swiss

National Bank (SNB) (27th May 2004, amended29th September 2005), the central bank can

include the following assets in its portfolio:

Fixed income securities

Bonds listed on a stock exchange or traded

on an organised market that regularlypublishes prices (includes corporate bonds)

Bonds of Swiss companies are not eligible, to


Source: IMF , LBMA; Gold prices at market prices


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avoid market distortions and conflictsof interest

Short-term, non-tradeable investments

Time deposits placed with the Bank for

International Settlements (BIS) or banks that

meet certain risk criteria

Repos and reverse repos with counterparties

that meet certain risk criteria

Equities

Shares of foreign companies that meet

certain criteria

Swiss shares are not eligible, for similarreasons to bonds of Swiss companies

Gold

The SNB is obliged by the Swiss Federal

Constitution to hold part of its reserves in

gold, stored both in Switzerland and abroad

Part of the SNBs gold holdings can be lent out

Currencies

Includes Swiss francs, euros, US dollars,Canadian dollars, Danish kroner, British

pounds and yen

Derivatives on the above mentioned

instruments

Includes interest rate futures, equity indexfutures, interest rate swaps, options on gold

and currencies, and forward foreign exchange

transactions

It is worth noting that a number of additional

restrictions exist for some of the above men-

tioned asset classes, but these are largely notrelevant to the purposes of this report. With

regards to the composition of Swiss reserves,

the table below provides a breakdown of thecountrys reserves (excluding gold), by currency

denomination and instrument type.

Composition of Forex & BondReserves of Switzerland at end-2006

FOREIGN SWISSEXCHANGE FRANC

CURRENCY ALLOCATION

Swiss Franc - 100%

US dollar 27% -

Euro 48% -

Pound sterling 10% -

Other 15% -

INVESTMENT CATEGORIES

Money Market Investments 3% -

Government bonds 58% 48%

Other bonds 29% 52%

Equities 11% -

Source: SNB Annual Report 2006

4. Gold Sales in 2000-5

BackgroundIn February 1997, the Economic Committee of

the National Council decided that gold hold-

ings of the SNB should be demonetised. Atthat stage, the requirement that 40% of the

Swiss franc note issue be backed by gold valued

at a fixed rate of exchange was scrapped, andreplaced with a 25% requirement. The issue of

further demonetisation, including a revaluationof the reserves, started to gain the attention ofthe wider public.

Later the same year, the President of theConfederation proposed that part of any

revaluation gains (at that stage gold was valued

at around one-third of the market price) shouldbe used to fund the Swiss Foundation forSolidarity, a foundation intended to provide

assistance to persons in need in Switzerlandand abroad. The idea was largely fuelled by the

controversy surrounding the Swiss banking

Switzerland


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systems activities in World War II and its deal-ings with the German government of the time.

It was suggested that the initial contribution to

the foundation should take the form of theproceeds from the revaluation of 500 tonnes of

gold, to be donated by the SNB.

A group of experts, established to examine

revisions to the countrys monetary laws,

recommended in 1997 that Switzerland sell1,400 tonnes of its gold reserves. At the time,

the government and the SNB did not fully agree

with the expert groups suggestion andproposed instead that sales should be limited

to the 500 tonnes initially suggested to fund

the Swiss Foundation for Solidarity.

In April 2000, a series of constitutional revisions

were put to the public vote and approved bythe Swiss electorate, to be effective from 1st

January 2000. Amongst these was the aboli-

tion of the requirement that 25% of the Swissfranc note issue be backed by gold valued at

the official price.

In May 1999, the Swiss parliament had proposed

a new Federal Law on Currency and Payment

Instruments that would further sever the link

between the Swiss franc and gold, by abolish-ing the minimum gold coverage of banknotes

in circulation and the gold parity of the

countrys currency. The law was adopted bythe parliament in December of the same year

and became effective on 1st May 2000, after

the 100-day window for the public to challengeit with a referendum had passed.

The passing of this law and the demonetisationof the SNBs gold reserves that it represented

essentially provided the Swiss government with

the legal framework for gold sales to beapproved. Indeed, at the time the government

enacted the necessary legislation for the SNB to

be allowed to sell 1,300 tonnes of gold,

accounting for a little more than 50% of thecountrys gold reserves. The SNB clarified its

intention to minimise the impact on the gold

market of its activities, through gradual salesinto the market.

On 1st May 2000, the first gold sales programmeof the SNB finally commenced. The programme

was concluded in March 2005, leaving the SNB

with holdings of 1,290 tonnes. In accordancewith the SNBs announced intentions, these

sales took place gradually over the period,

through daily sales in the spot market and thelimited use of gold derivatives.

Finally it is important to note that from end-

September 1999, the SNB had been part of the

first Central Bank Gold Agreement (CBGA), alsoknown as the Washington Agreement on Gold.

The accord limited gold sales from a group of

15 European central banks, including theEuropean Central Bank (ECB), over the following

five years to a total of 2,000 tonnes, or approx-

imately 400 tonnes over each 12-month periodstarting from 27th September 1999 and running

through to 26th September 2004. After the

expiry of the first CBGA, a second five-yearagreement started, to which the SNB was also a

member, with a higher sales limit of 2,500

tonnes for its duration or 500 tonnes annually.


Source: IMF


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In addition to limiting gold sales by the signato-ries, the two CBGAs also placed restrictions on

the central banks activities in gold derivatives

as well as gold lending.

What were the reasons forselling gold?

The principal reason for the SNB to sell part of its

gold reserves stemmed from the requirementfor the central bank to modernise its balance

sheet, by reducing the volume of officialreserves and changing their composition. At

the time when the sales were decided, the

countrys official reserves stood at exceptionallyhigh levels, considering the size of the Swiss

economy, the countrys population, and its status

as a G10 country with a stable currency andhealthy economy. It therefore arguably made

sense for part of the reserves to be liquidated

and the profits to be distributed or used in oneway or another.

Looking at the part of the reserves that the SNBcould mobilise, the Swiss franc denominatedassets were at too low a level to liquidate, while

a transfer of foreign reserves could have had a

negative impact on the banks operations.

Furthermore, the changes in the countrys

domestic monetary arrangements ended the

requirement that previously existed for allcurrency notes issued to be backed by physical

gold valued at the official price (which in thefew years leading to the time when sales weredecided had kept to around one-third of the

market price). The revaluation of the Swiss gold

reserves this change brought about made itapparent how overweight the country had

been in gold, valued at market prices. Indeed,

using indicators such as the value of gold/GDPunit, value of gold/imports, quantity of gold per

capita and value of gold/currency in circulation,and using gold at market value, Switzerlandemerged as the largest holder of gold world-

wide at the end of the 1990s.

With regards to the controversy overSwitzerlands banking record during World War

II, and the suggestion by the government to

endow its proposed Swiss Foundation for

Solidaritywith the proceeds from the disposal of

500 tonnes of the countrys gold reserves, thesefactors certainly helped accelerate themovement towards gold sales. Wider political

Switzerland

Source: IMF, Eurostat

Source: IMF, Eurostat

Gold Reserves:

Top-5 EU Countries and Switzerland, end 1999


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considerations therefore appear to have hadsome influence on the debate. Nevertheless,

one cannot conclude that such external pres-

sures were a reason per se for the adoption of agold sales programme. Indeed, discussions over

the SNBs excessive gold reserves had

emerged within Switzerland, prior to the coun-try having come under international scrutiny

over its financial dealings with the wartime

German government. For instance, the early1990s had seen suggestions for the countrys

gold reserves to be used to control the govern-

ment budget deficit, which was ballooning atthe time. Similarly, although the prospect of

obtaining resources for domestic expenditure

through the sale of the SNB gold was supportedin some quarters, it would be misleading to

assume that this was the original or unique driv-

er of the sales that eventually took place.

It is important to understand that a case could

be made for gold sales independently of the wayin which any profits would be used. From a sim-

ple portfolio allocation point of view there was a

strong argument to reduce gold holdings. Giventhe exceptionally high level of Swiss gold hold-

ings in the late 1990s, switching away from gold

and into assets that can provide a higher level of

return and are more liquid was likely to improvethe performance of the overall reserve portfolio.

What methods were chosento sell the gold?

The SNB initially commissioned the BIS to sell itsgold on its behalf, and then, from April 2001

onwards it undertook the operation itself. The

gold was released through regular sales of rela-tively small amounts. Available evidence indi-

cates that this gold was sold into the private

market, rather than through any off-markettransactions with, say, other central banks.

Regarding the portion of the gold sold throughthe BIS (220 tonnes), while we are not certain of

the exact instruments used by the BIS and their

immediate counterparties, public statements byofficials of the SNB, coupled with the limits set

by the CBGA on gold derivative activities, seem

to suggest that the gold was either sold in thespot market or through short-term derivatives.

Of the remaining 1,080 tonnes, 730 were solddirectly in the spot market, using 25 counterpar-

ties in four different continents. In an effort to

receive consistently competitive pricing, SNBtraders were allowed to perform two-way

trading. Specifically, they were allowed to buy

gold on an intra-day basis, amounting to up totwo-thirds of their daily-allocated sales volume.

Overall, daily sales were normally set to approxi-

mately one tonne, and the Bank of England wasused for the physical settlement of these spot

transactions.

In addition, the SNB sold 350 tonnes of its

reserves through options programmes. These

were typically structured so that a buyer wouldcommit to buy 50 tonnes of gold over a period

of several months, paying the daily average of

the AM and PM London fixes, plus a premium. In

order to achieve a somewhat higher premium,the SNB offered to cap the maximum selling

price. In essence, this structure comprised the

bank selling the gold on a spot basis and at thesame time writing out-of-the-money call

options. It should be stressed here that, in

choosing the aforementioned price-cap levels(in other words, the options strike prices), the

SNB remained prudent throughout the period

of the sales. On the one hand, this resulted inthe options only being exercised on two occa-

sions and, on the other, the bank only received

modest premiums over the gold price, varyingbetween $1.40 and $3.50 per ounce.



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Finally it is worth noting that, although nothedging their gold price risk over the period, the

SNB did hedge the currency risk associated with

the expected proceeds of the sale (related tofluctuations in the US dollar:Swiss franc rate).

Initially, 20% of the expected proceeds were

hedged, while from December 2000 onwards,35% of the expected proceeds were hedged.

This strategy augmented the return from the

SNB gold sales, as gold maintained a reasonablecorrelation with the US$:CHF rate over much of

the May 2000 March 2005 period (the corre-

lation coefficient in daily log-returns wascalculated at 0.42).

Why did the SNB choose thesemethods to sell the gold?

The principal goal the SNB wished to achieve

using its chosen strategy was to receive the best

price for its gold, or at least a good price. Thecentral bank concluded that a discreet and non-

public method of sales would be the best

approach to achieve this objective.

With regards to the SNBs decision to offload its

gold through regular sales of limited volume, thiswas mainly driven by its intention not to put too

much pressure on the gold price. As Jean Pierre

Roth, governor of the central bank said: The

Swiss National Bank has no interest in adopting astrategy which would push the gold price down.

We know that 1,300 tonnes of gold cannot beabsorbed by the market in a short period of

time. We therefore are considering distributing

the sales over a period of several years. 2

The central banks initial decision to use the BIS

as an intermediary for its gold sales was made ata time when the SNB had little recent experi-

ence in the gold market and no internal capabil-

ity or capacity to perform the required opera-tions directly with the market. The BIS, in

contrast, had developed considerable expertise

in releasing official sector gold into the marketand in generally acting as an intermediary for

central banks in their dealings with the market.

Furthermore, the important influence the BIShad on the setting up of the first CBGA made it

the obvious candidate to take up this role.

Nevertheless, from April 2001, at which pointthe SNB had acquired the necessary resources

and contacts in the gold market (including

bringing in experienced personnel from thecommercial sector), the central bank started to

perform trading operations in-house.

With regards to the choice of spot transactions

and the alternative options structures described

in the previous section, the SNB did not haveaccess to instruments such as longer dated for-

ward sales and other derivatives and combina-

tions of these instruments, because the CBGAlimited its signatories activities in the gold

derivatives market. As a result, the SNB could

not hedge its price risk for the entire period.

Nevertheless, the CBGA did not place anyrestrictions on foreign exchange derivatives, so

the SNB did hedge the currency risk of part of

the expected proceeds.

How were the proceeds of thesale distributed

By end-March 2005, the proceeds from the

sales of the SNB gold had reached CHF 21.1bn

Switzerland

2 A view on Switzerland in the run up to the demonetisation of gold, Speech by Jean-Pierre Roth Vice Chairman of the GoverningBoard Swiss National Bank, at the 22nd Annual FT World Gold Conference, London, 14 June 1999; Page 6

3 Philipp M Hildebrand: SNB gold sales - lessons and experiences, Speech by Dr Philipp M Hildebrand, Member of the GoverningBoard of the Swiss National Bank, at the Institute for International Economics, Washington, DC, 5 May 2005; Page 3


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($17.6bn), equivalent to an average selling priceof $351.40, $17.20 higher than the average PM

fix over the sales period3. The proposal to appro-

priate part of the proceeds from the gold salesfor the proposed Swiss Foundation for Solidarity

was introduced twice over the course of the

sales programme, once in September 2002 andthen subsequently in December 2004. The

September 2002 proposal was for one-third of

the proceeds to be earmarked for the fundingof the Swiss social-security programme, a

further third to be allocated to regional govern-

ments and the balance dedicated to helpingpeople in need abroad (in line with the original

goals of the Foundation). The second proposal

floated in December 2004 involved two-thirdsof the proceeds being put into the state old-age

pension fund, with the balance distributed to

the cantons.

On both occasions the proposals were rejected,

the former through a referendum, while the lat-ter was turned down by the Council of States. It

was thus finally decided in February 2005 that

proceeds would be distributed according to theexisting law, namely with the allocation of one-

third of the sales proceeds to the Confederation

and the remaining two-thirds to the 26 cantons.

Subsequently, it was decided that in the first halfof 2007 the Confederations share would be

transferred in several tranches to the state old-

age pension fund.

5. The Second SalesProgrammes

On 14th June 2007, the SNB announced their

plan to sell an additional 250 tonnes of gold

under the remainder of the second CBGA. Bythe end of that year, the central bank had

released 145 tonnes into the market through

regular sales amounting to, initially a little over30 tonnes monthly and later around 10 tonnes

per month. In contrast to the first sales

programme, there is no intention for the pro-ceeds of the sales to be used in any project, nor

for them to be distributed to the federal of can-

tonal governments. The original announce-ment of the programme in fact explicitly stated

that the SNB would sell 250 tonnes of gold and

increase its foreign exchange reserves by a cor-responding amount and that the overall level

of currency [including gold] reserves will remain

unchanged.

6. The Future of Swiss

Gold ReservesLooking ahead, after completing its ongoingsales programme, it is highly unlikely that the

SNB will sell further portions of its gold reserves,

at least in the medium term. Starting with thearguments that were put forward for sales in the

1990s, these are far less applicable given the

current state of the Swiss reserves. Although

still a significant holder, Switzerland has ceasedto look as overweight in gold as it did in the late

1990s. In addition, having more than halved the


Source: IMF


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The Philippines

allocation in the metal through its two sales pro-grammes, it could be argued that now would

not be the best time for the country to under-

take further sales, with all the logistical andpolitical implications these would involve.

Furthermore, an important element of themotivation for the sales programme of 2000-

2005 was the transfer of part of the substantial

official reserves of the country from the centralbank to the government, because of the

reduced need for a country like Switzerland to

hold such large reserves. These reserves are cur-rently significantly lower (when adjusted for

inflation) and this is on the basis of a current

gold price well above its historical average. Itwould thus make little sense to distribute any

part of these proceeds.

On the potential for further sales of gold serving

portfolio reallocation purposes (similar to those

of the second programme), one would expectthat if there were any such intention for the

medium term, the SNB would have simply

added these to the 250 tonnes they intend tosell until September 2009.

Moreover, one should not forget that from the

early stages of its effort to demonetise its gold,the SNB stressed that gold remained an impor-

tant asset on its balance sheet. This view of the

central bank is perhaps best illustrated by thewords of Jean Pierre Roth: Once the [first] sales

programme has come to an end, gold will con-

tinue to play an important role in our monetaryreserves. The recent revision of the Constitution

has led to the stipulation that we should main-

tain "sufficient" gold reserves. The fact that this

precision was introduced at the initiative of our

parliament indicates that the Swiss people wish

to keep ample gold reserves. 4

Finally it is also important to note that this was

stated in the late 1990s, when there was grow-ing scepticism within the central banking world

toward holding an asset that was perceived as

having a low yield and limited liquidity and wasdeclining in value. The price rally in recent

years, coupled with the changing global political

scene and the relative decline of the US dollar,have brought about a definite shift in senti-

ment, with some people in the central banking

community reconsidering the role of gold inreserves, especially as a politically neutral instru-

ment of diversification. This opinion was in fact

clearly put across in a speech by PhilippHildebrand, a Member of the Governing Board

of the Swiss National Bank, at the LBMA

Conference in Montreux on 26th June 2006.

At the same time, one cannot rule out the pos-

sibility that in the longer term the Swiss centralbank could return as a seller of gold. For

instance, should the general attitude towards

the yellow metal revert to that seen over the

1990s, or if renewed calls for mobilisation of theSwiss official reserves should somehow emerge,

further SNB sales would not be inconceivable.

After all, the country remains one of the largestholders of gold worldwide in terms of both per

capita and also per unit of GDP. Nevertheless, as

was stressed above, it is unlikely that we will seethis happen in the short to medium-term.

4 A view on Switzerland in the run up to the demonetisation of gold, Speech by Jean-Pierre Roth Vice Chairman of the Governing

Board Swiss National Bank, at the 22nd Annual FT World Gold Conference, London, 14 June 1999; Page 6


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Documents

Central Bank Case Swiss