Transition from Arab demand
Arabs trying to invest a portion of their petrodollars would have left very little investment gold for the advanced economies. As it happened, U.S. citizens had been banned from holding bullion until 1974, and British citizens were banned until 1971. Instead, they invested mainly in mining shares and Krugerrands, continuing this tradition by using derivatives and un-backed unallocated accounts with bullion banks in preference to bullion itself. This meant that, until the mid-1970s, investment in physical gold in the West was minimal, almost all gold being held in illiquid jewelry form. Western bullion investors were restricted to mainly Germans, French, and Italians, mostly through Swiss banks. The 1970s bull market was therefore an Arab affair, and they continued to absorb gold through the subsequent bear market.
By the late-1990s, a new generation of Swiss investment managers, schooled in modern portfolio theory and less keen on gold, persuaded many of their European clients to reduce and even eliminate bullion holdings. At the same time, a younger generation of Western-educated Arabs began to replace more conservative patriarchs, so it is reasonable to assume that Arab demand for gold waned somewhat, as infrastructure spending and investment in equity markets began to provide portfolio diversification. This was therefore a period of transition for bullion, driven by declining Western investment sentiment and changing social structures in the Arab world.
It also marked the beginning of accelerating demand in emerging economies, notably India, but also in other countries such as Turkey and those in Southeast Asia, which were rapidly industrializing. In 1990, the Indian government freed up the gold market by abolishing the Gold Control Act of 1968, paving the way for Indians to become the largest officially-recognized importers of gold until overtaken by China last year.
Lower prices in the 1990s stimulated demand for jewelry in the advanced economies, with Italy becoming the largest European manufacturing center. At the same time, gold leasing by central banks increased substantially, as bullion banks exploited the differential between gold lease rates and the yield on short-term government debt. This leased gold satisfied jewelry demand as well as continuing Asian demand for gold bars.
So, despite the fall in prices in 1997-2000, all supply was absorbed into firm hands. When gold prices bottomed out, Western central banks almost certainly had less gold than publicly stated, the result of managing the price until 1985, and through leasing thereafter. This was the background to the London Bullion Market Association, which was founded in 1987.
In 1987, the unallocated account system became formalized under London Bullion Market Association (LBMA) rules, allowing the bullion banks to issue gold IOUs to their customers, making efficient use of the bullion available. The ability to expand customer business in the gold market without having to acquire physical bullion is the chief characteristic of the LBMA to this day. Futures markets in the U.S. also expanded, and so derivatives and unallocated accounts became central to Western investment in gold. Today the only significant bullion held by Western investors is likely to be a small European residual plus exchange-traded fund (ETF) holdings. In total (including ETFs), this probably amounts to no more than a few thousand tonnes.
The LBMA was established in 1987 in the wake of the Financial Services Act in 1986. Prior to that date, the twice-daily gold fix had become the standard pricing mechanism for international dealers, whose ranks grew on the back of the 1970s bull market. This meant that international banks established their bullion dealing activities in London in preference to Zurich, which was the investment center for physical bullion. The establishment of the LBMA was the formalization of an existing gold market based on the 400-ounce "good delivery" standard and the operation of both allocated and unallocated accounts.
During the twenty-year bear market, attitudes to gold diverged, with capital markets increasingly taking the view that the inflation dragon had been slain and gold’s bull market with it. At the same time, Asian demand – initially from the Arab oil exporters but increasingly from other nations led by Turkey, India and Iran – ensured that there were buyers for all the physical gold available. Mine supply, which benefited from the introduction of heap-leaching techniques, had increased from 1,314 tonnes in 1980 to 2,137 tonnes in 1990 and 2,625 tonnes by 2000. Together with scrap supply, London was in a strong position to intermediate between a substantial increase in gold flows to Asian buyers, and it was from this that central bank leasing naturally developed.
Gold backed by these physical flows was the ideal asset for the carry trade. A bullion bank would lease gold from a central bank, sell the gold, and invest the proceeds in short-term government debt. It was profitable for the bullion bank, governments were happy to have the finance, and the lessor was happy to see an idle asset work up some extra income. However, leasing only works so long as the bullion bank can hedge by accessing future supply so that the lease can eventually be terminated.
Before 2000, this was a growing activity, fuelled further by Swiss portfolio disinvestment in the late 1990s. As is usual in markets with a long-term behavioral trend, competition for this business extended the risks beyond being dangerous. This culminated in a crisis in September 1999, when a 30% jump in the price threatened to bankrupt some of the bullion banks who were in the habit of running short positions.