Gold & Euros: Is Russia's Central Banker Really That Dumb?

For everything there is a season, a time for every activity under heaven - Ecclesiastes 3:1.

If you had loaded up on gold and euros during, say, the pre-global financial crisis time frame, I suppose you'd have done well as both increased significantly in value. China's voracious demand buoyed gold and the euro as well as the commodity supercycle approached its peak. However, in the run-up to a Federal Reserve rate hike--the first in a long time since rates were slashed to zero during the aforementioned financial crisis--you'd be a fool to go long on gold and euros. Unfortunately for Russia, that's exactly what its central bank governor Elvira Nabuillina has done:

Bank of Russia Governor Elvira Nabiullina picked the wrong time to load up on gold and the euro. The miscalculation means Russia is now down $200 million in its quest to raise international reserves, an effort it suspended Tuesday amid a rout in the ruble, after it spent about $10 billion on foreign currency since mid-May.

What the 51-year-old central banker was up against is this year’s slide of 9.5 percent in the euro against the dollar and gold’s 8.4 percent tumble in 2015. Both declines hurt because Russian reserves last year contained more euros than dollars for the first time since 2008 and its bullion hoard has tripled since 2005.

“It’s very strange for me that no one has yet put a question to the central bank over the results of its reserves management,” Alexander Losev, chief executive officer at Sputnik Asset Management in Moscow, said by e-mail.

Losev, in a democracy in name only, no one dares question the actions of Putin acolytes like Nabiullina.

Ravaged by a crash in oil prices and almost $90 billion in interventions to rescue the ruble last year, Russia’s reserves were at $358.3 billion on July 24, down almost 30 percent from last year’s peak. The central bank shifted to a free-floating exchange rate ahead of schedule in November as Putin said the country won’t “mindlessly burn up” reserves to defend its currency.

However, Leonid Bershidsky suggests that Russia's actions are not as stupid as they may seem if these actions are seen from a political rather than an economic lens:

The dramatic drop in the price of gold makes Russia look like a classic sucker: As the price went down, it expanded its gold reserves. The Russian central bank is getting punished for betting on gold rather than U.S. assets as the Cold War seemed to restart last year. But it's not that simple -- the gold that Russia's buying is domestically produced and paid for with devalued rubles...

One reason Russia's otherwise highly competent central bankers did this was political. Last year, after the Crimea invasion, the fear of Western financial sanctions made them dump U.S. treasuries, reducing holdings to $86 billion in December from $126.2 billion in February, and seek a safe haven in neutral, albeit unfashionable gold. It bought 171 metric tons, or 5.5 million ounces, in 2014.

The gold lobby has been particularly strong in pushing their cause wit h the central bank:

The reason for this strange behavior lies in the dependency of Russia's gold industry on central bank purchases. Last year, according to the Moscow-based Gold Mining Union, Russia became the world's second-biggest producer of the precious metal, extracting 288 tons. Producers are not allowed to export their output directly. Instead, they have to sell it to banks, which are authorized to deal with foreign buyers and the Russian central bank.

Last year, European banks bought 76 tons -- they have long-standing trading arrangements with state-owned Russian banks, the biggest buyers on the domestic market -- but the central bank dwarfed that, snapping up 59 percent of all output.

At the end of February, the Gold Mining Union, worried that its members' biggest customer was showing no interest, wrote a letter to the central bank, asking it to expand purchases by 30 percent this year compared with 2014 as compensation for sharply increased interest rates (the key rate had gone up to 17 percent in December to prop up the free-falling ruble) and to balance the domestic market. In response, deputy governor Dmitri Tulin promised to keep buying but said the central bank "considers it impossible to replace all domestic market buyers including domestic industries."

So, there may be an element of the central bank being held hostage by special interests, i.e., the gold lobby. That said, Bershidsky's version does not fully explain why the Russians have swapped large amounts of dollar- for (depreciating) euro-denominated assets. I think it's partly both behind Russia loading up on assets of diminishing value: special interests making themselves known and plain old wishful thinking.

Besides, I do not fully understand why Russia would consider holding euros rather than dollars "safer" from a security standpoint when the Europeans have been as keen on hitting Russia with sanctions as the Americans. Go figure.