Metals Report Gold loans for mines gain favor

Gold’s role as the currency of last resort is being enhanced by a growing trend among financial institutions to finance mine development through gold loans.

Gold loans work this way. A bank lends a company a so many ounces of gold. The company sells the gold to pay for capital costs. When the mine ente rs production and starts producing gold, it pays back the bank the number of ounces it borrowed with the gold it produces.

One might say that gold loans are specific only to the gold mining industry and therefore not indicative of gold’s role in the overall banking system. But, though limited to gold producers, that doesn’t seem to diminish the underlying confidence bankers have in the precious metal compared to paper money.

In reality, it’s gold’s unique property as a store of value — a currency that never suffers the vicissitudes of government issued paper — that permits its use even for this select group of commodity producers.

You don’t see any of Canada’s six stolid banks offering “wheat loans’ to farmers, “oil loans’ to oil producers or “lumber loans’ to forest companies.

What underlines gold’s role as a backstop for paper money is the low interest rates associated with gold loans. While they vary according to the creditworthiness of the borrower and the nature of the property, interest rates for gold loans are generally 3-5%.

Loans in U.S. or Canadian money would probably cost at least 10% while those in Swiss francs or German deutschmarks might be slightly more favorable, a reflection of international markets’ greater confidence in those two western European currencies.

The fact that gold loans incur interest rates as low as they do illustrates banks’ greater confidence in gold than in any of the currencies.

What’s more, banks would rather lend out their gold at a mere 3% interest than hold it in vaults where it collects no interest at all.

“If you took the view that gold is the ultiamte measure of value — inflation resistant — the real interest rate would be reflected in that 3%-4%,” says David Turner, assistant general manager for precious metals at the Bank of Nova Scotia.

(Real interest rates are considered to be the rate of 90-day Treasury bills minus the rate of inflation as measured by the Consumer Price Index.)

Gold is a commodity, but it is also a store of wealth and has many of the characteristics of currencies. Gold mining is unique in that its reserves are this store of wealth — almost like digging up American dollars but better because inflation doesn’t seem to erode the value of gold.

Debt financing has always been a large part of financing mine development, but the idea of lending gold as a means of effecting that debt financing is only recently gaining popularity in North America.

The risk for the borrower is that the price of gold will go up sharply before it pays back the gold it borrowed, but that is the same risk a producer incurs when selling gold forward.

For the Bank of Nova Scotia, the increased activity in lending gold fits in well with its growing involvement in the mining sector. The bank has long been an active bullion trader and has recently bolstered its mining team capable of evaluating mining properties for the purpose of extending loans. The two activities complement each other well, says Mr Turner.

He also sees a growing role for gold loans as more mines come to the development stage, particularly in the U.S.

“U.S. gold production is expected to exceed Canada’s by 1989,” says Mr Turner. “You can bet your life that some of that financing will be by bank debt and some in the form of gold loans.”