As a result of its status as the world’s biggest energy exporter, the Russian state has accumulated about $300 billion worth of U.S. dollar denominated foreign exchange reserves. It doesn’t want any more. After decades of eagerly accepting dollar payments, Russia has quietly asked its trading partners to pay in rubles.
Vladimir Putin's original announcement, back on May 10, 2006, that Russia intended to increase the value of the ruble and make it into a reserve currency, caused a shock to currency markets, sending the dollar temporarily downward. But, shortly thereafter, few people paid much attention. The World Financial Crisis intervened, oil prices crashed, and the Russian ruble plunged against the dollar. Quietly, behind the scenes, however, Putin continued to work on making his dream a reality.
Russia has been slowly converting oil and gas customers to paying in rubles rather than dollars. China and Belarus have already agreed. With special pricing incentives, others, like Ukraine, will follow. Occasionally, the once and future Russian President continues to have very nasty things to say about the U.S. dollar. He can't seem to hold back his annoyance toward American economic policies. But, where he is scripted, as in speeches to the Russian Duma, he now creates a facade that implies the world wants to turn to rubles, rather than dump dollars.
The official Russian position is that requests for ruble settlement originate from customers, and not from Russia. According to Putin, customers want to pay their bills in rubles. The reality, however, is the reverse. People prefer to pay in dollars, and receive other currencies. With the Federal Reserve's dollar diarrhea still in effect, dollars are easy to come by.
According to Putin, Ukraine has asked Russia if it can switch to rubles. Putin stated, in his annual address to the Russian Duma:
The ruble is getting increasingly stronger in former Soviet republics. Today our Ukrainian partners are requesting us to switch to settlements in rubles for energy products… I hope we'll be strengthening the national currency to make it a reserve currency for the region.
Perhaps Putin has been taking lessons from the Orwellian "perceptions management" team at the New York Fed? In mid-April, however, Ukrainian Prime Minister Mykola Azarov met with Putin and reported an agreement to discuss revising Ukraine’s gas pricing formula. The current formula ties the price of gas to the rising price of oil. The price of gas, in contrast, has not been rising where it is not tied to oil. In North America, for example, gas prices are falling. Regardless of what happens elsewhere, however, Ukraine is contractually bound to pay more for its gas than it thinks it should.
The request to dump the U.S. dollar did NOT come from the Ukrainians. They would be happy to continue paying Gasprom in dollars. The request came from Russia. Like many big exporters, Russia must balance the desire to escape from the dollar trap, with the fear of collapsing the existing value of dollar reserves. Its situation is not so bad as that of China, whose entire economy is built upon currency debasement against the dollar, but it is still delicate.
Putin wants to avoid saying things that torpedo the value of Russia's dollar assets, at least when he has a lot of time to think about what he is going to say. He also wants to pretend that people around the world want to join him in recreating the ruble into a world reserve currency. This desire to escape from the dollar zone began in 2001. Former Fed Chairman Alan Greenspan's released a flood of dollar liquidity to rescue American stock prices after the Tech Crash. Putin was not the only exporter who became alarmed. That year marked the beginning of both the secular bull market in precious metals and sharply rising oil prices.
“Liquidity injections” are not supposed to be the same as “quantitative easings”. Liquidity is a Wall Street code word for “temporary” money creation. Money is electronically created and handed out to a central bank's primary dealer banks in the form of low-interest “loans”. These are sometimes collateralized and, at other times, depending on the purpose of the loan, they are without recourse to any collateral. In the case of the Federal Reserve, since 2001, such loans have been rolled over so many times that they are never paid back.
The total amount of money endlessly increased, even when so-called "quantitative easing" was still just a pipe dream in Ben Bernanke's mind. From a practical standpoint, these supposedly "temporary" loans, which were supposed to create only "temporary" increases in the money supply, were really cash giveaways. Just like the counterfeited dollars created under color of law through quantitative easing, they permanently debase the dollar as thoroughly as a "QE" episode.
Commodities have been driven upward since these policies began, due to ever-increasing worldwide distrust of the Federal Reserve's intentions, and the ever-falling buying power of the U.S. dollar. But, Ukraine’s President Viktor Yanukovich doesn't mind. Ukraine is the recipient of a $16 billion IMF loan, and, as soon as the next tranche is released, it will be dollar-rich. It wants to capitalize on the desire of others to leave the U.S. dollar. Yanukovich says that Ukraine is more than happy to pay in rubles, but ONLY if Russia agrees to modify their contract to give it a cheaper price. On Thursday, April 2, 2011, at a press meeting, his exact words were as follows:
Switching payments for gas between Ukraine and Russia to rubles is acceptable for us. We can go this way, but we believe that then our Russian partners should lower the coefficient in the gas pricing formula.
The Ukrainian President noted that Ukraine's reserves of dollars can be exchanged for rubles. He doesn't doesn't seem to fully understand Putin's plan, or the full impact of a mass switch-over of Russia's oil and gas customers away from the U.S. dollar. If all are switched away from dollar settlement, they will all need to convert dollars now held in central bank reserves. In 2009, Russian oil exports amount to over 7 million barrels per day, with a total value of about $286 billion per year. Gas exports amount to about 180 billion cubic meters, which at the current European price, is worth about $89.5 billion per year. That is a total of about $375.5 billion. The amounts are higher in 2011.
Most of Russia's gas sales are quoted in dollars, but paid for in Euros. Oil is both quoted in, and, generally speaking, paid for with dollars. That is why more than 60% of Russia's foreign exchange stockpile is composed of dollars even though the Russians are skeptical about the dollar's future value. Because the U.S. dollar is still the world's reserve currency, dollars normally pass from nation to nation without conversion.
Let's assume, for argument's sake, that 1/4 of Russia's energy bills are settled in dollars, even though that probably understates the real percentage. If Putin eventually moves all customers to rubles, $94 billion will be converted from dollars to rubles every year. Some claim that the alleged "immense size" of the world currency markets means this is inconsequential. They are wrong. The world's currency market are "immense" only because they are built from derivatives and a very high velocity of money passing from hand to hand. But we are talking about "high powered" currency here. We are talking about the international dollar "base", which is the "stuff" upon which all the velocity and all the derivatives are built.
The base currency market is smaller than most people realize. It consists of the amount of currency in demand deposits and cash, held by individuals, banks and, mostly, government foreign exchange reserves. When nations shift the right to receive money from recipient to recipient, but $94 billion must be changed from one currency to another, that money must leave central bank currency reserves somewhere in the world, year after year. Ultimately, it means $94 billion per year less demand for U.S. Treasuries. That is a huge reduction because the U.S. government is trying to sell about $1.6 trillion worth of new debt every year. The loss would need to be absorbed somewhere in the system, and that means a reduction in the exchange value of the dollar.
If other commodity exporters follow Russia's example, the dollar could deeply decline in real purchasing power. It will be in good company, however. The world financial markets are also now floating on a sea of pound, yen, Euro, and yuan liquidity. Commodity exporters like Putin are not easily fooled by Federal Reserve perceptions managers. They often know about hyperinflation. Russia experienced it first-hand after the fall of the former Soviet Union. The monetary authorities of that doomed state and its successors began by wildly printing money and ended by wiping out the middle class. Brazil and others also know how devastating heavy inflation can be.
Russia may be among the first major trading nations to exit the dollar reserve currency zone. Thankfully, Russia is trying to exit in a controlled manner to avoid disrupting markets. Russia still holds a huge number of dollars in its reserve fund, and it will take time to get rid of them. While we do not believe that the Federal Reserve Note dollar will end the decade at zero, or as toilet paper, we do expect it to command a very small fraction of its current buying power.
A steady but continuing major dollar debasement will affect retiring Americans. Their plans will be disrupted by the fact that their dollars will buy much less than they did before. The main task of American investors during this decade is to preserve buying power against huge levels of stagflation and dollar debasement.
In the beginning of all highly inflationary periods, stock markets are the first to receive the inflationary impact. It was so during the first part of the Weimar hyperinflation in 1919-20, and in every other inflationary episode elsewhere. Stock prices tend to outrun inflation in the early stages both by central bank design, and by virtue of the structure of financial markets. Later, they lose ground. The law of diminishing returns goes into effect.
Eventually, monetary authorities cannot buy stock market gains with anything less than heavy currency debasement and inflation. The decline in the value of the currency eventually overtakes the increase in stock values. We are very near that turning point right now.
Bond markets are usually the direct targets of inflationary monetary policy, and are temporarily supported by manipulative bond buying by central bankers pursuing inflationary monetary policy. But this can continue for only so long. Eventually, yields must rise and bond prices must fall unless central bankers accept hyperinflation. Sovereign debt can, theoretically, be endlessly sold to a central bank like the Federal Reserve, or the Weimar Reichsbank, at high prices and low interest rates.
However, the money proceeds will buy less and less, until finally, they will buy nothing as society rejects the particular type of money being used. Once that happens, there is no longer any point to monetization. No one but the central bank will buy bonds anymore and no one wants to accept worthless currency in exchange for valuable goods or services.
We are optimistic. We believe that currency counterfeiting (a/k/a quantitative easing) has been designed to bail out the executives of major European and American banks that control the Federal Reserve, rather than by foolish policy-makers. After a few more iterations of money printing, the Fed is going to try to stop short of an overt dollar collapse. Interest rates are going to shoot up, but we expect not as fast as inflation. Bond prices are eventually going to fall through the roof.
The increase in the cost of commodities that results from heavy but not hyper inflation, coupled with an inability to pass price increases on to customers will dramatically lower corporate profits. Stock prices will fall once inflation is factored out. To preserve wealth, precious metals are the only game in town now that the first stages of stagflation are upon us.
We do believe that the Bernanke Fed is going to create a few trillion more of funny-money dollars. This is unlikely to be enough to cause hyperinflation on the scale of Weimar Germany or Zimbabwe, but it will be enough to put heavy stagflationary pressure into the economy. We do not know, however, whether the Fed will go straight into QE-3, or if there will be a multi-month pause in order to allow the dollar to recover a bit before new counterfeiting operations resume. Sudden cessation of QE-2 will put temporary but immediate upward pressure on the exchange value of the dollar and downward price pressure on the stock and bond markets.
A cessation of QE may also adversely affect the price of precious metals because many traders will face margin calls on other investments. Yet, the risk of not owning precious metals, and getting clobbered by continued fiat money debasement exceeds the risk of a temporary precious metals price decline when viewed from a long term perspective. Gold, silver and platinum are all going up long term, and should be bought, especially upon major price dips.
Positions in various precious metals can be taken through the purchase of physical metal in the form of coins and small bars, the purchase of shares in the various precious metals ETFs, including GLD, SLV, PSLV, SGOL, SIVR and others. One can also purchase substantial quantities of gold, silver or platinum at the futures markets.
Finally, you can buy shares of stock in any number of mining companies, including Hecla Mining (HL), Anglo-American Platinum (AAUKY.PK), Newmont Mining (NEM), Yamana Gold (AUY), North American Palladium (PAL), and many others. When you buy stocks instead of actual metal, you take additional risks, including the potential for executive overcompensation, political risk in the nations in which they operate, and bad decision-making by company managements.
Disclosure: Long precious metals.