There is a quiet revolution taking place in the monetary vacuum that's developing on the back of the erosion of the dollar's hegemony. It is perhaps too early to call what's happening to the dollar the beginning of its demise as the world's reserve currency, but there is certainly a move away from it in Asia. And every time the Americans deploy their control over global trade settlement as a weapon against the regimes they dislike, nations which are neutral observers take note and consider how to protect themselves, "just in case."
Vide Europe over the Iran issue. And Turkey. These are rifts in NATO. Countries in Africa, and elsewhere are now taking China's money. And to please the Chinese, Gambia, Burkina Faso, Panama and the Dominican Republic have all recently severed diplomatic relations with Taiwan. Small fry perhaps, but a weathervane showing which way the wind is blowing.
We've seen Russia set up an alternative to SWIFT in order to be free from American monetary interference in pan-Asian trade. We've seen China take major steps to exclude the dollar from her trade as much as possible and to enhance the role of her own currency. And now we have a schism over Iran between America and Europe it set up after WW2 through the mechanism of the CIA-controlled American Committee for United Europe in 1948.
It is unprecedented, and today America obviously cares less for her relationship with European allies than she hates Iran. There can be little doubt that America's undeclared war against the land of Omar Khayyam is intended to undermine its economy and create the conditions for internal revolution. The Iranian rial has continued its collapse, and the theocratic government has played into US hands by shutting down "unauthorised" money-changers, with Grand Ayatollah Naser Makarem Shirazi calling for the execution of money changers to help end the currency crisis. The black-market rate for rials has rocketed as a result, and according to Professor Steve Hanke whose department at John Hopkins University makes a study of these things, the true rate of price inflation has jumped to 74.8%.[i]
For the ordinary Iranian, gold has always been the ultimate money, while their government's rials are to be rapidly passed on to someone else. America's sanctions and the government's actions merely reinforce that message. Time will tell whether America's attempt to undermine Iran's theocracy succeeds, but history suggests it is unlikely. And at a national level, Iran is driven by American actions into accepting anything but dollars in payment for her oil exports. She would like euros, and given the EU is still trying to sell her capital goods, that makes sense. But no commercial bank dares facilitate payment in any currency under the threat of US sanctions and penalties.
That leaves only three possibilities beyond America's influence: Chinese yuan, Russian roubles, and gold, all independent from the West's banking system. It is no wonder the new yuan for oil contract in Shanghai, perhaps with a little help from China's state-owned banks, has got off to a roaring start. We can all understand the desire to lock in oil prices for future delivery, in this case it is in return for yuan issued by the People's Bank of China. However, in the future Iran will be able to spend the bulk of her yuan on other raw materials, using a range of yuan futures contracts as a bridge to them from her oil.
Essentially, US sanctions are forcing Iran onto a yuan standard for her foreign trade. Furthermore, China is there to pick up the pieces the West abandons because of American sanctions, driving Iran into an increasing dependency on China. The new Silk Road, the Chinese-built 200kph railway between Tehran and the eastern city of Mashad, as well as other Chinese-led rail projects are opening up Iran in a purely Eurasian context, marginalising American power. Iran's problem with this, if there is one, is international yuan markets are not yet developed enough to make full use of hedging instruments. But Iran's demand for sophisticated financial tools, as well as from other nations in Asia turning their backs on America, is bound to hasten their development.
I have written several times in the past about the importance of yuan-denominated deliverable gold futures in this context, and the evidence that the two markets offering these contracts, Hong Kong and Dubai, are cooperating in establishing additional vaulting facilities in China, roping in other gold centres in South-east Asia as well. In the case of gold, where physical delivery measured in tonnes is tight, the Chinese are ensuring as far as possible that deliverable liquidity will be there.
Additionally, last week the London Metal Exchange, owned by the Hong Kong Exchange and Clearing (HKEX), admitted it is considering introducing yuan contracts for base metals as well. We can safely assume that while the HKEX is an independent commercial entity, its strategic objectives are closely aligned with and encouraged by the Chinese government. Not only do the Chinese dominate gold markets in Asia, but last year HKEX successfully introduced regulated precious metal contracts in London. There can be little doubt that HKEX will be an important platform for expanding international markets for the Chinese currency. And at some time in the future, a state like Iran will be able to use not only yuan contracts to sell commodities in order to buy other commodities, but to use them as a stepping-stone to mobilise state-owned gold for payments as well.
Our topic is now moving on to gold being actively used as money instead of fiat currencies. While this point is not yet being considered by Western commentators, we can be sure it is by the forward planners in Asian governments. It's not for nothing India is trying everything to get hold of its citizens gold. To an extent, gold is already used as money by governments, which is why they are still included in monetary reserves. But they are there as a backstop, the money of last resort, no one's liability. What we could be seeing with the development of international yuan currency markets is a platform that links the use of gold to trade settlement.
This insight means we must look at both the Chinese and Russian policies on gold in a new light. Assumptions in the markets seem to be that China and Russia only see gold as a dollar hedge, or alternatively their accumulation of gold is either to balance the US's holding of 8,133 tonnes, or alternatively (if you believe the American's are lying about their reserves) Chinese and Russian gold is there to be used like a sword of Damocles held over the dollar. It would be wrong to dismiss these theories out of hand, but surely, they miss the point. You don't carefully plan to become a dominant world power, edging out the Americans and their dollars, without careful forward planning of monetary affairs.
There is irrefutable evidence that China has been planning for a post-dollar world since shortly after her leadership threw in the towel on communism and embraced free markets. The regulations appointing the People's Bank with sole responsibility for gold and silver date all the way back to 1983, since when we can confidently assume the PBOC has quietly accumulated gold on behalf of the state at prices that varied between $250-500 over a nineteen-year period. We know this, because in 2002 the PBOC then permitted private ownership, setting up the Shanghai Gold Exchange to facilitate physical acquisition. This would only have happened after the state had had a clear run at accumulating sufficient physical gold for its future purposes. And, as the largest gold mining nation for many years by far, with state monopolies in refining domestic production, recycling scrap and refining imported doré, there should be no doubt over her policy towards her accumulation of gold bullion.[ii]
Since 2002, the Chinese government has actively encouraged its nationals to accumulate physical gold and judging by net withdrawals from the Shanghai Gold Exchange vaults, the public possesses roughly 18,000 tonnes from more or less a standing start.[iii] My estimate for state ownership of bullion, based on contemporary prices, an analysis of capital inflows in the 1980s, followed by trade surpluses in the 1990s and before the public were permitted to buy in 2002, is approximately 20,000 tonnes. Even so, that may not be enough gold bullion owned by the state at current prices to operate a simple gold exchange standard, being the equivalent value of ¥5.22 trillion, compared with currency in circulation of ¥7.15 trillion.[iv] For comparison, when President Roosevelt devalued the dollar to $35 in January 1934, the US Treasury held gold worth $7.44bn at the new price against currency in circulation of $5.72bn. Therefore, if the Chinese government has 20,000 tonnes, and if it is to have the same currency cover as America had on 31 January 1934, at current exchange rates gold would have to be priced at $2,317.
Russia began accumulating gold only more recently and is now aggressively building her official reserves. Whether she has accumulated bullion "off balance sheet" is not known but should not be dismissed. Based on her official reserves at 1,910 tonnes worth RUB5.0 trillion, it does not cover M0 yet (RUB8.44 trillion)[v] but a rise in the gold price to $2,200 will do so, and a gold price of $2,860 would be required to match the Americans in 1934. In fact, for both Russia and China if gold is to have a monetary role it would have to be at a far higher price than it is today.
A scheme for linking currency to gold
Comparing the value of bullion held to the narrowest expression of money is likely to prove insufficient upon which to base a future monetary policy. But, given a good base of monetary gold, it is possible to set up arrangements to discourage redemptions of currency for physical gold when a gold exchange standard is fully implemented[vi]. The suggested arrangement that follows is based on the issuance of irredeemable government bonds with a coupon payable in either gold or currency at the owner's choice (the gold bond). Furthermore, an issue of this sort could be used to improve government finances at the same time.
By issuing the gold bond at a discount to par, early buyers get an enhanced yield. This rewards them for buying a new instrument which has yet to gain its potential market recognition. The market price of the bond will become linked to the yield on physical gold once the conversion rate is set, with an additional margin for issuer risk. And if currency balances invested in such a bond are rewarded with a yield payable in gold, demand for currency redemptions into gold is unlikely to be significant, so long as the public has confidence in the issue and the gold exchange standard. So, a country putting its currency on a gold exchange standard should, with a correctly priced bond, minimise redemptions.
A sinking fund should be established at the same time as the bond is announced to buy physical gold to cover anticipated demand for coupons paid in gold. Some gold from reserves can be allocated for this purpose initially but additional gold should be bought to establish sufficient cover to add conviction to the scheme by winding down existing foreign currency reserves where they are unbacked by gold, immediately.
From here on, we shall assume this scheme to introduce a sound, gold-exchangeable currency is taken up by the Chinese government. Government finances can be expected to improve from the arrangement, to the extent that borrowing costs are reduced. For example, China's 30-year bond currently yields 4.1% having been as high as 4.4% earlier this year. A gold-linked irredeemable Chinese bond, even allowing for issuer risk would probably yield no more than 3% at the outset, which is slightly less than the current yield on 1-year maturities. If it was issued with, say, a 2.25% coupon, it would be priced at 75.00, giving the attraction of a capital gain to private citizens as the risk premium on Chinese government bonds declines.
This will also lend support to the currency in the foreign exchanges. The gold bond should be listed in Shanghai, Hong Kong, Tokyo, Singapore, Dubai, London and Moscow so that sovereign wealth funds and other conservative long-term investors have ready access to it. New York is not on the list because it is Chinese policy to exclude the American banking system from her monetary affairs as much as possible, and the conflicts that necessarily would arise with the US government. Ultimately, for funds based outside America, the gold bond itself would come to be regarded as a gold substitute for investment purposes, integrating gold into both Chinese-led monetary and investment reforms.
There can be little doubt that if these measures are taken gold convertibility would rapidly promote the yuan to foreigners in Asia and beyond as an acceptable store of value in exchange for trade. In time, all foreign currency held in China's monetary reserves not backed by gold would have to be disposed for gold or yuan, as being inconsistent with the new monetary policy. As stated above, China's gold buying using dollars would start immediately and continue until the price of gold has risen to the point where the gold exchange rate is finally established.
Furthermore, with no final redemption on the gold bond, there would be no need to make any repayment provisions. This model is the one that was adopted by the British government for financing the Napoleonic Wars by issuing Consolidated 3% Annuities at a deep discount, so that investors providing war finance not only got an enhanced yield, but also a substantial capital gain when peacetime returned. The fortunes created on the return to peace played an important part in financing the industrial revolution in the early nineteenth century.[vii]
In this sense, there are good parallels between Britain's war financing two hundred years ago, and China's current position. In both cases, government expenditure exceeded and exceeds respective tax income by a significant margin, and neither were and are on a gold standard. Britain had temporarily abandoned her gold standard in the 1790s, before reinstating it a few years after Waterloo.
In China's case, excess government expenditure is due to planned infrastructure spending, which is likely to be ongoing for at least another ten years and extending well beyond her borders. However, Chinese instigated capital expenditure throughout Asia will increasingly be covered by project financing through the Asian Infrastructure Investment Bank, releasing the Chinese government from much of the financing burden.
The British came out of the Napoleonic Wars with an estimated debt to GDP of about 260%. In cash terms it was considerably less, because the debt figure is the total of nominal debt in issue. This was the beauty of irredeemable Consols, because they never need to be repaid, which meant a more accurate debt to GDP figure was 180%. As a historical footnote, it is interesting they were repaid only recently.
China's government debt is considerably less at just under 50%, but still rising. China is blessed with a savings rate of close to 50% of GDP as well, so further issues of a gold-linked bond into the domestic market should be heavily subscribed. Once the current expansion of infrastructure spending diminishes, the Chinese government will easily return to a budget surplus, paying down its debt more rapidly than the British did in the 1800s.
I would suggest China undertakes the monetarisation of gold in two stages. The first would be to issue the new gold loan outlined above. Proceeds of the new gold bond would be used to finance government expenditure, to purchase existing bonds in the market for cancellation, and to build a sinking fund to provide cover for future coupon demands in gold. The price relationship between coupons paid in gold and yuan will be fixed at a later date and will be the rate for the gold exchange standard once it is set. It cannot be set at the outset, because it is clear that for gold to be rehabilitated into China's monetary system, and consequently the likelihood it will be elsewhere, will require a far higher gold price than at present. In price theory, it is the introduction of a new use that will set a higher marginal price. That will be the second step, which is announced in advance when the new gold bond is first issued but at a rate yet to be decided.
China is the ideal jurisdiction for the reintroduction of gold into a monetary system by way of a gold exchange standard. To briefly summarise:
- China has been secretly accumulating gold since regulations appointed the PBOC to do so in 1983. Not only has the state accumulated significant quantities of gold, but the citizenry has as well. China and its population are therefore fully attuned to the use of gold as money.
- The Chinese government has no need to resort to the illusory benefits of inflationary financing. Her budget deficits are the consequence of infrastructure spending, which will diminish in time, and her citizens have a savings rate of nearly 50%, which is the real engine behind her economic progress and wealth creation. Furthermore, government debt to GDP is relatively low at about 50%, and she is not burdened by the costs of a Western-style welfare state.
- China's success is driven by a political requirement to improve the standards of living for everyone in as many as 42 diverse ethnic groups, representing an unwritten contract between the state and its people in lieu of democracy. A gold standard and a savings vehicle that gives ordinary people a yield on gold will increase personal wealth and guarantee the cohesion and economic strength of the Chinese nation, at a time when America's finances are relying increasingly on the destruction of private wealth through inflation. There has to be a parting of the ways for the two currencies.
- The introduction of sound money by way of a gold exchange scheme will ensure China's economic dominance will develop and continue for a considerable time, much as it did for Britain in the nineteenth century.
Russia is also manoeuvring towards a gold standard, which given her partnership with China at the head of the Shanghai Cooperation Organisation, will most likely build on the Chinese model. The differences are one positive and one negative. The positive is the Russian government's finances are in excellent order, the negative is Russia has only relatively recently begun to accumulate significant gold reserves. She is therefore likely to want to accumulate more gold before embarking on a gold exchange standard and may therefore encourage China to delay her plans until she is ready.
The consequences of Asian gold exchange standards
The economic cost of a change to sound money is that the transfer of wealth from lender to borrower, which is the dominant feature of unsound money, ceases. Inevitably, overindebted businesses are likely to experience difficulties. Furthermore, Chinese exporters to countries with pure fiat currencies will have to invest in more efficient production to remain competitive.
This is less of a problem than first appears. In her current five-year plan, China is moving away from relying on competitive export models towards developing high-tech and service industries aimed at satisfying a growing middle class. Furthermore, Asia represents a new semi-captive market for China, where the yuan is likely to become the standard foreign currency.
The effect on the dollar, euro and Japanese yen could be ruinous, depending on how the relevant central banks develop their monetary policies. They would have to realise that the era of pure fiat is over, and currencies which depend entirely on confidence in their value are no longer fit for purpose. The PBOC could smoothen this process by giving the other major central banks advance notice of its intentions, to minimise the risk of bullion banks being badly wrong-footed with undeliverable bullion obligations.
In the wider context, financial markets are themselves completely wedded to neo-Keynesian economics and may take some time to adjust to why a successful gold exchange standard is a threat to unbacked fiat currencies. But by providing a globally-acceptable, sound-money alternative to the current fiat money system, those that do adapt will avoid the hyperinflations that are the logical destiny for governments that rely on inflationary finance. The eventual prize will be for the Shanghai Cooperation Organisation to have two gold-backed currencies for cross-border trade for use throughout Asia, Eastern Europe, sub-Saharan Africa and parts of South America. The Middle East as well will find these currencies attractive in payment for oil, and countries that stay purely fiat will be marginalised.
Those countries whose currencies have been recently destabilised by the dollar's rally should be among the first to realise that being tied to a Chinese-led sound money regime is a better option. In the course of only a year or two, in theory over half the world's population could have access to a currency exchangeable for gold, or at least tied to it.
If the whole scheme of Asian revival through economic power is to progress and survive long into the future, it will be a precondition that gold is central to monetary policy. Indeed, given the increasingly certain fate for the inflationary dollar, which is likely to drag down the rest of the world with it, it should no longer be a matter of choice, only of timing. And unless the welfare-driven nations, whose governments have waxed on the destruction of their citizens' wealth through deliberate monetary inflation reform their ways, they will deserve to slide into obscurity.
[i] By email dated May 29.
[ii] It's worth noting that most guestimates concerning the Chinese government's secret gold holdings ignore the period before the establishment of the Shanghai Gold Exchange in 2002, assuming it is likely to be a few thousand tonnes.
[iii] For an independent analysis as at June 2017, since when a further 1,793 tonnes have been withdrawn, see here
[iv] See here
[vi] Correctly defined, a gold exchange standard is one where the national monetary unit is legally defined as the equivalent of a fixed weight of gold, no gold coins circulate, and the monetary authority maintains the relationship between the weight of gold and the monetary unit. See the glossary in von Mises's Human Action for a fuller definition.
[vii] I'm grateful to Professor Kevin Dowd of Durham University for providing me with the background information to the British Treasury's financing strategy from the creation of Consolidated Annuities in 1752 onwards.