Captain's Log: November 22nd, 2014
Gold still trends down amidst accumulation by Russia and China
There are reports circulating in the financial media about how much physical gold is being accumulated by both Russia and China. Are there plans afoot among competing superpowers to supplant the US Dollar as the world's reserve currency, with gold backed currencies of their own? If so, will that ultimately put pressure on interest rates for our "sovereign debt", as overall demand for US Treasuries wanes?
Recent US Dollar strength would seem to refute that thesis, even though there are sordid warnings out there in the financial press that plans are afoot for replacing the US Dollar as the world's reserve currency-which would have enormously negative consequences for our domestic economy. That threat does not appear imminent, but it is curious why Russia and China are in the process of accumulating physical gold, even as domestic demand for gold in jewelry, electronics, and ETF investment products is waning, and gold continues to fall in price. Someone is right and someone is wrong.
Russia bought about 19.7 metric tons of gold last month, raising its total to 1,169 tons, and taking this year's purchases by the end of October to 134.3 tons, according to Bloomberg calculations based on IMF data. Another 15.7 tons or so were added so far in November. Yet gold accounts for only about 10% of Russia's total foreign reserves, according to the World Gold Council. The US and Germany reportedly hold about 70% of their total foreign reserves in gold bullion.
China has reportedly increased its gold holdings significantly over the last few years secretly. Alan Greenspan recently penned an op-ed for the Council on Foreign Relations noting that if China converted only a relatively modest part of its $4 trillion foreign exchange reserves into gold, China's currency could take on unexpected strength in the international financial system. Despite the People's Bank of China failure to disclose any changes to its gold holdings in years, it is widely believed that the central bank is buying gold to diversify its reserve holdings. Analysts speculate that it holds between 2000-3000 tons of gold, and China remains the world's largest gold consumer and producer in the world. US gold holdings, in comparison, total 8,133.5 tons of gold. The bottom line is that Russia and China are increasing their gold reserves aggressively-but why?
Well, let's put together the pieces. All Central Banks know that trust in the financial system is paramount. In a world of fiat currencies, holders must have trust that their cash will retain its value.
In Russia, the rouble has fallen 23% against the US dollar in recent months.
That plunge, in turn, causes inflation in the form of more expensive imports. Russian inflation is already rising at over 8% per year. On November 5th, the Central Bank of Russia hiked interest rates to 9.5%, in order to make the Russian currency deposits more attractive than US Dollar deposits. But falling oil prices from the global oil glut is keeping pressure on Russia's finances, since gas and oil sales account for 68% of Russia's total exports. With oil prices dropping from an average of $109 per barrel during the first of half of 2014 to about $80 today, that 26% drop in revenues is hurting not only the Russian economy, but also its currency.
So it appears that Russia's current gold purchases are intended to back a declining rouble, which is causing quite a bit of pain in their homeland. Russian farming is still hugely inefficient compared with countries like the US. Its milk, eggs, and meat imports are becoming very expensive and there are few domestic substitutes. Wholesalers that import these goods need dollars to buy them, which in turn keeps pressure on the rouble. A lower rouble keeps import prices and inflationary pressures high.
This Russian dependence on US Western markets and currencies disturbs Putin to no end. He and Xi Jinping of China just inked an historic deal for Russia to export gas from Siberia to China via new pipelines, providing a huge new source of demand for Russian energy products. More importantly, the two countries agreed to start trading in yuan rather than dollars, which in turn will cut demand for US Dollars. The first pieces are now in place for trading between superpowers without using the US Dollar, and efforts are afoot to expand these agreements with other trading partners such as Brazil and India.
This effort by competing superpowers to replace the US Dollar as the reserve world currency will probably take years to accomplish, but the ramifications for the US standard of living are serious. Loss of the US Dollar as the world's reserve currency will put pressure on Treasury interest rates, and the cost of imported products. Some pundits even suggest a crash of up to 50% in the US Dollar's purchasing power. These are pure speculations at this point, but trade deals between Russia, China, Brazil, and Iran are occurring already without use of the almighty petrodollar, and so the handwriting is already on the wall…
Western sanctions against Russia are actually accelerating the birth of a parallel financial system where countries not allied with the West can operate without the threat and economic pain of sanctions. China welcomes the opportunity to increase the impact of the renminbi on world trade, and offer a gold-backed alternative to the US Dollar. Russia is anxious to get rid of the US Dollar ramshackle, and begin to trade its energy products for the currencies of other nations, especially those that can back up their currencies with hard assets like gold or other valuable fungible commodities. Its own currency will hold its value better if Russia has higher gold reserves, like that of China or the US. That might explain why China and Russia are both in the midst of increasing their gold reserves. They both want to trade in their domestic currencies and offer the world a gold-backed alternative to the US Dollar.
Gazprom, the giant Russian oil company, is now shipping oil from the Arctic to European ports this month with payment to be received in roubles. It will also deliver oil via the Eastern Siberia Pacific Ocean pipeline accepting payment in Chinese renminbi. The $400 billion gas contract between Russia and China, which was haggled over for a decade, was finally inked in May of 2014, after Western sanctions kicked in. Furthermore, Russian weapons depend on Western suppliers for some of their high tech components. China is taking advantage of the current sanctions against Russia by becoming a major producer of high end electronic and mechanical components, replacing Western suppliers, to the tune of about $1 billion a year. Russia and China are also expediting aviation joint ventures in wide body aircraft and mid-size airlines.
Thus, the sanctions against Russia for its invasion of Ukraine, are about to have a boomerang effect, not only on Europe, but directly on the US as well. Not much attention is paid to these currency wars in the mainstream media, but the impact of these developments on the markets and the standard of living in the US, China, and Russia could be very significant…
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Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.