(By Chris Hamilton)
My article “10,000 tons of gold…The math says China could have easily done it!” explains how it’s possible or even likely China has amassed 10,000+ tons of gold. What it doesn’t explain is the context as to why this is so important. I know some now this story well, but for most, this needs repeating.
A little History
Gold has long represented the primary means of rebalancing trade surplus / deficits between nations. As a nation ran a trade surplus with another, the exporter ended up with an excess of the importer nations currency. The primary means to rebalance was for the exporter to transfer back to the importer nation it’s currency in exchange for gold. If this continued, the importing nations falling gold holdings would represent a weakening currency…which would mean higher prices to the importing nation and less purchasing of the exporting nations goods slowing down the trade imbalance. Since the advent of paper money until 1971, this had been the general method to rebalance.
The US assumed the role of global reserve currency formally at the Bretton Woods conference just prior to the culmination of WWII. The agreement entailed the US dollar would be the “peg” to which all other currencies would maintain their value within a +/-1% band. This was the resolution of what had been lacking between the two world wars: a system of international payments that would allow trade to be conducted without fear of sudden currency depreciation or wild fluctuations in exchange rates. And of course, nations accumulating excess US dollars would be allowed to freely exchange them with the US for gold. And so it was from 1945 through 1971.
The US had amassed 20k+ tons of gold following WWII as the primary exporter during the war but by 1971 the growing surplus of dollars sent abroad (initiated primarily under Johnsons’ Vietnam war and the creation of unfunded liabilities) had been increasingly exchanged for US gold holdings. The 20k+ US tons of gold were down to 8k+ tons and falling precipitously. Nixon subsequently closed the gold window and ended the basis of post war monetary rebalancing. In the place of the Bretton Woods system of balance, Nixon initiated the Petro-Dollar system with Saudi Arabia and eventually all OPEC members.
The Petro-Dollar would ensure all oil would be paid for in dollars (no matter the purchasing nations’ currency or preference) and the US would make available weapons and “protection” for those oil exporting nations that maintained the Petro-Dollar. The Petro-Dollar would allow the US to maintain large trade and budget deficits without the expected inflationary impacts in the US or significant dollar weakness. All the excess dollars would need be soaked up and utilized by all oil importing nations as foreign exchange working capital.
China and the Dollar
Fast forward to China in 2000 running a large trade surplus with the US. China had taken over the manufacturing leadership from Japan and began accumulating a stockpile of US dollars. From 2000 till 2011 China recycles on average 50% of this dollar trade surplus into US Treasury’s. Initially these Treasury’s offered an inflation adjusted positive yield but over the ensuing decade this yield collapses to the inflation adjusted negative yield currently offered. And since the advent of QE, the Fed has created $2+ trillion dollars to buy US Treasury’s essentially printing new dollars to roll over old debt and allow ever more debt at ever lower interest rates and essentially at no greater cost to the US (see chart)… unless one considers the potential the US is paying for its deficits via higher energy costs and co-opting the world to likewise pay for America’s debt?
Or factoring in growth in population (Households) and spreading interest costs and oil costs evenly among them to determine how the US is paying for increased debt…see chart below.
And then the July 31st, 2011 debt ceiling debate determined that the US would not reduce its budget deficit nor trade deficit and would instead continue monetization (QE, etc.) indefinitely. China held nearly $1.3 trillion in Treasury’s and another couple trillion dollars for which it would be paid trivial interest and which the US made clear it had no qualms with printing new dollars to pay back these debts.
It is with this background that the sudden shift in China’s Treasury purchases was noted in 2011. China continued selling consumer goods to America at record pace but halted their rapid accumulation of Treasury’s and became a net seller. China and other BRICS nations rapidly increased the pace of building a non-dollar denominated structure for trade.
And China, noting the weakness of their position, holding massive currency of a nation that had just announced to the world its intention to maintain budget and trade deficits via printing new currency, seems to have rapidly and without abandon initiated a program of exchanging something easily diluted (the dollar) for something relatively fixed and stable (gold and likely other hard assets).
The importance of China (and Russia) having re-balanced is it affords them an insurance policy against a dollar conflagration. If (when) the US runs into its next headwind, the only real answer the US has shown it is willing to entertain is more QE or a like program of monetization. But to be effective, it will need be larger than the previous editions. This dilution of the dollar (and all major currencies will be forced similarly continuing dilution to maintain “competitiveness”) absent US trading partners recycling dollars into Treasury’s (and thus the US diluting into a de-dollarizing world which will need fewer dollars just as the US pushes the “print” button)…this should mean too many dollars and fewer exporters trading utilizing them.
Well, some very bad implications arise. Primarily the estimated $10 – $20+ trillion US dollars sent abroad from the advent of the Petro-Dollar in ’71 till present coming back to the one place they are legal tender; the US of A. And even a fraction of this amount of money coming back with modest leverage will not go unnoticed…first as a trickle (pushing prices of assets higher) and then as a rush (pushing asset prices into overdrive) likely absent an economic boost. This would likely be some sort of asset hyperinflation alongside continued wage deflation (due to structural unemployment and a multitude of factors containing US wages). As an aside, I’m more than a bit curious if this repatriation of dollars combined with corporate share buybacks made possible by ZIRP and a continued strong Belgium / Cayman Island Treasury bid will continue to push the “markets” higher even absent any additional QE.
Since Jan 1, 2011 equity markets of the BRICS representing growing economies w/ strong demographics and low but rising wages coupled w/ low levels of consumer debt…are falling. While the slow growth, highly indebted, falling income, demographically backward markets of the US, Japan, and EU are flying. The Brazilian Bovespa is down -23%, Russia’s Micex -20%, Chinese Shanghai -19.5%, India was only up +8% until a gold import ban in Aug of ’13 was implemented and up +44% since. By comparison, the S&P is up +48%, Nikkei +42%, DAX +25%, FTSE +7%, French CAC +5%, and among larger markets only Spain (-4%) and Italy (-10.5%) are down. This despite collapsing crude oil consumption in the US, Japan, and Europe compared to rapid consumption increases across the BRICS (see chart below from ’05-’13…but the trends have been consistent). Drops in energy consumption of this magnitude typically indicate depression conditions exist, and increases in consumption usually represent economic growth. All I can say is something does not add up.
And China’s gold holdings would act as an insurance policy paying off in the case of a dollar dilution. Of course Chinas’ economy would be harmed by shrinking exports to the US and Europe but that was the “re-balancing” they’ve been talking about all along. Now, whether this will work just as China is likely falling into the third great real estate collapse of the last 3 decades (Japan in ’89, US in ’07, China likely now in ’14)…well China may be protecting itself from itself as much as from the US because if they follow the Japanese and US model to print their way out of a real estate collapse…gold may simply be “priceless” in sovereign currencies.
Gold…the case to go “All In”?
What I’ve explained is how things work for those who make the rules…so while precious metal fundamentals may seem bright vis-a-vi fiat currencies…please don’t go out and sell everything to buy gold. I’m not an advisor and I only write this to inform you in your decision making. I have no crystal ball and the more I know, the more I’m sure I don’t know. So the only advice I’ll offer is follow the old axioms, “all things in moderation” and “hope for the best and plan for the worst”.
This article was written by Chris Hamilton. You can find the original article at CharlesBiderman.com.
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