Submitted by Alasdair Macleod via GoldMoney.com,
Advance signs of a global slump in economic activity emerged in 2015.
Furthermore, the dollar's strength, coupled with
widening credit spreads confirms a global tendency for
dollar-denominated debt to contract. These developments typically
precede an economic and financial crisis that could manifest itself in
2016, partially confirmed by the disappointing performance of equity
markets. If so, demand for physical gold can be expected to escalate
rapidly as a financial crisis unfolds.
Introduction
Gold has now been in a bear market since September
2011. Major central banks in the advanced economies have implemented
policies that have covertly suppressed the gold price, while they have
overtly inflated asset prices. This has led to valuation extremes in all
asset markets, including gold, that would never be seen in free markets
backed with sound money. We can be certain that today's unprecedented
build-up of price distortions will be corrected eventually by market
forces, probably in the coming months. The commencement of a crisis has
already been evidenced by the collapse in energy and
industrial-commodity prices, causing major problems for nations and
international companies with US dollar obligations and suddenly finding
they lack the revenue to service them. The scale of commodity-related
losses is not generally understood, but cannot be ignored for much
longer.
The rapid
expansion of central bank balance sheets since the Lehman crisis is the
ultimate phase of a process that can be traced back to at least the
1980s. Starting in London, US and European banks at that time took
control of securities markets. Since then, they have increasingly
directed bank credit at the expansion of those securities markets,
principally through the development of over-the-counter (OTC)
derivatives, but also by dominating bond and equity markets, and
regulated derivatives.
The expansion of bank credit aimed towards financial
activities has had the triple effect of inflating financial assets,
suppressing commodity prices below where they would otherwise be, and
enhancing international demand for the US dollar as the main pricing
currency. The result has been an unprecedented peace-time expansion of
global debt, while confidence in the reserve currency has been
maintained. However, there are indications that this period of expansion
is now at an end. According to the Bank for International Settlements'
statistical releases, the gross value of bank-held derivatives has been
contracting since 2013. Notional amounts of outstanding OTC contracts
peaked at end-2013 at $711 trillion, and by June 2015 had declined to
$553 trillion.
This is an important point, because an unseen bubble
at the heart of the financial system is deflating with unknown
consequences. When bubbles deflate, and here we are talking about one in
the hundreds of trillions, bad debts are usually exposed. Even though
much of the reduction in outstanding OTC derivatives is due to
consolidation of positions following the Frank Dodd Act, much of it is
not.
When free markets reassert themselves, and they
always do, the disruption promises to be substantial. We appear to be in
the early stages of this event.
Dollar and European dangers
As noted above, the rising value of the dollar
measured against commodities is a major problem. In the short-term the
dollar is extremely over-bought against record levels of commodity short
positions. Most notable is the dollar price of oil, with West Texas
Intermediate having fallen from $105 in June 2013 to $32 today. While
much of the fall can be attributed to lower demand from a slowing global
economy, some of it is undoubtedly due to the strength of the dollar
itself. Bad and potential bad debts, many commodity-related and
denominated in dollars, are a global issue, and the US banks are trying
to control their international loan exposure. Consequently,
international borrowers with dollar-denominated debt are being forced to
sell down local currencies to buy dollars in order to cover their
dollar obligations. The problem has been aggravated further by
speculators bidding up the dollar against these distressed buyers.
The dollar's overvaluation is also supported by the
belief that the US economy is healthy and performing relatively well.
With official unemployment down to 5%, demand for domestic credit, while
patchy, is basically sound and growing at a moderate pace. However,
nominal GDP growth is entirely due to monetary stimulus being not yet
offset by lagging price inflation, and is not the well-founded economic
recovery generally supposed. But for dollar bulls, the apparent strength
of the US economy is another reason to believe the dollar will remain
strong, given the prospect of a rising interest rate trend. There are
considerable dangers to this bullish view for the dollar, not least the
degree to which it is already discounted in current prices.
A second global problem is the financial and
economic condition of the Eurozone. 2015 saw the Greek crisis deferred,
but for 2016 we have the prospect of trouble from Spain and Portugal,
with government debt as a percentage of GDP estimated at 100% and 130%
respectively. In the Spanish general election in December an
anti-austerity combination of the left-wing Podemas and PSOE political
parties won 159 seats against the ruling party's 123. Negotiations are
now underway, but it looks like an anti-austerity coalition will form
the next government. Greece was difficult enough, but Spain is many
times greater in terms of its economic impact and the amount of
government debt involved. Also, Portugal, whose economy is about the
same size as that of Greece, had its general election in October, and
the ruling party lost its overall majority, suggesting that
anti-austerity pressures will increase in Lisbon as well. And Greece has
not gone away.
Greece in 2015 was the warm-up act for what's ahead
in the Eurozone. Meanwhile, €3 trillion of government bonds in Europe
now trade with negative yields, an unprecedented situation, which
illustrates how overvalued European government bonds in general have
become, particularly when taking into account the parlous condition of
some major governments' finances. The Eurozone banks are also
financially precarious, having an average Tier 1 capital ratio to
tangible assets of 5.1%, dropping to 4.1% when off-balance sheet items
are included. Furthermore, the netting off of credit default swaps
permitted under new Basel Committee rules has allowed the banks to
conceal their true loan risk. The combination of European banks gaming
the system, average core balance sheet leverage (including off-balance
sheet obligations) of 24:1, and their balance sheets laden with wildly
overvalued government bonds, has the makings of a crisis in search of a
trigger.
A European banking crisis could escalate very
rapidly if and when it starts, and would be an event beyond the direct
control of an alarmingly undercapitalised ECB. The initial effect might
be to drive the dollar higher in the foreign exchanges, particularly
against the euro, and instigate a further markdown of commodity prices,
as markets try to discount the economic implications of a systemic
problem in the Eurozone. If an event such as this occurs, it would be
impossible to limit it to a single geographical area. The major central
banks would be forced into a coordinated rescue programme, involving a
major expansion of all their balance sheets, on top of the post-Lehman
crisis expansion.
Once initial uncertainties are out of the way, the
prospect of escalating systemic risk should be very positive for gold,
which is the only certain hedge against these events. To determine the
potential for the gold price, its current value should be assessed by
looking at the long-run inflation of fiat dollars relative to the
increase of above-ground gold stocks, and adjusting the dollar price of
gold accordingly.
FMQ and gold
The fiat money quantity represents the total fiat
money that has been produced by the US banking system. It includes fiat
currency not in circulation, being mainly bank reserves sitting on the
Fed's balance sheet. The chart below shows the monthly accumulation of
US dollar FMQ since 1959.
Following the Lehman crisis, the dollar-price of gold fell initially
before recovering and gaining all-time highs in September 2011. With the
benefit of hindsight, we can surmise that the immediate effect of the
Lehman crisis was to trigger a flight into the dollar, before it became
evident that the Fed's actions aimed at stabilising the financial sector
were succeeding at the expense of monetary inflation. This also
provides an explanation as to why, in order to maintain confidence in
the dollar, the gold price had to be subsequently suppressed. Judging by
all the circumstantial evidence following the Cyprus crisis, the most
notable suppression exercise was in April 2013, and close study of
market actions and volumes reveals that other less dramatic price
suppressions have from time to time also taken place.
Given this experience, it would be wrong to rule out
another attempt by the western central banks to suppress the price of
gold in the event of a crisis. However, it is becoming clear that they
can only suppress the price through the paper markets, given the
relative scarcity of physical bullion in western central bank vaults,
and the reluctance of individual central banks to compromise their
bullion holdings any further. These short-term uncertainties cannot be
quantified, but we can have a clear idea as to gold's current true
value, expressed in US dollars. This is the subject of our next chart.
The chart shows the price of gold deflated by both
the increase in FMQ over the years and by the expansion of above-ground
gold stocks, since the price was fixed at $35 in 1934 by President
Roosevelt. Adjusted by these two factors, gold at end-December 2015 was
priced at the equivalent of $3.25 in 1934 dollars, less than 10% of the
1934 price. The only occasion the adjusted price has been lower was in
1971, just months before the Nixon shock, when the Bretton Woods system
finally collapsed. The adjusted price stood at $3.13 in March that year.
The next chart shows the same price adjustments
applied to the gold price, this time from August 2008, when the Lehman
crisis broke and the nominal gold price was $918.
The adjusted price, reflecting the expansion of both
the FMQ and above-ground gold stocks, now stands at $402, a decline of
56% in real terms since Lehman.
On value considerations, we can therefore conclude the following:
•
Gold is cheaper than it has ever been against the world's reserve
currency, with the single exception of the time when it was so
under-priced that the US Government was forced to scrap its peg at $35
and abandon the Bretton Woods Agreement.
• Compared with the
situation at the time of the Lehman crisis, gold is significantly
cheaper today, which is wholly at odds with the continuing systemic risk
to fiat currencies from undercapitalised banks, unprepared for the
prospect of markets normalising.
Many contemporary financial analysts would argue
that gold is not relevant to these issues, because gold is no longer
money. This line of reasoning ignores the fact that ordinary people in
the west do not get this message and are accumulating gold coins and
small bullion bars at increasing rates. And more
importantly, economic power is shifting from countries where this
Keynesian view is prevalent to countries where it is not. The next section looks at the geostrategic implications of the shift in the ownership and pricing of gold from west to east.
China, India and the rest of Asia
China and India, together with all the other
countries in mainland Asia, have been draining the west's vaults of
above-ground gold stocks for far longer than most people in western
capital markets realise. China first delegated the management of gold
policy to the Peoples Bank by regulations adopted in 1983, in a move
that followed the post-Mao reforms of 1979/82. The intention behind
these regulations was for the state to acquire substantial amounts of
gold, to develop gold mining, and to control all processing and refining
activities. At that time the west was doing its best to suppress gold
in order to enhance the credibility of paper currencies, by releasing
large quantities of vaulted bullion through leasing and outright sales.
This is why the timing is important: it was an opportunity for China,
with its one-billion plus population in the throes of rapid economic
reform, to diversify growing foreign currency surpluses, in the same way
as the Arab nations did earlier and contemporaneously between 1973-1990
following the oil price boom.
When China set up the Shanghai Gold Exchange in 2002
and encouraged its private sector to accumulate gold, the state had
obviously acquired enough bullion for its own strategic purposes. We
cannot know how much the state has actually accumulated, or indeed to
what extent the gold she has mined has been taken into state ownership
since, but the amount is likely to be very substantial. We do know that
gross deliveries into public hands since 2002, satisfied mainly by
imports from western vaults, exceed 11,000 tonnes to date. It is
therefore quite possible that China and its citizens now have more gold
than all the other central banks put together, given that some official
gold is currently leased by western central banks and some has been
secretly sold to suppress the price.
The monthly statements about China's gold reserve
additions are therefore meaningless. However, Russia is now accumulating
official reserves as well, and the Indian state is trying to acquire
her citizen's gold by stealth, having been frozen out of the market
through lack of supply. The bulk of Asia is, or will be, bound together
through the Shanghai Cooperation Organisation, an economic partnership
dominated by China and Russia, encompassing more than half the world's
population, and which accepts physical gold as the ultimate form of
money. And what clearly emerged in 2015 is that the dominant trade
currency in this bloc will unquestionably be the Chinese yuan, the
currency of the country that has now cornered the world's physical gold
market.
The future for the world's money is rapidly developing, as will become increasingly apparent in 2016. The
era of dollar supremacy is coming to an end, no doubt hastened by the
Fed's ultimately destructive monetary policies. The threat to the
dollar's primacy is also a threat to the other great paper currencies:
the euro, the yen and sterling. Whether or not these fail before, with
or after the dollar, is only a matter for timing. China must have
foreseen this possible outcome, otherwise she would not have embarked on
a policy of accumulating gold as long ago as 1983, invested substantial
resources into gold mining and refining, actively encouraged her
citizens to own it, and is today promoting use of her currency for
global trade and the pricing of gold.
Western market observers seem to be unaware of how
advanced China's currency policy is today. Instead, they expect a
full-blown credit crisis, the result of the credit expansion of recent
years being undermined by a rapidly slowing economy. Furthermore, they
argue that Chinese labour costs have increased and require a much lower
yuan exchange rate to become competitive again. Based on western-style
macroeconomic analysis, they naturally conclude that China will require a
substantial currency devaluation to contain these problems.
While it is a mistake to gloss over the considerable
economic difficulties, this analysis is flawed on two counts. Firstly,
the state owns the banks, so a credit crisis stops with the debtors. And
secondly, under the thirteenth five-year plan, China is embarking on a
redirection of economic resources from being the cheap manufacturer for
the rest of the world to serving its growing middle class and developing
trans-Asian infrastructure. China's unemployment rate is estimated to
be about 5%, so workers employed on current production lines will need
to be redeployed, if the state's economic strategy is to progress. A
substantial devaluation is therefore counterproductive, though the
central bank does move the yuan's peg against the dollar from time to
time.
The purpose behind China's accumulation
of gold can only be to eventually make the yuan a reliable store of
value. China will need to see a higher gold price in yuan, probably at a
time dictated by external events, which she will patiently await. This
is why, having developed the Shanghai Gold Exchange into the world's
most important physical gold market, China plans to price gold in yuan,
with the objective that the yuan-gold peg will eventually supersede
yuan-dollar peg.
We will surely end 2016 with a wider appreciation that the dollar is
no longer king, and that the future for money lies in Asia, the yuan,
and gold.
Conclusion
In the near-term, paper gold is extremely oversold,
reflecting the expression of western establishment sentiment in the
paper markets. Futures and forward markets are short of paper gold to an
extraordinary degree. Whether or not this leaves open the possibility
of further falls in the dollar price of gold in the next few months is a
moot point. More importantly, on longer-term considerations, gold has
not been this undervalued since the events leading to the collapse of
the Bretton Woods agreement. If current events lead to a
systemic crisis in western capital markets in 2016, which given the
global slump in economic activity looks increasingly likely, a further
expansion of central bank balance sheets on top of the post-Lehman
expansion seems certain. If this happens, it is unlikely the purchasing
power of the dollar and the other major currencies will remain at
current levels. And if the dollar loses purchasing-power, price
inflation will rise along with nominal interest rates, and a wider debt
liquidation in western capital markets becomes a real possibility.
China and her SCO partners have taken
steps to be protected from this outcome and have cornered the gold
market. A wise person should take note and think seriously about the
implications.
Enjoy 2016.
By John Vibes
