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Sunday, June 5, 2016

A Gold Backed SDR (or Yuan)? There's Clearly Smoke - Is There a Fire?

If you follow the topic of potential monetary system change at all, you know that there is a lot of speculation around the world that China (and Russia) are quietly and steadily pushing to toward a future where the US dollar does not occupy its current position as the dominant global reserve currency. It's pretty easy to establish that this is true based on public statements by officials and other credible sources of information.


Where there seems to be a divergence of views however, is exactly what would eventually replace the US dollar in that role. For years a number of gold advocates have insisted that China intends to either back the yuan with gold or push for a gold backed SDR to take over from the US dollar. They cite the fact that China has been making a big effort to build up its gold reserves and promote gold ownership by its citizens as support for this view. They also point to China opening the new gold trading exchange earlier this year and Chinese purchases of gold related assets like vaults and mining companies.


On the other hand, I am unable to find any Chinese official that has publicly stated that China intends to officially back the yuan with gold or that the SDR should be officially backed with gold. PBOC Governor Zhou Xiaochuan clearly did call for the SDR to take on a leading role in 2009 (see this paper top of page 3). He had this to say at that time:


"The allocation of the SDR can be shifted from a purely calculation-based system to a system backed by real assets, such as a reserve pool, to further boost market confidence in its value."


This year he repeated his call for broader adoption of the SDR but did not mention any kind of gold backing in his remarks as far as I know. So I will leave it to the reader to decide if he was thinking about gold in his 2009 statement quoted above when he suggested backing "by real assets."


All this talk caused me to decide that it might be useful to post recent comments by both Jim Rickards and Dr. Warren Coats (former IMF) on this topic. In his recent monthly webinar Jim Rickards talked directly about this so we have very recent comments by him we can look at. Dr. Warren Coats agreed earlier this year to do a Q&A style interview for readers here about his Real SDR proposal. In the interview I asked him about gold backing for the SDR so we have his recent thoughts on this as well. Below I have pasted in Jim's comments and Dr. Coats comments to make it easy to compare them. After that I will add a few comments.

Jim Rickards Recent Comments on SDR Gold Backing
(from one Q&A in his recent webinar)


Jon:  "There’s one other voice, but this one’s really demure, and I don’t know quite how to interpret it. Alex pointed this out from a speech just published by the chief economist for the Bank of International Settlements. While addressing the issue of diversification away from the dollar, he basically says that merely diversifying currencies doesn’t work. Then he goes into analysis of the structural problems in the world’s monetary and financial system.
He goes on to say that the system lacks what he calls an effective anchor, but he doesn’t describe what that anchor might be. Is that speech possibly clearing the way for introducing gold as a more central and overt player in the organization of the international monetary system?"
Jim:  "There’s no doubt about it. You’re referring to Claudio Borio, head of monetary economic research at the Bank for International Settlements or the BIS. For listeners who may not know, the BIS is the central bankers’ central bank. I’ve often referred to the IMF, the International Monetary Fund, as the central bank of the world because they have this money printing function, but the BIS is even older than the IMF. It was created in 1930 and is based in Basel, Switzerland
I call it a tree house for central bankers. Much like a little child wants a tree house to get away from their parents or get away from scrutiny, this is where the top central bankers, the G10 economies, go once a month. They have a nice lunch overlooking a river there in Switzerland. They close the doors. There are no minutes, no records, no statements, no press conferences, and no accountability. Nobody knows what goes on inside that room unless you’re in the room or speak to someone who was.
. . . . .
Claudio Borio is their chief monetary economist. Just last week he gave a speech in Zurich, Switzerland (see our blog article on this here), and said exactly what you said, Jon; the international monetary system is rudderless and has no anchor. There’s no gold standard and there’s no dollar standard. From 1980 to 2010, the reason things were not more chaotic was because we had a dollar standard. That may not be a strong anchor, but it’s something. The US was committed to a strong dollar before President Obama launched into the currency wars in 2010. Now there’s no anchor at all.
I’ll relate two other conversations I may have mentioned on the podcast before, so I’ll be brief. I spoke to Ben Bernanke, former chairman of the Federal Reserve, in Korea not long ago. Shortly thereafter, I spoke to John Lipski. John is an interesting figure. He was the only American ever to head the IMF, which is odd because the deal at Bretton Woods stated that an American would head the World Bank and a European or non-American would head the IMF. How on earth do you get an American head of the IMF? It’s never happened.
The answer is it happened once when Dominique Strauss-Kahn got arrested and had to resign under dubious circumstances, to say the least. They weren’t ready with a successor, so John stepped in. He was the first deputy managing director, so in effect he became acting head of the IMF.
I spoke to both of them, head of the Fed and head of the IMF, 9000 miles apart, in two separate conversations. They both used the same word to describe the international monetary system. They said it’s “incoherent.” I knew they didn’t rehearse that for my benefit. I knew that that was in the air. Incoherent just means no anchor, no rules to the game, and that’s exactly what Claudio Borio said last week.
Basically, the whole world wakes up and every day is jump ball. We don’t know what currencies are worth. We don’t know who’s up or who’s down. Part of the reason there’s a flight to gold is because at least with gold you have a little bit more confidence in it. They’re not printing any more of it and mining output is only about 1.6% a year, so the physical supply doesn’t go up that much under the best of circumstances.
Borio also said effectively that the international monetary system is incoherent, there’s no anchor. He referred to the SDR (Special Drawing Rights) which is the world money issued by the IMF. This was an all-day monetary conference with other speakers including William Dudley, president of the Federal Reserve back in New York.
Borio made reference to the fact that some of the speakers were referring to SDRs. He said, “Why is the SDR any more of an anchor than anything else?  What is the anchor for the SDR?” I think it’s a very good question. He just raised it rhetorically and didn’t answer it, but of course, there is no anchor. Left hanging in the air is gold. Gold has been an anchor.
Special Drawing Rights is a misleading name. Just think of it as world money and it’s really easy to understand. SDR is world money printed by the IMF. The IMF has a printing press and can print these SDRs and hand them out, so don’t let the funny name or the initials SDR throw you off. It’s world money printed by the IMF out of thin air, is handed out to the members, and gets used like any other kind of money. It’s not that hard to figure out.
Interestingly, when the SDR was invented in 1969, it was convertible into gold. The definition of an SDR was a fixed weight in gold, and they actually called it paper gold. It was meant to expand reserves at a time when the US was still on the gold standard. Well, they got rid of that within two years. When the US abandoned gold in 1971, the IMF abandoned the gold linked to SDRs very shortly thereafter sometime around 1972 or so. Now the SDR is just another fiat currency.
I’ve hypothesized this in my books and in particular chapter 11 of The Death of Money. You could have a gold-linked SDR with some reference to gold. That would address Borio’s argument, and obviously, once you do that, if you want to avoid deflation, you’re talking about much, much higher prices for gold.
I’ve said publicly that I expect gold to go to $10,000 an ounce, which I do. When I say that, it’s not a number I pull out of the air just to attract attention or to be provocative. It’s actually the implied non-deflationary price and the lowest price gold would have to be in a gold standard to avoid deflation. Any lower dollar price for gold would be deflationary and a blunder. It would throw the world into a recession if not a full-blown global depression that you couldn’t get out of. I’m not saying you have to have a gold standard; I am saying that if you have a gold standard, you have to get the price to at least $10,000 an ounce.
Going through all these hedge fund mavens, professors like Ken Rogoff, economists like Claudio Borio, and others, this is very much front and center in the elite conversation today."


Dr. Coats Comments on Gold Backing Earlier This Year


Q: Would you view your proposed 'Real SDR' currency as still being a fiat currency even though valued using a 
basket of goods and commodities?

A: I don’t consider the designation of a currency as fiat (or not) as very useful.  I prefer to classify monetary regimes as those with a hard peg (redeemable for something else for a fixed and know price, as with the SDR valuation basket) or a soft peg (exchangeable at fluctuating market rates, as with a money growth rule or an inflation target).  All legal tender money can be used to pay taxes, the amounts of which are fixed in amounts of such currencies.  This establishes one source of its demand and market value.

Q: Some readers will of course want to see any new global reserve currency backed by gold instead of being
a fiat type currency. What are your thoughts on that view? Do you think China has any preference to see
gold re-enter the monetary system in some way?

A: See my comments to 5 above.  The choice is between fixing the price of the SDR to an amount of gold (as it was initially) or to a broader basket of goods and or commodities.  The price of gold has not been very stable.  I would prefer, and I think most people would prefer, fixing the price of the SDR to a broader basket of goods rather than to just one such as gold.

Q: A question I get from readers is why would the public trust a new version of a fiat currency if the existing 
US dollar version were to collapse in a crisis? What could be done to restore public confidence in a new
version of a fiat currency? 

A: The Real SDR Currency Board I propose would, like other existing currency boards, be fully backed with assets equal in value to the SDRs issued.  That is also true of the U.S. dollar and most other currencies, but the Federal Reserve is not obligated to redeem its currency at any particular price.

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My added comments: When I research the various views on this topic (future gold backing for the yuan or the SDR) I find three prominent views. 

One is the belief that China is quietly planning what would amount to coup to replace the US dollar with a gold backed yuan or SDR. Here is a recent article that shows you an example of that view by William Engdahl

A second view is that both China and the IMF (West) may eventually agree to a gold backed SDR of some kind. In this view the yuan is not viewed as a viable currency to replace the dollar, only the SDR. This is the view that Jim Rickards talks about above. Please note the comments I put in bold type in Jim Rickards statement above. Jim took a very nuanced position in his answer. Although he speculated about some kind of future gold backed SDR and tied that in to what Claudio Borio said in his recent speech, please note that Jim stated clearly that Claudio Borio did not refer to gold as the future anchor for the SDR. In his speech Mr. Borio simply said that at present there is no anchor to the SDR of any kind. Also, please note that near the end of Jim's answer he says, "I'm not saying you have to have a gold standard . . ."  

I wanted to make that clear because even though Jim talked quite a bit about the idea of some kind of gold backing to the SDR, he did not say there is any official plan to do that or that he knows that it will happen. He just speculates that it is a possible way to anchor the SDR in response to the question raised by Mr. Borio in his speech. This is important to emphasize because right now I know of no official plan of any kind to put the SDR or any other global currency contender back on a gold standard. If such a plan exists, it is a truly secret plan that I have no knowledge of.

Lastly (the third view), whenever I get input from anyone I would view as an expert with experience and connections inside the global financial system, they tend to talk about the SDR as a possible global reserve currency without any official gold backing. Dr. Coats has a specific proposal we have covered here that would use a basket of goods based on an index (see question #4) rather than just gold and you can see his comments on this directly above.

I don't know which alternative is more likely to evolve if we do get a so called "reset" of the monetary system and the US dollar is replaced as global reserve currency. I believe that the most important factor for any currency is that the public has trust in it. Therefore, I guess that any of the above alternatives could unfold depending on what the public would trust and accept. That is a complete unknown to me. First we have to actually have some kind of "reset" for it to matter anyway. So far no reset has taken place and I know of no plan for a reset any time soon. I have speculated that another major financial crisis could change that.

I follow a lot various information sources in an effort to stay as informed as I can. What I can report is that without question there is a lot "smoke" (speculation) that gold will be used again in some way to back a new global reserve currency. What I am waiting to see is if there is really a "fire" (a real plan) behind all the smoke or not. I don't have the answer, but above you can read and compare the views of two leading experts who have talked about it recently. You can decide for yourself if Chinese Governor Xiaochuan was thinking of gold or not in his 2009 paper on the SDR when he talked about "a system backed by real assets."

Added notes: Here is an OMFIF work paper (2013) relevant to this topic commissioned by the World Gold Council. (foreword by OMFIF Advisory Board Chairman Meghnad Desai). This article on the World Bank web site suggests that a multi reserve currency system (dollar, euro, renminbi) is most likely to replace a US dollar dominated one by 2025. Also, Jim Rickards will debate gold with Barry Ritholtz on Bloomberg TV on June 23rd (4:30 ET).

Additional added notes: After reading this article Willem Middelkoop pointed me to two additional studies that have been done on gold related to the SDR. This first one looked at including gold for backing of the SDR and was done at the request of China Willem tells me. The second one also looked at using gold in SDR valuation. It was done by Catherine R. Schenk (U. of Glasgow). Neither study endorsed using gold as the sole backing for the SDR in its conclusions (see pp. 28-29 of the first study). The second study mostly noted what impact gold would have on the value of the SDR had it been included in recent years.

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