The global economy, propped up with credit, is likely to go down in flames. The only insurance is gold.
The recent hike in gold prices after a drastic fall last year serves to reinforce the position of gold as a safe monetary asset in an increasingly uncertain global economy. Chart I (KITCO) shows the rally in gold from December onwards with current prices hovering about $1382 per ounce. Despite a slight correction in March, amid expectations of the Fed tapering it’s quantitative easing (QE) program and announcing rate hikes, the rally in gold prices continues unabated.
While detractors like to credit the ‘rise of gold’ to the woes of emerging market economies, the Ukraine crisis and lackluster US economic data, it can be argued that the story goes much deeper.
The US Dollar has long enjoyed the position of being the world’s reserve currency. Oil-producing nations traditionally pegged their currencies to it hoping to import low inflation and also because the United States was traditionally their largest bilateral trading partner. As a result, crude oil, which is arguably among the world’s most valuable commodities, continues to be priced and paid-for in US dollars.
However, this scenario seems to be changing rather fast in the aftermath of the post-2007 economic crisis coupled with the emergence of Asian and Latin American economies. The fall of the dollar in the Middle-East started when Kuwait dropped its currency peg in 2007. In nearby Qatar, which incidentally is the world’s largest Liquified Natural Gas (LNG) producer, senior Qatar Central Bank officials have been exhorting GCC nations to drop their dollar peg to tackle rising inflation. After the West imposed sanctions on Iran, reports suggested that India had offered to pay for Iranian gas in gold.
It can be clearly seen then that any international diplomatic incident would have far-reaching effects on the position of the US dollar in the world economy. With the looming Ukraine crisis, it remains a real possibility that Russia, which is among the world’s largest gas exporters, might begin demanding payments in an alternate currency. China, which has been reducing its dependence on the US dollar for the past few years, might follow the Russian example and switch to an alternate currency (probably the Yuan) for accepting trade payments. (It is already siding with Russia on the Ukraine issue). In fact, Sergei Glazyev, an adviser to the Russian President, was recently quoted saying: “We hold a decent amount of treasury bonds – more than $200 billion – and if the United States dares to freeze accounts of Russian businesses and citizens, we can no longer view America as a reliable partner. We will encourage everybody to dump US Treasury bonds, get rid of dollars as an unreliable currency and leave the US market.”
Meanwhile, China has been preparing for this eventuality for a decade or so. It has established bilateral trade agreements with numerous countries (including Russia, India, Australia, Brazil, Germany, Japan, etc.) in lieu of using the Dollar as a reserve currency; and is now changing regulations to make its own currency more acceptable to its trading partners.
The current geopolitical tensions are bringing forth what the economists already see as inevitable—the demise of the dollar and a radical change in the current global economic equation, which has so far allowed surplus credit to grow unchecked.
The Gold Standard
Historically, gold one of the oldest global currencies has gone up when global uncertainty makes risk appetite lower, like now. According to the Austrian School of Economics, gold is the only “monetary” asset that is not another entity’s liability. Every other form of “monetary” asset is effectively some other entity’s liability. Or as the World Gold Council puts it: gold is the only asset that carries no credit risk.
With geopolitical uncertainties and fears of slow economic growth playing on investor’s minds, gold prices have spurted, almost touching the highest-ever quarterly gain in 27 years.
Should the Russians decide to respond to the economic sanctions by dumping of their dollar reserves and accepting gold bullion for payment for their gas, oil and other commodity exports, it could lead to fall of dollar prices and a further rise in the prices of gold. It is possible that one diplomatic skirmish might overturn the entire global currency system, which has been on the brink of collapse for a while. If this happens, several countries might have to revert to the gold standard (pegging their currency to an actual physical asset like gold rather than another currency i.e. the Dollar) till the global systems stabilize.
The world has been preparing for such a scenario (destabilized global economy) for the last few years. This can be clearly seen in the aggressive accumulation of gold by the central banks of various countries. Collectively, the central banks around the world have increased their purchases of gold 31,800 tonnes in 2012 (as per data provided by the International Monetary Fund).
Both Russia and China have been the most aggressive in accumulating gold. In fact, China has overtaken India as the largest consumer of gold, increasing consumption to about 1200 tonnes in 2013. The Chinese government is said to have acquired about 500 tonnes indirectly though imports in the last one year.
The India Story
India as a country consumes gold differently than the rest of the world. Unlike other countries where Central banks invest in bullion as a hedge against currency fluctuations, in India, gold is consumed at an individual level. Indians, who have been the world’s largest consumers of gold (till China stumped us last year), understand the inherent risk protection the metal offers, especially in the domestic stagflation prone economy.
According to Mr C Rangarajan, chairman, Economic Advisory Council to the Prime Minister, Gold is a ‘non-productive asset’ that keeps undermining the country’s balance of payments. But neither his disapproval (of the individual Indian’s conspicuous consumption of gold), nor his suggested additional duty on import of the yellow metal has kept Indians away from it. In fact, gold buying in India seems to continue unabated, through official or unofficial means.
Currently, Indian consumers are paying almost 18% more for Gold than the world prices. Given the global scenario and easing of higher duties on the yellow metal import to India, the world prices might catch up with the local prices much sooner than imagined. Or the import duties might be eased and ‘official’ consumption will soar leading to increased ‘official’ demand.
And, if it ever comes down to it, the RBI could be forced to move to the gold standard by simply offering to buy gold from the country’s citizens (at market prices), thus insuring investors in gold against any fallouts of such a changeover.
Whichever way one looks at it, the price of gold is going to be a whole lot higher than the price we see today. With gold prices going through a minor correction right now, it is an opportune time to stock up on the yellow metal.