Herbert Poenisch: Creeping Gold Standard?

2017-10-09 IMI

Herbert Poenisch, Member of IMI International Committee, Former Senior Economist of BIS The question ‘what to do if the USD collapses’ has busied brilliant minds for decades. This is reasonable, as the collapse of any system requires precautionary preparations for the survival of individual members. In case of the International Monetary System boosting the stock of gold reserves by central banks has been seen as one safe away for ensuring survival in case “if”. China, among other countries[i] has been reported to be doing this. Another way of gradually weaning countries off the predominance of the USD has been the internationalisation of RMB. The inclusion of RMB in the SDR was a signal. Although the pace has slowed recently, the direction is unchanged[ii]. There is a combination of both, invoicing and payment in RMB and conversion into physical gold, both without having to resort to USD. Recent reports, such as by Nikkei Asian Review suggest that China is expected shortly to launch a crude oil futures contract priced in RMB and convertible into gold. The existence of RMB-backed oil and gold futures means that users will have the option of being paid in physical gold[iii]. While this is commendable, this has been hailed prematurely by some as a return to the gold standard. This short note will put this in perspective. While denominating gold futures in RMB is well on the way through the Shanghai gold exchange (SGE)[iv] since its inauguration in early 2016, the denomination of future commodity contracts is in its early stage. Commodity pricing is increasingly moving to China[v], but the launch of China’s first oil futures contract in RMB has been delayed[vi]. The Shanghai Futures Exchange (SHFE) released details of the crude oil futures in May[vii] but it is unclear when the contract would actually start to trade[viii] . Future contracts on RMB versus the USD are available for CNH in Hong Kong and Singapore but not yet for CNY on a big scale[ix]. Bearing in mind the three functions of a currency, denomination, exchange and store of value, the first one, denomination is not controversial and should not give rise to any deeper concern. Therefore denominating future energy and future gold in RMB will not topple the USD any time soon. Actual payment and clearing in RMB is a step further and could have far reaching impact on foreign exchange markets by fundamentally changing supply and demand of a currency. Even as these future contracts are denominated in RMB, the impact of a surge of supply of RMB and the current clearing facilities, such as CIPS are not up to the job of allowing a major shift to be paid in RMB. It is highly uncertain whether this surge of RMB in international markets and its implication is accepted by Chinese authorities. Assuming that future energy contracts will lead to major payments in RMB to suppliers such as Saudi Arabia, Russia etc it remains to be seen what they in turn will do with these receipts. In the best case they will purchase Chinese exports. If not, will they add the RMB to their foreign exchange reserves boosting internationalisation of RMB? Will they invest in RMB denominated securities, or purchase physical gold as would be possible through Shanghai gold futures? Will these contracts be limited to the suppliers of energy to China or open to other market participants? If other market participants could purchase these future contracts, verification of the underlying current account transaction, to prevent speculation and hidden financial transactions would be a major challenge. From the point of view of crude oil exporters, their calculations will have to take into account three sets of prices, the future crude oil price, the future gold price and the future RMB exchange rates and match them with corresponding USD prices. This will open the doors for a lot of arbitrage! Now, finally to the backing in gold. The crucial question is whether this is to be done at market prices or fixed prices. If the settlement will take place at future gold prices in RMB in Shanghai, this would not be a major game changer. The major implication for China would be to ensure that a required amount of gold for RMB would be available at the SGE at a future date. The best way is to ensure is a wide participation in the market to reduce the risk that China as last resort might actually have to supply physical gold. The major risk for RMB as for other currencies would be a rebalancing of the world supply of gold with the vastly expanded amount of global currencies (USD M2, EURO M2 and RMB M2) as part of global liquidity. This rebalancing could lead to astronomical gold prices[x]. However, in case of a collapse of the current international monetary system, such a mopping up of excess liquidity needs to be done once and for all. Such a rebalancing would be too painful for the world’s real economies. Therefore future exports of energy could be expressed in physical gold (there is no such open discussion at the moment) at a fixed gold price in RMB. In that case the gold standard would creep back, with major negative implications for China. Although China is the major gold producer in the world[xi], it would be premature to give such a unilateral guarantee for the rest of the world. The discussion of pros and cons of the gold standard during the Bretton Woods system should be revisited[xii] before considering such a move. While both these alternatives are highly risky for the foreseeable future, gold can be brought back another way to play a role in the financial system. What seems more reasonable, bearing in mind that all of the BRICS countries are gold producers, and in the case of India a major gold consumer is a sharing of responsibilities of moving to a gold standard. As the BRICS communique of September 2017 suggests[xiii], LC (local currency) bond markets should be encouraged. Issuing LC bonds could be supplemented by a clause linking the repayment of the debt with a certain amount of gold determined by the future gold price at the date of redemption. Trading these LC bonds would be on the BRICS LC Bond Fund, similar to the Asian Bond Fund 2[xiv]. The central banks of BRICS countries which would buy these LC bonds would have some assured equivalent of gold, as alternative to the LC of their partner countries. This arrangement could then be opened to other central banks, sovereign wealth funds and other qualified institutional investors. This would be a modest step towards a sort of new gold backed standard which the markets should welcome as a concerted action with contributions from major gold producers. [i] Rickards, James (2014): The Death of Money, p226. Penguin Random House, UK [ii] International Monetary Institute (2017): Report on the Internationalisation of RMB www.imi.ruc.edu.cn [iii] Nikkei Asian Review (2017): China aims for dollar-free oil trade. 14 September 2017. www.asia.nikkei.com [iv] South China Morning Post (2017): Shanghai Gold Exchange to offer RMB-backed futures contract in Budapest. 21.June www.scmp.com [v] Financial Times (2016): China launches RMB-denominated gold benchmark. 19 April www.ft.com [vi] Financial Times (2016): China’s ambitious oil future contract delayed. 14 September www.ft.com [vii] Shanghai Futures Exchange (2017): Futures Daily: Contract Specifications and Detailed Regulations of Crude Oil Futures Officially launched 12 May www.shfe.com.cn [viii] Reuters (2017): China plans Shanghai crude oil futures launch in H2 2017-sources. One sticking point is the conversion in foreign currency.18 April www.reuters.com [ix] Limited RMB futures for QFII investing in RMB bonds. See Herbert Poenisch: RMB hedging foreign exchange risk. In: IMI Review, April 2017 www.imi.ruc.edu.cn [x] Rickards, James (2012): Currency wars p 243. Penguin Books, London [xi] World Gold Council (2017): Gold mining map. www.gold.org [xii] Good coverage in the history of the BIS up to 1973. Toniolo, G and Clement, P (2006): Central Bank Cooperation at the BIS, 1930-1973, Cambridge University Press. [xiii] BRICS (2017): BRICS Leaders Xiamen Declaration, article 10. 4. September www.brics2017.org [xiv] ADB(2017): Asian Bonds Online www.asianbondsonline.adb.org

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Herbert Poenisch: Creeping Gold Standard?

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