India’s central bank, Reserve Bank of India, announced on Nov. 2, 2009 a purchase of gold from the International Monetary Fund (IMF):
"The Reserve Bank of India (RBI) has concluded the purchase of 200 metric tonnes of gold from the International Monetary Fund (IMF), under the IMF’s limited gold sales programme. This was done as part of the Reserve Bank’s foreign exchange reserves management operations. The purchase was an official sector off-market transaction and was executed over a two week period during October 19–30, 2009 at market based prices."
By my calculation, the bank disposed of about 2.3 percent of its June 30, 2009 foreign currency assets or about $7 billion worth, expressed in dollars. These assets grew tenfold between 1998 and 2007, and by only 20 percent since then. RBI’s gold reserves, at market value, were 3.85 percent of the total foreign currency assets before the purchase. They jumped by 60 percent. They become about 6.3 percent of the new lower amount of foreign currency assets.
We don’t know how many dollar assets RBI disposed of as compared with pound and euro assets. It’s likely to have been a large amount.
This transaction has a significant meaning that goes well beyond the dollar amounts involved, which are not that large. It means that a major central bank has actually disposed of dollar assets and prefers gold instead. It means that it regarded its dollar holdings as excessive. There are more central banks in the same position. They may do the same. China had been suggested again and again as the potential buyer of the 403 tonnes of gold to be offered by the IMF. India’s purchase was a surprise.
In financial terms, RBI is not simply adjusting its reserve position. It is arbitraging. It has a profit incentive to sell dollars and buy gold. In a recent article, I suggested the following:
"There is another way to arbitrage the difference between the market price of gold and its ZDV [Zero Discount Value] when the market price is less than the ZDV. Other central banks can borrow dollars, buy gold, and then issue currencies against it. With these currencies, backed by gold, they can repay the dollar borrowings and still have a profit. They can gain the arbitrage profits in precisely the same way that the FED might have or that private entrepreneurs might have."
RBI and other central banks hold dollars whose nominal gold backing is about 15 percent of the FED’s monetary base liabilities (currency plus reserves). RBI sells $1,000 worth of U.S. securities and gets 1 oz. of gold. The $1,000 that it gives up have only $150 worth of gold behind them. RBI profits by $850. The article pointed out that this arbitrage is an economic incentive or force for selling of dollars and buying of gold. RBI has availed itself of this opportunity.
The article observed that foreign central banks and governments, for their own reasons, had spurned this opportunity in the past, thereby maintaining various economic disequilibria:
"MANY foreign central banks have done the opposite. They sometimes have sold gold. They have usually accumulated dollars in substantial amounts in the form of dollar loans. They have not only not competed with the FED and taken advantage of this arbitrage opportunity, they have gone the other way and supported the FED and the U.S. government by their loans. This was one part of the financial side of government-run economic policies."
RBI’s action signals a change in this behavior. It is a fresh signal, since we already had been given others. The arbitrage between dollars and gold is so large that it is bound to draw further players into it. The dollar is on its way to losing its reserve status.
Does India’s purchase signal a run on the dollar? Does it signal a rapid and widespread attempt by major players to divest the dollar in favor of hard assets? Not at this time. Bear in mind that China has already been accumulating hard assets for a few years now. There is no run on the dollar, but there is a steady movement away from dollars as a reserve asset in the coffers of central banks. A stroll on the dollar has become a brisk walk on the dollar, and there is a threat that this will become a trot on the dollar.
In economic terms, the end of dollar dominance has momentous implications for the world’s political and economic arrangements. Price levels, interest rates, loans, asset prices, production facilities, trade arrangements, and much else all have been put into place based on the dollar as a reserve asset. Domestic political arrangements, promises, taxes, and programs are involved. All of these are in for adjustments. Some serious changes await us. Even if the changes are smooth and gradual, they are likely to be large. Large discontinuous changes cannot be ruled out.
A dollar overhang is a sword of Damocles hanging over the U.S. government and economy. If a surplus of dollar securities exists at current prices, then their prices will have to decline. This will drive U.S. interest rates up. This has many implications. For one thing, it will drive the U.S. budget deficit up even further, which in turn will set off untold political actions and reactions.
Dollar overhang is not a new problem. It goes back to 1971 and earlier. It has never been solved. The problem is now far larger than ever before. If a scramble for new solutions is not already on among economists who are trying to save this system, it will be soon enough. We can expect to hear new ideas broached, each of which is supposed to resolve the problem.
There are only two kinds of solutions: inflationary and non-inflationary. A British pound as good as gold is long gone. A U.S. dollar as good as gold is long gone, but the dollar has hung on for 37 years now. A yuan as good as gold does not exist. A basket of currencies as good as gold does not exist. The inflatable dollar and inflatable currencies are ruling the roost at present. India’s action and some of China’s actions signal that they are inching – really groping – their way back to hard assets and a non-inflationary solution.
China’s IMF proposal indicates a degree of confusion on her part. It is at best an attempt to buy time and gain political influence, but it does not address the international monetary problem. The IMF solution won’t work if the SDR is backed up by paper currencies or is a paper currency basket. There is no way that all the central banks can offload their dollar reserves on the IMF. What good will it do to receive another paper credit, the Special Drawing Right (SDR) in return? It especially won’t work if the IMF is selling gold reserves, for that weakens the backing for its supra-national currency, which is the SDR. RBI’s purchase shows that at least one central bank is not waiting for such a "solution." It prefers gold.
The world’s State-controlled money system based on the dollar has built up serious and embedded economic imbalances or disequilibria. They are what lay beneath the stock and real estate bubbles and the market crashes of 2008 and 2009. They are just beginning to be unwound. Political and economic statements, trial balloons, conferences, speeches, negotiations, and frictions among the major powers will be the ongoing indications of this process. So will actions like that of the Reserve Bank of India.
Viewed in this context, U.S. fiscal and monetary policies seem grotesquely out of step with reality. Yet another bout of massive inflation and debt creation in order to "create" a buoyant economy does nothing to address the basic political economic issues. While America ponders further socializing health care and further controlling and taxing energy use, it continues to debase its currency. This used to provide U.S. pressure for other countries to inflate their currencies. That situation appears to have changed. It now provides ever-greater incentives to other countries to abandon the dollar and revalue their currencies upwards against the dollar and gold. American legislators have not yet woken up to this fact, which entails serious changes in U.S. domestic and foreign policies.
Frm- Michael S. Rozeff(retired Professor of Finance)
