Commodities | Oct 07 2009
By Greg Peel
At the end of World War II, the major world economies signed the Bretton Woods Agreement, pegging all currencies to the US dollar as global reserve currency. The US dollar was in turn pegged to gold. The signatories had little choice, as they were either the vanquished at the hand of the Americans or the victors who owed America significant amounts for its help. In 1972 the Gold Standard was dropped by President Nixon, and all currencies were marked against the reserve currency of a US dollar backed only by US economic might. Since then, the US has been in constant debt.
In more recent times, countries such as China and America’s Arab allies in the Persian Gulf, including Saudi Arabia, Abu Dhabi, Kuwait and Qatar, have chosen to peg their currencies either directly or in a range to the US dollar. In the case of the oil-producing nations, the denomination of oil trade in the reserve currency determined that the value of oil was controlled by the actions of the US government and Federal Reserve. The US has always maintained a “strong dollar policy” by fair means or foul, thus controlling the value of oil exports from the Gulf, and indeed all OPEC states.
In 1974, OPEC revolted against America and cut off oil supply. The price of oil surged in dollar terms, thus sparking a recession in the Western world and a surge in the value of gold in US dollars as the relative value of the dollar fell. The US was technically bankrupt from fighting the Vietnam War, which is why Nixon unilaterally dumped the Gold Standard. When the Shah of Iran was deposed in 1979, the price of gold leapt exponentially, eventually peaking out at US$850/oz in 1980. There are various means by which one can calculate the equivalent in “today’s dollars” of US$850/oz in 1980, but one measure puts it at US$2,300/oz.
America is by far the greatest consumer of oil on the planet, and despite being a significant producer as well the US economy is totally reliant on oil exports from both its allies, such as Canada, Mexico and the aforementioned Arab states, but also its enemies past and present including Iraq, Iran, Sudan, Libya and Venezuela. That is why the ability to control the price of oil is of vital importance to the US economy. But as oil’s surge to US$147/bbl last year proved, America’s influence over the global economy is giving way to that of emerging economies, including Brazil, Russia, India and China (the BRICs).
The onset of the Global Financial Crisis only served to highlight the perilous state of US indebtedness to the rest of the world, and the global economic imbalance caused by currency pegs. At one point pre-GFC, economists suggested that the Chinese renminbi was undervalued to the US dollar by as much as 40%, and figures of over 20% are still touted today. If the US suffers from monetary inflation and a depreciation of the dollar, due to its excessive debt issuance, then down go China and the Arab States as well.
While China is yet to catch up to the US in terms of oil consumption, it is accelerating fast. China now imports 60% of its oil needs, much of it from the Middle East and Russia. China has no truck with any of America’s enemies, such as Iran, Sudan, Libya or any South American recalcitrants, and yet all of the above are forced to trade oil denominated in US dollars. Iran has already declared it will hold its oil receipts in euro, but it is still beholden to a US dollar price. In short, global trade in oil has expanded well beyond the largely one-way traffic of the seventies, yet the US is still effective arbiter of the global oil price. And the US is not just “broke” post the GFC, it is spiralling into greater and greater indebtedness.
Earlier this year, China and Brazil signed a major deal in which China would fund the exploitation of Brazil’s significant deepwater offshore oil reserves in return for a long term off-take agreement. The significance of the deal was that the two countries agreed to transact on the basis of the real against the renminbi, thus cutting out the US dollar. In the meantime, the aforementioned Arab states of Saudi Arabia, Abu Dhabi, Kuwait and Qatar have been planning the introduction of their own basket currency, along the lines of the euro, to replace individual US dollar pegs.
The BRICs have also pledged to purchase initial issues of the International Monetary Fund’s new multi-currency bond, while at the same time hinting they would be willing buyers of the 403t of gold the IMF has leave to sell over the next five years. Such purchases are an alternative to the past practice of sinking the bulk of foreign holdings into reserve currency debt issues.
Whichever way you look at it, the rest of the world is acting quietly, and often stealthily, to remove itself from the influence of the reserve currency. That is why the US dollar has been weakening substantially this year, because a move away from the US dollar implies the end of the rest of the world’s inclination to support the US economy by buying its debt.
It is in this environment that yesterday’s bombshell was dropped.
An article in the UK newspaper The Independent, published yesterday, cited Gulf Arab and Chinese sources in revealing that the two parties, along with Russia, Japan and France, had been involved in secret meetings. The result of the meetings is a nine-year plan to end the inter-dealing of oil in US dollars and instead move to a basket of currencies. That basket would be comprised of euro, yen, renminbi, the new Gulf Arab basket currency, and, most significantly, gold.
That’s why gold shot up US$25 last night to a new high around US$1042/oz, surpassing the previous record nominal high set in May 2008 of US$1033/oz.
The US is believed to be aware of the meetings, according to the article’s author Robert Fisk, but to date has been unaware of the details. One thing is for certain – America is not going to sit idly by. But Chinese officials believe President Obama is too busy trying fix the US economy, Fisk notes, to worry about a currency upheaval that is intended to be nine years in the making.
It may all be academic anyway. Saudi Arabia’s central bank governor Muhammed al-Jasser is currently in Istanbul for the IMF summit, and in response to reporters’ questions on The Independent article he last night suggested the report was “absolutely incorrect” and that there has been “absolutely nothing” of such a nature discussed between the world’s biggest oil exporter and anyone else.
Bloomberg quotes one HSBC economist in Dubai as stating “I don’t give any credence to this story”. Japan’s finance minister responded that he “doesn’t know anything about it”, and further denials came out of Russia and Kuwait.
Clearly the gold market is not so sure. Gold shot up to US$1045/oz once the northern hemisphere got hold of the Independent article last night, but while it slipped back to under US$1040 on the back of denials, it is still trading around US$1038 in the Asian time zone as this article is being written. That’s still around US$20 higher than the New York close on Tuesday morning. The US dollar, however, failed to break through its twelve month low of 76 on its trade-weighted index last night, and closed off the session’s lows.
While the denials have flooded in, we will have to wait and see whether they were simply a response to being “sprung”. At the end of the day, all the countries implicated hold US dollar reserves, some massively so, and thus it is not in their interest to see US dollar depreciation in anything other than an orderly fashion over a reasonable time period (nine years?). For gold traders however, the breach of the previous high is a strong technical signal that the long-awaited push towards US$1100/oz and beyond has begun.
For all other countries measuring the value of gold in their own currencies, a push towards US$1100 is tempered by local currency appreciation against the US dollar (as is the case for the oil price and the price of other commodities). The Aussie is on its way to US$0.90 it would seem, aided by yesterday’s decision by the Reserve Bank to begin tightening monetary policy post the GFC stimulus.
If the US dollar continues to fall against the Australian dollar, then the Chinese renminbi will fall with it as a result of its peg. A weak US dollar is thus not in the interests of Australia as a significant exporter to China, as the currency shift undermines the value of export profits. But for the plan outlined by The Independent to have any level of success in its intent, it will be incumbent upon China (and the Gulf states) to release the renminbi from its peg and allow it to float freely against the reserve currency.
Were China to enact such a release in one fell swoop, the ramifications for the Chinese economy would be devastating. China’s hopes to restart its export economy would be scuppered, and the value of the country’s foreign reserve surplus, that which is funding domestic economic stimulus, would be crushed. Thus it is in China’s interests to continue with its longstanding “softly, softly” approach to financial reform, and to approach rebalancing as a long term goal.
So it is unlikely, on the assumption the Independent article is true, that a major US dollar collapse is upon us. However, the growing boldness of the rest of the world to undermine US hegemony (despite the US still being far and away the world’s superior military power) suggests that the days of US financial control of the planet for its own benefit are likely numbered.
