Commodities | Jul 07 2009
By Greg Peel
Last night on Wall Street the markets opened weaker, led down by falling commodity prices. Commodity prices are now considered to have run too far too fast and there is little surprise in a pullback. In a wider sense, commodities are a proxy for the general global economy, which has yet to confirm the faith global stock markets have placed in an impending recovery.
The fall in commodity prices and the stock market sparked a rush back into the US dollar. It is the feature of any return of risk aversion that funds flow back into the reserve currency. Commodities are sold for US dollars. Stocks are sold for US dollars. Emerging market investments placed by US funds are sold for US dollars. There are no two ways about it – the US dollar is simply the well-entrenched global reserve currency.
But it is also a reserve currency poised to lose its value as soon as risk appetite returns with a level of confidence. (See The US Dollar’s Downward Path published yesterday.) With the cash rate in the US now at zero, the US dollar provides the perfect funding mechanism for investment into dollar alternatives – real commodities, gold, emerging market stocks, commodity currencies such as the Aussie dollar. The world agrees that when the global recovery comes, it will feature a very slow turnaround in developed economies as the deleveraging process continues, but a potentially rapid turnaround in emerging economies which have little deleveraging to achieve and significant upside in domestic economic growth. This dichotomy implies that global recovery will only result in endemic weakness for the reserve currency. Just as Japan has experienced over the past two decades, the US dollar has become a carry trade currency.
The expectation of ongoing potential weakness in the US dollar is further supported by America’s US$4 trillion of national debt – a figure that grows monthly and will continue to do so until stability is confirmed in the US economy. This historically unprecedented and almost unfathomable total is the reason why emerging economies, many of which carry current account surpluses, feel they should not be hindered by massive reserve currency debt. Thus the move is on across the globe to quietly diversify foreign currency holdings out of the dollar. At present, some 70% of global foreign currency reserves are held in US dollars.
But the operative word here is “quietly”. Given 70% of all foreign reserves are held in US dollars, any move to dump dollars will only be self-defeating. It is thus understood that the dollar will remain the reserve currency for some time yet. That hasn’t stopped emerging economies persistently stating their desire for a more diversified reserve currency to take over one day. And such statements continue to make currency markets jumpy. There is a G8 meeting in Italy this week, which will also be attended by various non-G8 representatives. US investors have been worried that the BRICs and co will use the opportunity to again push for reserve currency diversification. But last night opinion swung the other way, and now support for the greenback is expected. In the latest round of to-ing and fro-ing from Chinese officials, the Chinese vice foreign minister stated in Rome:
“The US dollar is still the most important and major reserve currency of the day, and we believe that that situation will continue for many years to come. You may have heard comments, opinions from academic circles about the idea of establishing a super sovereign currency. This is all, I believe, now a discussion among academics. It is not the position of the Chinese government.” (Reuters)
If only that were to be the last word. One presumes a vice foreign minister has diplomacy on his mind, whereas most of the dollar criticism stems from the finance department.
Such affirmation quells the fear of dollar traders, and further comments in Rome from the likes of European central bank president Jean-Claude Trichet that it is “extremely important” the US stay committed to a strong dollar suggests a certain level of solidarity among the G8. (Incidentally, it is China that makes the previous G7 now a G8). But leave it to France in particular to undermine a committed stance. France’s economy minister stated in Rome:
“We should explore a better coordination of foreign-exchange policies, which would raise the question over the medium term of the balance of exchange rates and the role of currencies that have changed both as a result of the crisis and the role played by emerging market countries.” (Reuters)
Pass me the Freedom Fries. Yet France is only stating the bleeding obvious, and G8 meetings are famously all about handshakes, smiles and “united we stand” platitudes when in reality each nation then leaves to go and do whatever it damn well pleases.
And it pleases India – to date relatively silent among the BRICs in the reserve currency debate – to diversify its foreign currency surplus away from a heavy weighting in US dollars. India holds a high percentage of its reserves in dollars, and “this is a problem for us,” said the chairman of India’s Prime Minister’s Economic Advisory Council over the weekend. It is now India’s intention to alleviate that problem to some degree.
One way to do so is to buy newly issued IMF bonds as a substitute for US bonds. The IMF bonds – available only to sovereign authorities – are denominated in a basket of currencies and have already attracted buying from the likes of China, Russia and Brazil. But let’s face it – the basket contains 40% US dollars anyway, as well as euro, yen and pounds. Legacy “Western” currencies are not exactly an encouraging investment solution in the current climate. But then, what is?
Enter gold. If ever there was a “commodity” which offers an alternative to all “currencies” then it is gold. But there are a couple of problems with gold. And those problems explain why, despite all this talk of reserve currency diversification, gold has managed to reach towards US$1000/oz in 2009 but has since stalled.
Firstly, unlike sovereign bonds, gold provides no income return. (It can to a small degree if “lent” but that is not important for this discussion.) Secondly, gold is also the global inflation hedge and the general panic safe haven – or the hedge against all paper financial instruments.
As an inflation hedge, gold will not distinguish between currencies but rather focus on the reserve currency. Emerging markets may be due for a rise in inflation as they look to build their domestic economies but the “West” is still very much in the grip of deflation. The world might be concerned about ultimate inflation stemming from all the quantitative easing going on around the globe at present, but until deflation is conquered such strategies are simply not a threat. Thus while the bulk of analysts still see gold hitting US$1200/oz some time in the future, it won’t be tomorrow.
As a safe haven against general economic meltdown, gold has already served its purpose. It is agreed by most now that the world has successfully avoided such a meltdown, and as such those who leapt into gold in fear are now divesting of those holdings as they look to re-establish risk trades in stocks, commodities and so forth. Indeed, given we are currently between jewellery buying seasons, analysts also believe gold could drop below US$900/oz before it again tackles US$1000/oz at some later date.
This hasn’t stopped emerging economies addressing the fact that they are pitifully underweight in gold among their surplus holdings. Most of the world’s gold held by central banks is held by the US, the IMF, and the legacy nations of Europe. Everyone else is comparatively underweight gold, and that even includes the gold-producing nations of Australia, Canada and South Africa. China was also very underweight gold as a percentage of its surplus holdings, but China has also recently become the world’s largest producer of gold. This fact wasn’t lost on the Chinese authorities, who spent last year quietly amassing 454 tonnes of the stuff from their own domestic market without the rest of the world even noticing.
Now it’s South Korea’s turn to address its gold situation. Korea is one of those economies which is considered “developed” but still with a hint of “emerging”. Like Japan, Korea punches above its weight on the economic front, and boasts the world’s sixth largest holding of foreign exchange reserves. Yet as a holder of gold, Korea comes in a distant 56th. Korea has not bought any gold for eleven years, and China’s recent purchases means it now has 32 times more gold than its neighbour.
Korea is currently undertaking a review of its foreign reserve policy, looking ahead to 2010. A Bank of Korea official suggested last week:
“The bank has begun to set up a plan to manage foreign exchange reserves for next year. It has also closely watched central banks in other nations and trends in the global gold market. Given the changing global financial environment, the bank’s management plan is critical.” (East Asia Daily)
This was not an official statement of policy, and the BoK has officially remained coy about whether it will actually start buying gold or not. But with gold representing a mere 0.19% of Korea’s reserves the gold market is happy to assume the strategic review will result in Korea going on a “gold buying spree”.
This is good news for gold investors, but don’t expect such purchases to be made in the open market in a frenzy. Korea will likely become a quiet accumulator of gold over time rather than the immediate catalyst for the next assault on US$1000/oz. Indeed, if the BoK needs a willing off-market seller it need look no further than the IMF, which has been given approval to sell a significant portion of its vast gold reserves in order to fund all the bail-outs of basket-case economies it has either already implemented or stands ready to implement soon. The IMF has an agenda to sell gold over a five year period within the Washington Agreement quota, so as not to upset world gold markets. Maybe Korea will prove a perfect recipient, leaving the open gold market with little net effect.