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Not Currency War. A Revolution, Part II

Why China isn't to blame for the fighting now breaking out in currencies...

The CURRENCY MARKETS are changing, as all nations are fully aware, writes Julian Phillips at the GoldForecaster.

(You can read the first part of Julian's currency war analysis here...)

The main change comes as the impact of the development of China starts to impact the global economy most heavily.

Many will say that "China started it!" – meaning the currency war now apparently under way. But the Chinese Yuan is not yet an international trading currency. China pegged itself to the US Dollar, which allowed them to improve their competitive position through the export of cheaper goods than could be produced in the developed world. They kept the 'peg' at a level that brought forward calls of currency manipulation (but their very low wages was a key factor in the cheap export pricing).

This even the US did not validate by deeming the Chinese government as a "currency manipulator" as the Chinese then allowed their currency to appreciate 8.8% in the last two years from 6.84 to 6.23 Yuan for $1. In real terms, this is a token gesture.

Over the last two years, however, China has been slowly building up its expertise in using the Yuan internationally through a series of contracts with key trading partners such as Australia and Russia. There the Yuan is now used in bilateral trade. The next step is for China to take the Yuan and use it as their global trading currency, in place of the US Dollar, at least in non-US trade and where it does not suit them to use their Dollars. (We expect for imports to lower the Dollar's percentage of their reserves.)

It is only a matter of time, when it suits China to do so before China lets the Yuan become a global reserve currency.

So what exchange rate would China like to see for the Yuan against the US Dollar? First ask why that is a pertinent question. Because it will be entirely China's decision, one that will suit their interests alone. They will decide how many Yuan will be released into the market at that point. This will dictate the exchange rate too.

China has been encouraging its citizens to buy gold so will not want the Yuan price of gold to fall because of the Yuan exchange rate. We also know that they will want to protect their international trade competitiveness too. But they will not follow the developed world's dictates unless it suits them to do so. All of this points to the same, or weaker, USD exchange rate as we are seeing now. Meanwhile their policy of using their Dollar reserves for paying for imports will remain intact until these reserves are much lower.

We are all becoming familiar with the term Currency War. But we feel this is more of a revolution than a war. After all a war usually has two sides that battle each other. In a revolution, it is authority that is the target and self-interest the objective. Quantitative Easing, encouraging the loss of value in currencies and any actions that result in the manufactured fall in exchange rates, are the weapons of this revolution. On top of this, the most powerful seven nations issue a duplicitous statement that says that, "the macroeconomic policies (of this seven) will be conducted based on domestic objectives and will not be used to target exchange rates". Now you can be sure the process will carry on from top to bottom on an ongoing basis.

No longer will nations attempt to keep their exchange rates related to the condition of their Balance of Payments, but the statement from the G-7 will allow for internal policies that do lead to exchange rates being lowered!

It was in the US that the revolution started surreptitiously. A policy of exporting Dollars in vast amounts began after the war. That was when President Nixon closed the US gold window, forcing foreign central banks to keep their Dollars. This worked because everybody had to pay for their oil in Dollars, so they weren't stuck with them. But the perpetual trade deficit of the US that followed was a supreme act of self-interest (the exorbitant privilege) and the only reason that the Dollar has not fallen over the last few decades is that outside nations re-invest their massive Dollar surpluses back into the States. But once they become convinced that interest rates will rise, the capital flow back into the States will drop like a stone.

The US can only then hope that they have turned their perpetual trade deficit back into a surplus through domestic oil production and manufacturing exports. If they haven't, then watch the Dollar fall! It may well be that foreign Treasury-bond owners will then sell their bonds too while the value of the Dollar then holds up.

Today the US is debasing the Dollar and doing so knowingly, while ignoring its exchange rate; Federal Reserve Chairman Ben S. Bernanke has unleashed the power of the central bank to buy unlimited amounts of Treasury and mortgage-backed securities in a bid to end a four-year period of unemployment above 7.5%.

The European Central Bank has pledged to buy unlimited quantities of government bonds if necessary to save the Euro, while the Bank of Japan said last month it will shift to open-ended asset purchases next year.

The system of currencies has already degenerated to looking out for No.1. It will lead to the fragmentation of the global monetary system as we now know it.

In revolutions you have chaos, which spreads across the nation until systems are brought down. Once the feeling that this is on the way, confidence in the overall system will collapse. Trust between governments and their banks suffer badly. Mobile, internationally-accepted replacements for national currencies will be brought solidly back into the system. Gold is the prime one of these. But it will have to represent a 'value-anchor', measuring values, as well as serving as the one asset that will ensure that nations do perform as they promise to. The loss of the gold reserves will still be the same as the loss of the family jewels.

This is why the World Gold Council-sponsored report by the Official Monetary and Financial Institutions Forum came to their conclusion that gold will move back to a pivotal position in the monetary system. Its need will be at its greatest, as the Yuan arrives on the scene.

These consequences will also have ripple effects that will produce additional ripples. Banco de Mexico Governor, Agustin Carstens, expressed it in this way:

"My fear is that a perfect storm might be forming as a result of massive capital flows to some emerging market economies...Risk appetite among investors has returned and the search for yield is in full force. Concerns of asset-price bubbles fed by credit booms are starting to appear. This could lead to bubbles, characterized by asset mispricing, and then face a reversal in flows as the major advanced economies start exiting their accommodative monetary policy stance."

The 'carry trade' is blossoming as monetary easing from Japan to the US spurs demand for higher-yielding assets and boosts inflows into emerging markets. The risks are not being ignored by emerging-market governments...

  • Russia warned last month that Japan's currency-weakening policies may lead to reciprocal action as nations try to protect their export industries;
  • The Philippines have said they'll consider how to reduce the impact of such funds;
  • Mexico's Carstens says "We have to live with this unconventional monetary policy in the largest economies. We need to take care of the hazards that these inflows represent from the financial vulnerability point of view;"
  • Philippine central bank Governor Amando Tetangco says he's studying more measures to counter excessive capital inflows lured by growth;
  • South Korea is to consider taxes on currency trading and bonds to help limit "speculative" inflows of capital;
  • The managing director of Singapore's central bank has said, "We need to avoid competitive currency devaluations. Past episodes of currency friction have only led to more misery and further downward spirals."

As the revolution accelerates, a return to using gold – to facilitate and produce greater levels of liquidity and generally shore up the current global monetary system – is on the way, we believe.

Once this happens the race to get as many ounces of gold into the central bank and the banking system itself will be on. How will this happen? There isn't enough free market supply to feed this demand. Only higher prices that precipitate selling of currently held gold will increase this amount. If the banking system joins the picture, then substantially higher supply will be needed, which will bring with it substantially higher gold prices.

One way nations will increase their holdings is for nations that produce gold to take local production directly into their coffers. This will lower newly mined supplies of gold even more than at present. We do believe that China is doing this already, but it will be followed by others. Canada with so little gold currently has a good amount it can harvest locally. Such a drop in supply will take gold prices higher until 'scrap sales' of gold become the main source of supply.

We also expect to see more and more developed and emerging world central banks repatriate their already owned gold out of prudence. As Carstens of Mexico said, "We need to take care of the hazards that these [currency] inflows represent from the financial vulnerability point of view."

But then the cheapest source and perhaps the largest source of gold a nation has is the gold of its own citizens. In such times of monetary need we have no doubt that, out of concern for the nation's financial security, the confiscation of their citizen's gold will happen. And not just as a currency collapses, but ahead of it, when payment in that currency is viable to the holders of that gold.

Just as the domestic US confiscation of gold in 1933 was ahead of 1935's devaluation of the Dollar for money-supply purposes, so a future confiscation will happen ahead of the major devaluation of a nation's currencies.

JULIAN PHILLIPS – one half of the highly respected team at – began his career in the financial markets back in 1970, when he left the British Army after serving as an Officer in the Light Infantry in Malaya, Mauritius, and Belfast.

First he worked in Timber Management and then joined the London Stock Exchange, qualifying as a member and specializing from the beginning in currencies, gold and the "Dollar Premium". On moving to South Africa, Julian was appointed a macro-economist for the Electricity Supply Commission – guiding currency decisions on the multi-billion foreign Loan Portfolio – before joining Chase Manhattan and the UK Merchant Bank, Hill Samuel, in Johannesburg.

There he specialized in gold, before moving to Capetown, where he established the Fund Management department of the Board of Executors. Julian returned to the "Gold World" over two years ago, contributing his exceptional experience and insights to Global Watch: The Gold Forecaster.

Legal Notice/Disclaimer: This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment. Gold Forecaster/Julian D.W. Phillips have based this document on information obtained from sources they believe to be reliable but which it has not independently verified; they make no guarantee, representation or warranty and accepts no responsibility or liability as to its accuracy or completeness. Expressions of opinion are those of Gold Forecaster/Julian D.W. Phillips only and are subject to change without notice. They assume no warranty, liability or guarantee for the current relevance, correctness or completeness of any information provided within this report and will not be held liable for the consequence of reliance upon any opinion or statement contained herein or any omission. Furthermore, they assume no liability for any direct or indirect loss or damage or, in particular, for lost profit, which you may incur as a result of the use and existence of the information, provided within this report.

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