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Gold's Role in the Reserve Currency Crisis

With the Dollar facing currency crisis, what role might gold play in the solution...?

the issue of a new global reserve currency and only finding some verbal support from France's President Sarkozy, China still put the issue of replacing the Dollar with another currency (or currencies) firmly on the table at the G-8 conference in Italy this week, writes Julian Phillips of the

The issue, while acknowledged, was not treated seriously. We believe that's a major error on the part of the G8 group of leading industrialized nations.

China's position was made clear in March: "To avoid the inherent deficiencies of using sovereign currencies for reserves, there's a need to create an international reserve currency that's delinked from sovereign nations." The IMF should expand the functions of its unit of account, Special Drawing Rights, the People's Bank has also said. Its restatement of Governor Zhou Xiaochuan's proposal from March added great weight to the likelihood that China will diversify its currency reserves, now the world's largest at $2.0 trillion and more.

Zhou Xiaochuan sees the current international financial system as flawed, putting too much emphasis on the Dollar as a reserve currency. The Chinese authorities feel that the Dollar should depreciate to address the global imbalance, but if this happens and because it's a reserve currency, it would give the rest of the world a monetary crisis too.

We are certain China will not wait for the West to accommodate their wishes, but as you can see below will act in the short-term to adjust their own reserve policies for the benefit of China. With little cooperation from the West we can now look forward to the destabilization that attends global currency confrontation.

China, the biggest foreign holder of US government, is already in the process of cutting its Dollar holdings. In April it cut them by $4.4 billion to $763.5 billion, the first monthly reduction since February 2008. It is difficult for China to do this quickly, for such moves would cause the Dollar to collapse, if seen as a departure from the US Dollar by the Chinese.

Unhappiness with the Dollar is not limited to China, however. Russia holds more Euros in its reserves now, in reaction to the dangers facing the Dollar. Internationally, by the end of 2008 the Dollar accounted for 64% of global central bank reserves, down from 73% in 2001, after the arrival of the Euro on the global monetary scene.

The US Dollar is being undermined by US economic problems and its over-issuance by the Fed, despite comforting platitudes flowing from US Monetary authorities over the last few years. The threats internal US policies posed to the international monetary system are frightening. The virtually zero response from US monetary authorities to international Dollar problems has disturbed eastern central banks because the Dollar holdings in the reserves of foreigners are huge and could well be diminished in value considerably in the years to come.

It is also clear that the US has a great deal to gain both from a depreciating Dollar and from inflation, despite the impact on the US economy. As a result confidence both in the US economy and in the Dollar has dropped considerably since the credit crunch impacted in August 2007. The problem is how to get away from the Dollar's grip without collapsing the global monetary system itself.

"The excessive reliance on the credit of several sovereign currencies has added to the risks and crises," People's Bank of China said, adding that "A currency with stable value in the long term is required."

The other big Dollar reserve holders are taking small and uncertain steps. Russian President Dmitry Medvedev, Chinese President Hu Jintao, Indian Prime Minister Manmohan Singh and Brazilian President Luiz Inacio Lula da Silva called for a "more diversified" monetary system to reduce dependency on the US Dollar at a June 16th meeting.

In May, China and Brazil also began studying a proposal to move away from the Dollar and use Yuan and Reais to settle trade instead.

The Group of 20 leaders on April 2nd gave approval for the International Monetary Fund (IMF) to raise $250 billion by issuing Special Drawing Rights (or SDRs) the artificial currency that the agency uses to settle accounts among its member nations. The G20 also agreed to put another $500 billion into the IMF's war chest, and last month, Russia and Brazil announced plans to buy $20 billion IMF bonds, while China said it is considering purchasing $50 billion.

IMF First Deputy Managing Director John Lipsky said on June 6th "It's possible to take the revolutionary step of making SDRs a reserve currency over time". The US and other developed nations will attempt to drag out such moves because this disturbs the present global balance of power.

Special Drawing Rights were created by the International Monetary Fund (IMF) in 1969 to support the Bretton Woods exchange-rate system which collapsed in 1971 after the Dollar was "floated" against gold. Gold sales followed thereafter, first from the United States (who saw few nations were convinced, snapping up the US Treasury's gold sales), and then by the IMF. This was seen by many as an act in support of the Dollar, which was rapidly moving to its position as the world's reserve currency.

The IMF also saw that gold sales were a failure and stopped them. But the attempted discrediting of gold as money was part and parcel of these moves. It was hoped that the SDR would act as a currency, but few nations were willing to trust it, as the IMF was considered an arm of the US Treasury. (It still is to some extent.) Now SDRs act as a unit of account rather than a currency.

Each SDR is issued against cash provided by IMF members, and the "money" is then disbursed as SDRs in proportion to the money each member nation pays into the fund. China will be most keen to hand over its Dollar reserves in exchange for SDRs and partially escape the collapse of the Dollar that may happen then.

With no other globally linked organization available, the IMF is the only institution able to provide an alternative to the Dollar. It already has a template in place through the SDR. This "basket of currencies" is the only sound way to counter the flaws in the Dollar at present, hence the push towards the SDR by China and Russia.

The value of SDRs are based on a 'basket' of Dollar, Euro, Yen and Sterling valuation, shielding the notional currency from swings in any single currency. We foresee the Pound being dropped and the Yuan taking a major role in the basket as the US Dollar portion is considerably reduced over time. But for now, one SDR is currently valued at $1.54.

China is proposing the basket be broadened. The current weighting is: 44% for the US $, 34% for the Euro and 11% each for the Yen and the Pound Sterling. It doesn't include the Yuan – not yet. Neither does it include Gold Bullion.

The four currencies in the SDR, which must be fully convertible on the foreign exchange market, are those issued by fund members with the largest share of global trade. The weights assigned by the IMF are based on the value of exports and the amount of reserves denominated in those currencies. The composition of the basket is reviewed every five years. The next review is due in 2010. We fully expect the Yuan to become a major constituent of this basket – perhaps 20% or more?

But before then, China has to make the Yuan available freely for international trade at least.

As the Chinese are already pressing for a change the implication is that they will be ready and happy to see this happen by then. 2009 and 2010 will therefore prove to be watershed years in the world's monetary system. This has to mean a rising degree of currency volatility this year through next.

The IMF itself will also have to change its rules too. The United States' 16.83% of votes and a need for 85% of votes to pass any resolution will have to change for the IMF to be a truly international body. The US will have to step back to a role of just another member, or no SDR role will be plausible.

It is even possible that in time the IMF's headquarters will move away from US shores. Certainly, no national or nationally controlled currency will be allowed to rule the roost.

But will there be a role for Gold Bullion in the SDR? Will China and Russia as well as developed nations want this? If this were to happen, as we explain to subscribers this week, there will be a rising chance globally that governments will attempt to confiscate locally owned gold. This may well not be restricted to the United States either.

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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