ALL THAT GLITTERS... THE FINANCIAL MARKET IMPLICATIONS OF COMPETITIVE DEVALUATION

Debt Strategy Global 15 September 2003

Bloomberg: DRKW

John Butler Head of Debt Strategy +44 (0) 20 7475 7396 [email protected]

Reuters: DRBCA-DRBCB

All that glitters...The FX implications of competitive devaluation

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Guido Barthels Global Head of Debt Research +49 (0) 69 713 12260

PLEASE REFER TO THE TEXT AT THE END OF THIS REPORT FOR OUR DISCLAIMER AND ALL RELEVANT DISCLOSURES. IN RESPECT OF ANY COMPENDIUM REPORT COVERING SIX OR MORE COMPANIES, ALL RELEVANT DISCLOSURES ARE AVAILABLE ON OUR WEBSITE www.drkwresearch.com/disclosures OR BY CONTACTING DRKW RESEARCH DEPARTMENT, 20 FENCHURCH STREET, LONDON, EC3P 3DB. Online research: www.drkwresearch.com Bloomberg: DRKW<GO>

Gold no longer functions as money in modern, credit-basedeconomies. Floating currencies allow for cross-border imbalancesto adjust, obviating the need for gold transfers. But there arereasons why gold may be about to stage a comeback, withpotentially large implications for currency markets.

� The dollar remains under fundamental pressure. Record globalproductive overcapacity implies that above-trend growth is unsustainable,making it increasingly difficult for the US to attract foreign portfolio flowssufficient to prevent an ongoing decline in the US dollar.

� Asian governments will probably continue to resist dollar weakness.If the Eurozone decides to implement a similar policy, a globalcompetitive devaluation contest may begin.

� Global reflationary policies could push global money rates to nearzero. Were the interest rate differential between paper currencies andgold to fall to near zero, a major gold rally would likely result. This wouldbenefit certain currencies.

� In an extreme case, financial markets could respond to aggressivereflationary policies by moving to a de facto gold standard. Someinvestors might want to hedge against this admittedly remote risk. Is gold on the verge of a historic break-out?

91 92 93 94 95 96 97 98 99 00 01 02 03200

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(000�s)

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GOLD $/TROY OZGOLD EUR/TROY OZGOLD JPY/TROY OZ(R.H.SCALE)

91 92 93 94 95 96 97 98 99 00 01 02 03200

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(000�s)

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GOLD $/TROY OZGOLD EUR/TROY OZGOLD JPY/TROY OZ(R.H.SCALE)

Source: Thomson Financial Datastream

http://www.drkwresearch.com/disclosures/






15 September 2003 All that glitters...

2

A return to gold?

Gold no longer functions as money in modern, credit-based economies. Floating currencies allow for cross-border imbalances to adjust, obviating the need for gold transfers. But there is a growing risk that gold may soon stage a comeback, with potentially large implications for currency markets.

Imagine if you will for a moment... It is early 2005, and Eurozone politicians are becoming desperate. Growth remains

below trend and unemployment keeps rising. Germany and France have tipped into

deflation and bank lending remains weak despite strong money growth. The ECB has

cut interest rates to 1% but the euro is surging toward 1.30 as a result of the large US

current account deficit and a clear willingness by US policymakers to accept a weaker

currency. Asian central banks still refuse to allow their currencies to rise versus the

dollar, contributing to upward pressure on the trade-weighted euro.

Eurozone finance ministers and the ECB hold an emergency meeting and decide that,

given Asian central bank reluctance to accept stronger currencies, there is no choice

but to intervene to prevent a further rise in the euro. The next week, the market tries to

push EUR/USD through 1.30 one morning and the ECB pushes the sell button. The

euro drops two big figures within minutes. Later that afternoon, the ECB holds a press

conference explaining that further euro strength would be unwelcome, implying further

intervention. The ECB also criticises �other central banks� for contributing to excessive

euro strength out of line with fundamentals. The euro loses another big figure.

Meanwhile, the price of gold surges, not just versus dollars, but versus every major

currency. Within days it has risen through $400/oz, despite continuing disinflation

worldwide.

Several months later, major exchange rates have barely moved. Investors are afraid to

fight central banks determined to keep their currencies stable versus the dollar.

Disinflation continues, however, and the Fed finally cuts rates to zero at the May

meeting, citing the need for further insurance against �unwelcome further disinflation.�

Surprised by the move, markets sell the dollar, which passes through EUR1.30. The

ECB pushes the sell button again and the euro falls back.

Later that day, gold surges through $450/oz, the highest level since the stock market

crash of 1987. The financial press is now talking about the return of the �Gold Bugs�.

Financial pundits offer confused answers to the question of why the gold price is rising

despite fears of global deflation.

Following is our answer to this puzzle.

John Butler Head of Debt Strategy +44 (0) 20 7475 7396 [email protected]

What if the ECB intervenes to prevent a euro rise through

1.30 vs the dollar?

What if US interest rates fall to zero to compensate for an

overvalued dollar?

Why might the gold price surge amidst deflation fears?






3

The FX implications of competitive devaluation The gold price has been in a downtrend for over two decades.

Last year, interest in gold was reignited as the dollar started to decline sharply versus

most currencies. But this was hardly a sign of rising global demand for gold: in euro

terms, for example, the gold price was essentially unchanged in 2002. The same was

true in SDR (special drawing rights) terms.

In recent months, however, this has changed, with gold appreciating versus every

major and most minor currencies. Is gold just the next speculative bubble? Or has the

gold demand function shifted for some exogenous reason?

This paper assumes the latter. It assumes that despite current disinflationary

pressures, the long-term balance of risks in the global economy is indeed shifting

toward reflation. If European central banks were to start managing their exchange

rates as Asian central banks are already doing � the scenario presented on the

previous page � the balance of risks would shift further in this direction.

It is our view that reflation, when it happens, begins in the United States. We see this

happening partly as a result of a weaker dollar. As the US consumer is highly leveraged

up on foreign credit, and domestic monetary and fiscal stimulus is near maximum, there

are few other obvious sources of reflation. US policymakers increasingly seem to

recognise that dollar weakness is necessary for a sustainable recovery in the US

economy. Pressure on China to revalue the yuan is merely the most recent example of a

dramatic shift in the official rhetoric during the past two years.

However, with Japan, the Eurozone and even China and several other emerging

market economies teetering on the edge of deflation, significant further dollar

weakness will be considered unwelcome. The result, so far, of aggressive Asian FX

management has been for European currencies but also commodity currencies to be

squeezed higher: �Squeezed� because they have not risen primarily as the direct result

of superior economic performance versus the US.

Enter the ECB But what happens if European countries decide that they will not allow their currencies

to be squeezed higher by this aggressive Asian policy? If even the ECB tries to

prevent dollar weakness, everyone will need to print more money. The result will be a

large increase in the global money supply. Will this increase be inflationary?

If overcapacities are sufficiently large and risk aversion sufficiently high there is no

guarantee that monetary policy will have sufficient �traction� to reflate economies. Japan

provides an obvious example. In a world of managed currencies, reflating central banks

will absorb the growing supply in each others� currency, removing it from circulation and

probably driving interest rates down to extremely low levels in the process.

The rise in the gold price versus nearly all currencies

could be interpreted as a sign of growing reflation risks


4

Now things get interesting. If interest rates for all major currencies are driven down to

low levels or, in an extreme case, to zero, then the interest rate differential between all

major paper currencies and gold collapses to essentially zero.1 It becomes costless for

investors to hold gold. And if it is costless, and policymakes are trying to reflate...

...the nominal price of gold starts to go up.2 We stress that there is a fundamental

difference between a situation in which the interest rate differential between gold and a

major currency is effectively zero � as it has been for the yen for years now � and

when the interest rate differential between gold and all major currencies is zero. In the

former case, there are liquid paper money alternatives for investors seeking positive

carry and looking to avoid reflationary policies. In the latter, there is no liquid paper

currency alternative to gold.

As the nominal gold price rises, it probably begins to attract also speculative interest.

Meanwhile, central banks keep printing money, which is purchased by other central

banks as a result of active FX management policies, rather than by investors, who

increasingly prefer gold and other real assets.

The supply side As the demand for gold increases, what happens to supply? First, mining activity will

pick up. But this is a slow process and the forward selling practice of many

producers is likely to limit the impact that changes in supply have on the spot price

except over the long term.

The supply of gold is linked to production, which is price inelastic

Source: USGS/Gold Fields Mineral Services

Second, some central banks may be tempted to sell their gold at the more attractive

price. But selling gold is at odds with reflationary policies, in which central banks want

to increase, not decrease, the amount of currency in circulation.

1 Hypothetically, gold could even offer positive carry, as gold lease rates, while extremely low, could lie above market rates for paper currency deposits. That said, it is more reasonable to assume a decline in gold lease rates to essentially zero as demand picks up and gold shorts are squeezed out. 2 We focus here on the nominal price because while certainly probable in a world of productive overcapacity, it is not automatic that gold will acquire more real purchasing power in this scenario.

What if the global interest rate differential to gold collapses to

essentially zero?

The price of gold rises, perhaps dramatically

There is no plausible way that gold supply could keep up with

a large rise in demand

0

500

1,000

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4,000

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000

Cum. world gold production since 1900 (Troy oz. mn)

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000

Cum. world gold production since 1900 (Troy oz. mn)


5

While one central bank might sell gold for dollars, another will sell gold for euros and

yet another for yen, the result being a decline in the supply of all three; this unwelcome

decline in the global money supply would need to be met with a fresh round of new

money creation. For these reasons there is, in fact, no reason to expect gold supply to

keep up with demand in a world where central banks are trying to reflate.

The gold price post-Bretton Woods

Source: Thomson Financial Datastream

In two key respects, this environment would be even more gold supportive than the late-

1970s, when the price of gold reached $700/oz. First, in the 1970s, dollar devaluation

was resisted at first by Japan but not by Germany, as the Bundesbank was not willing to

tolerate a weak currency amidst global inflationary pressures. The mark remained a

relative safe haven, as did the Swiss franc. But in the scenario above, all major

currencies are seeking to reflate. Second, the amount of liquidity parked in money-

market funds and other monetary equivalents is much larger today than in the 1970s,

whereas the global gold stock has expanded only slowly, in line with production. Arguing

against a major surge in the gold price is the obvious fact that, for the time being, inflation

expectations are much, much lower than the double-digit inflation rates seen in many

countries in the late 1970s. In time, of course, this could change.

A global reflation today could well be more bullish for gold

than the 1970s

73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 030

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GOLD $/TROY OZ

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73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 030

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GOLD $/TROY OZ

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6

As central banks try to reflate economies, the global money supply explodes versus gold

Source: Thomson Financial Datastream; DrKW Debt Research estimates

At first glance there is no obvious upward limit for the nominal gold price � versus any

currency � in a competitive devaluation scenario. It depends on how aggressive

reflationary policies become; how long interest rates are held near zero and how risk-

averse investors are. At the extreme, the world will be forced onto a de facto gold

standard as investors eschew paper currencies as stores of value, preferring instead

the only �unmanaged� currency out there: gold.

If that happens, paper currency in circulation will be valued as it once was, as a claim

on gold. 3 But today�s paper currency values are nowhere near their theoretical

equilibrium gold price. For example, the United States has official reserves of 265m

ounces of gold. USD M0 � the raw money supply � is about 710bn. If dollars in

circulation (and held as bank reserves, also part of M0) are valued as claims on gold

then the equilibrium gold price is currently $2,716. For the euro, the equivalent price is

EUR1,335. The ratio of these two prices is 2.03, the implied EUR/USD exchange rate

if the world were to return to a de facto gold standard tomorrow, assuming no

adjustments in central bank foreign reserves or other cross-border portfolio holdings.4

The corresponding equilibrium gold prices for the yen, sterling and Swiss franc are

4.2mn, 3,878 and 717, respectively, implying FX rates of JPY1,551, GBP0.70 and

CHF0.26. When looked at in terms of gold, the Swiss franc is indeed a true safe haven

currency, and the consequence of an aggressive quantitative easing of monetary

policy in Japan is readily apparent.

3 For an outstanding discussion of the development of the global gold standard in the 19th century and the role of paper monies therein, please see Bordo and Eichengreen, The Rise and Fall of a Barbarous Relic: The Role of Gold in the International Monetary System, NBER Working Paper No. 6436, March 1998; available at www.nber.org. For a grand historical study of the role of gold from ancient times to the present, we recommend Peter L. Bernstein�s highly entertaining book The Power of Gold: the History of an Obsession. 4 We use M0 to generate equilibrium gold prices because we assume that under the weak confidence conditions leading to a de facto gold standard, financial markets would differentiate between government money and private bank liabilities. We further assume that, until markets stabilise, they will demand full gold backing of M0, which was not generally the case during the early 20th century. Certainly, one could also imagine a scenario in which markets would trust governments to guarantee bank deposits, in which case M1 or possibly even M2 could be used. In that case, equilibrium gold prices would be correspondingly much higher than those derived above.

If zero interest rates combine with a surge in risk aversion,

investors may flee paper monies for gold...

...forcing the financial markets onto a de facto gold standard

1700

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1900

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2300

2400

2500

2600

Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-033500

3750

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4750

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Total M0 (USDbn) Gold (Troy oz. Mn, RHS)

1700

1800

1900

2000

2100

2200

2300

2400

2500

2600

Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-033500

3750

4000

4250

4500

4750

5000

5250

Total M0 (USDbn) Gold (Troy oz. Mn, RHS)


7

These calculations help to demonstrate just how far removed the world now is from a

gold standard. In 1913, the year the US Congress passed the Federal Reserve Act,

the global �gold cover ratio� was nearly 50%; that is, the market value of global gold

reserves was half the face gold demand value of global M0.5 Today, the global �gold

cover ratio� is around 10%.

Equilibrium gold prices and implied FX rates under a de facto gold standard

Currency M0 (end Aug 2003) Gold (troy oz, mn) Equilibrium gold price

(per troy oz) Implied USD rate

USD 710bn 261 2,716 NA

EUR 529bn 396 1,335 2.03

GBP 39bn 10.1 3,878 0.70

JPY 104tn 24.6 4,212,857 1,551

CHF 41bn 57.3 717 0.26

Source: Official central bank statistics; DrKW Debt research estimates

It gets worse... It is unlikely that the story would end there. It is unreasonable, for example, to expect

that central banks will want to hold on to the current amount of dollar reserves if the

world moves back onto a de facto gold standard.6 Some might even seek to increase

their gold holdings.7 Meanwhile, as discussed above, private investors should prefer

gold to foreign currency assets as a store of value in a potentially reflationary, near

zero-interest rate environment. In the event of a return to a de facto gold standard,

non-official non-US investors would also likely reduce their dollar asset holdings in

favour of domestic currency or gold.

So what happens then, if non-US investors and central banks dump their dollars

following the move to a de facto gold standard? In the most extreme case, in which all

dollar assets in foreign official and non-official hands are sold, dollar interest rates will

rise sharply. If the Fed resists this rise, in line with a reflationary policy, they will need

to step in and purchase (ie monetise) some portion of these assets. In the most

extreme scenario in which the Fed monetises all foreign USD assets, dollar M0 swells

fivefold, to about $3.9tn. In this scenario of a de facto gold standard and zero cross-

border net assets/liabilities, the equilibrium gold price soars to about $15,000. This

implies a EUR/USD exchange rate of 11.3. The big winner, however, is the Swiss

franc, where the USD/CHF rate collapses to 0.05.

Of course, the Fed could try to have it both ways, holding interest rates low and

defending the dollar by selling foreign currency reserves, but it would quickly run out of

ammunition, as the Fed holds a mere $36bn. Once these meagre reserves were

exhausted, the dollar would collapse as described above, making the 1992 sterling

crisis look tame by comparison.

5 In many countries in the early 1900s, the gold cover ratio was well in excess of that specified by law (normally around 30%), suggesting a degree of hawkishness�or merely an irrational fondness for gold�on the part of central bankers. 6 According to the IMF, at end 2002 central banks held approximately 65% of their FX reserves in dollars. 15% was in euros and 10% in yen, Swiss francs and sterling. 7 If central banks were to switch into gold from foreign exchange reserves, the impact would be to strengthen the domestic currency, which would be at odds with a competitive devaluation/reflationary policy. Interestingly, however, this is exactly what happened in the early 1930s, when the share of foreign currency in central bank reserves collapsed from nearly 40% to only 10%. The deflationary consequences thereof are well-known and form much of the empirical laboratory for both Keynesian and Monetarist theory.

Global investors are likely to reduce foreign currency

holdings in favour of gold, placing pressure on the dollar

A dumping of foreign asset holdings would be a huge

negative for the USD


8

This discussion might smack of nonsense. Such dramatic swings in FX rates are almost

unthinkable. Of course they would have a huge impact on relative prices and wages and

cause immense shifts in global trade and investment patterns.

As such, they would be strongly resisted by policymakers through trade barriers and

capital controls. But this illustrates an important fundamental point, which is that

contrasting rates of money supply growth in recent years, combined with large

cumulative net foreign asset/liability positions, would make the return to a de facto gold

standard almost unimaginably disruptive for the global economy. It could not be expected

to be otherwise. The last time the world went through such an adjustment, during the

interwar years, there was deflation in Britain, hyperinflation in Germany and at least

some economic chaos everywhere else, culminating eventually in the Great Depression.8

Implied FX rates on a de facto gold standard, assuming foreign asset repatriation+monetisation

Currency Net foreign asset

position (USDmn) Adjusted M01 Equilibrium gold price

(per troy oz) Implied USD rate

USD -3,235 3,945bn 15,087 N/A

EUR 258 529bn 1,335 11.30

GBP -322 243bn 24,076 0.63

JPY 1,990 104tn 4,212,857 279

CHF 386 41bn 717 0.05

1Monetisation increases M0 for debtor countries in an amount equivalent to the net foreign debt position. It remains unchanged for net foreign creditors

Source: National finance ministries and central banks; DrKW Debt research estimates

Back to reality (Whew!) The world need not return to a de facto gold standard for the shiny metal to reassert

some of its historical monetary importance and for certain currencies to benefit. If

markets move out even one or two rungs of the long causal chain described in this

paper � such as a refusal by Asian countries to allow even modest currency

appreciation, or intervention from the ECB at some point � and the risks of competitive

devaluation and global reflation rise, there are asset allocation implications.

The first implication, and obvious, is that gold is likely to outperform major currencies.

While other real assets may also rise in value versus paper monies, they are unlikely

to keep up with gold which, as a monetary asset, offers superior liquidity. Even silver

and copper, which in the past frequently had monetary properties, are unlikely to

benefit as much as gold.9

Second, certain currencies are likely to outperform. These are currencies with the

following characteristics:

� Relatively high nominal economic growth rates (making deflation danger more

remote).

� Large current account surpluses and/or net foreign asset positions (implying

fundamental upward pressure on the currency).

� Older populations (implying less political tolerance of inflation).

8 There are those who believe in multi-decade economic cycles leading to Great Depressions such as the 1930s or the late 19th century. The Russian economist Kondratieff (1892-1938) is perhaps the most famous exponent of this idea. 9 Silver and copper were used for coinage in the past because gold was highly scarce and valuable, making gold coin impractical for small, everyday transactions. But in an electronic age, where physical transfer of money is no longer required for everyday transactions and �electronic gold� could be traded in infinitesimally small as well as large amounts, there is no need to have multiple metal standards. Already regarded as the reserve metal of choice, it is unlikely that gold would share this status with silver or other metals in a future metal reserve system. Other factors equal, gold should therefore outperform other metals if financial markets price in a growing risk of competitive devaluation.

A massive repatriation of foreign assets would cause immense disruption of the

global financial system

While competitive devaluation policies would be a signal to

buy gold, some currencies would also benefit...


9

� Large gold mineral deposits (implying an investment boom as the gold price rises).

� Large gold stocks relative to currency and government debt in circulation.

While no currency satisfies all of these conditions, some come close, including the

Swiss franc, Swedish krona, and euro. Among emerging market currencies, the

Russian rouble and South African rand stand out. Among the majors, the euro looks

the best, primarily the result of the Eurosystem�s large gold reserves, roughly 50%

greater than those of the US and nearly eight times greater than those of Japan.

Winners and losers in a sustained gold price rally

Currency Nominal growth rate Net foreign asset

position Population age Gold relative to M0

and gov�t debt

USD - - - - -

EUR - + + + +

GBP + - + -

JPY - - + + + + - -

CHF - - + + + + + +

SEK - + + + +

CAD + - - -

AUD + + - - - + +

NZD + + - - - -

RUR + + - + +

ZAR + + - - - + +

Source: DrKW Debt research estimates

Be prepared Our current FX forecasts are based on the assumption that the dollar continues to

decline under the weight of unsustainable foreign borrowing in a context of global

growth which is at best around trend and at worst stagnating. We further assume that

Asian governments allow for a modest appreciation of their currencies during 2004,

although not nearly to the extent implied by underlying fundamentals. A logical

consequence of this continuing Asian FX management policy is that the euro, in trade-

weighted terms, will continue to rise, perhaps to a level considered unwelcome by a

majority of Eurozone finance ministers and possibly also by some ECB officials. It is

not unreasonable for financial markets to anticipate a risk of ECB intervention if the

euro rises toward 1.30 already next year. If that happens, the gold price would

probably rise further, to levels not seen in years, and the safe haven currencies listed

above would likely outperform.

...including the Swiss franc, Swedish krona, euro, Russian rouble and South African rand

Rather than being a mere flight of fancy, this discussion may become relevant as the euro rises to around 1.30, as we

expect in late 2004


10

Notes


11

Notes


12 F: 5844 G: 2279

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ALL THAT GLITTERS... THE FINANCIAL MARKET IMPLICATIONS OF COMPETITIVE DEVALUATION