Global Debt Strategy

15 September 2003

The FX implications of competitive devaluation

All that glitters...

Reuters: DRBCA-DRBCB

Bloomberg: DRKW

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 are reasons why gold may be about to stage a comeback, with potentially large implications for currency markets. The dollar remains under fundamental pressure. Record global productive overcapacity implies that above-trend growth is unsustainable, making it increasingly difficult for the US to attract foreign portfolio flows sufficient 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 global competitive devaluation contest may begin. Global reflationary policies could push global money rates to near zero. Were the interest rate differential between paper currencies and gold to fall to near zero, a major gold rally would likely result. This would benefit certain currencies. In an extreme case, financial markets could respond to aggressive reflationary policies by moving to a de facto gold standard. Some investors might want to hedge against this admittedly remote risk.
Is gold on the verge of a historic break-out?
(000s) 420 400 380 360 340 320 300 280 260 240 220 200 91 92 93 94 95 GOLD $/TROY OZ GOLD EUR/TROY OZ GOLD JPY/TROY OZ(R.H.SCALE) 96 97 98 99 00 01 02 03 25 30 45 50 55

John Butler
Head of Debt Strategy +44 (0) 20 7475 7396 john.butler@drkw.com

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Source: Thomson Financial Datastream 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.

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

Online research: www.drkwresearch.com Bloomberg: DRKW<GO>

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15 September 2003 All that glitters...

A return to gold?
John Butler Head of Debt Strategy
+44 (0) 20 7475 7396 john.butler@drkw.com

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.
What if the ECB intervenes to prevent a euro rise through 1.30 vs the dollar?

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.

What if US interest rates fall to zero to compensate for an overvalued dollar?

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.

Why might the gold price surge amidst deflation fears?

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.

15 September 2003 All that glitters...

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?
The rise in the gold price versus nearly all currencies could be interpreted as a sign of growing reflation risks

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.

15 September 2003 All that glitters...

What if the global interest rate differential to gold collapses to essentially zero?

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.

The price of gold rises, perhaps dramatically

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
4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0 1900

1910

1920

1930

1940

1950

1960

1970

1980

1990

2000

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

Source: USGS/Gold Fields Mineral Services

There is no plausible way that gold supply could keep up with a large rise in demand

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.

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.

15 September 2003 All that glitters...

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
700 700

600

600

500

500

400

400

300

300

200

200

100

100

73

75

77

79

81

83

85

87

89

91

93

95

97

99

01

03

GOLD $/TROY OZ

Source: Thomson Financial Datastream

A global reflation today could well be more bullish for gold than the 1970s

In two key respects, this environment would be even more gold supportive than the late1970s, 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 moneymarket 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.

15 September 2003 All that glitters...

As central banks try to reflate economies, the global money supply explodes versus gold
2600 2500 2400 2300 2200 2100 2000 1900 1800 1700 Dec-98 3750 3500 Dec-03 4750 4500 4250 4000 5250 5000

Dec-99

Dec-00 Total M0 (USDbn)

Dec-01 Gold (Troy oz. Mn, RHS)

Dec-02

Source: Thomson Financial Datastream; DrKW Debt Research estimates

If zero interest rates combine with a surge in risk aversion, investors may flee paper monies for gold...

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 riskaverse 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 todays 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.

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

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. Bernsteins 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.

15 September 2003 All that glitters...

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 EUR GBP JPY CHF

710bn 529bn 39bn 104tn 41bn

261 396 10.1 24.6 57.3

2,716 1,335 3,878 4,212,857 717

NA 2.03 0.70 1,551 0.26

Source: Official central bank statistics; DrKW Debt research estimates

It gets worse...
Global investors are likely to reduce foreign currency holdings in favour of gold, placing pressure on the dollar

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 crossborder 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.

A dumping of foreign asset holdings would be a huge negative for the USD

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 hawkishnessor merely an irrational fondness for goldon the part of central bankers. 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.
6

15 September 2003 All that glitters...

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.
A massive repatriation of foreign assets would cause immense disruption of the global financial system

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 EUR GBP JPY CHF

1

-3,235 258 -322 1,990 386

3,945bn 529bn 243bn 104tn 41bn

15,087 1,335 24,076 4,212,857 717

N/A 11.30 0.63 279 0.05

Monetisation 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.
While competitive devaluation policies would be a signal to buy gold, some currencies would also benefit...

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).

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. 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.
9 8

15 September 2003 All that glitters...

Large gold mineral deposits (implying an investment boom as the gold price rises). Large gold stocks relative to currency and government debt in circulation.
...including the Swiss franc, Swedish krona, euro, Russian rouble and South African rand

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 Eurosystems 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 govt debt

USD EUR GBP JPY CHF SEK CAD AUD NZD RUR ZAR
Source: DrKW Debt research estimates

+ --+ ++ ++ ++ ++

+ ++ ++ + ---

++ + ++ ++ + + --

-+ -++ ++ ++ + ++

Be prepared
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

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 tradeweighted 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.

15 September 2003 All that glitters...

Notes

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15 September 2003 All that glitters...

Notes

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15 September 2003 All that glitters...

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F: 5844 G: 2279