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Gold in concept of common BRICS currency p. I

2023-02-20
Gold in concept of common BRICS currency p. I

Concept of a common currency for BRICS countries, and quandaries about role of gold in it, has been subject of less or more serious considerations and speculations for several years. It is of multidimensional significance, as concern changes of a monetary scope, in which de-dollarisation trend is embedded.


A nother aspect to discuss lies in geopolitics and the emerging bipolarity of the world, where US and China will form respective core powers of new political blocs, while remaining at same time practically inseparable from each other. It is clear that within US bloc, it is USA that would have to play dominant role. On the other hand, given the diversity and different aspirations of the more important BRICS members, we could risk thesis that they do not have much in common, but are united primarily by the idea of weakening highly abused financial and political dominance of the United States. Whether they are able to produce an encouraging and viable to all interested alternative remains an open question.

Hence discussions about financial aspects and potential for gold price appreciation or changes in geographical weights in between international gold markets.

Due to the size of the issue presented, we have decided to divide it into several separate parts. In doing so, we’d like to inform, that distribution of information on gold per se may therefore be uneven.



Źródło: Source: Compiled by author

Onshore dollar and petrodollar

Among the assets held in central bank reserves, there are but whose recognition seems to be timeless and universal. First is US currency, the dollar, and second is gold. First part of our analysis will cover these two, as subject of BRICS common currency is directly related to them.

Increase in the global weight of the USD occurred in the period before and then in the aftermath of the First World War, as a natural consequence of the flows of bullion from Europe to USA. In this way, the Allied countries secured their equipment supplies. Between the wars, USD shared its role as the world's reserve currency alongside British Pound Sterling. It did not achieve full global dominance until the next devastating conflict on the European continent, World War II.

Role of the USD as world's reserve currency was received legal legitimacy by the Bretton Woods Agreement of 1944. This, dethroned pound sterling from its long-standing position of dominance, to the role of just one of many currencies in the system,

Of course through the whole time, dollar was price-linked to gold. This has finally changed in 1971, when President Nixon introduced a 90-day freeze on US prices and wages to combat rising inflation - averaging 4.6% at the time. As a part of a package, he also announced unilateral suspension of the dollar's convertibility to gold. Another attempt to keep dollar linked to gold – this time without element of convertibility - was produced a few months later in the form of the Smithsonian Agreement. For multiple of reasons it did not stand test of time pushing the world towards floating exchange rates.

Current informal status of US dollar as a world’s reserve currency is due to actions resulting from a fuel crisis. Israel fighting the Yom Kippur defensive war in 1973 received US support. This in turn, triggered retaliatory action by the oil producers' organisation - OPEC, which resulted in a sharp and severalfold increase in fuel prices and fuel shortages in USA. In result, US president Richard Nixon and his national security adviser Henry Kissinger, traveled to Middle East to seek an agreement with King Faisal of Saudi Arabia. Eventually they got one, and who knows if it was not even better than Bretton Woods itself. Within the frameworks of a debt money system or fiat money, it created petrodollar.

OPEC countries, currently supplying world with 70% of its oil needs (and even more at the time), were to sell their product only in US dollars. Having a surplus of US dollars they kept investing it in US assets, primarily Treasury bonds, but also shares. This created huge and extremely liquid market for the US dollar, generating massive global demand at the same time. In simple terms, currency is a commodity like any other, so when demand grows supply must increase. In petro-dollar system, it was merely enough to give non-communist countries opportunities for natural GDP growth.

US dollar reinvestments by Arab countries generated cheap credit and kept up demand for US bond debt. In the process, a gigantic petrodollar recycling mechanism was created. Excess profits from oil sales were to be deposited in foreign banks. Those banks did lend money to governments, which financed their overspending and covered deficits on balance of payments. Governments also used proceeds received to buy and import oil, enabling economy to grow.

What remains to be clarified, is what OPEC countries get out of the deal. Profits arosed from increase in the value of shares in US companies or from maturing of US debt securities could have been be used for Arab countries infrastructural development or military reforms. These were often made with involvment of US companies in form of contractors. It’s not difficult to guess, that in authoritarian- countries transparency on money flow was significantly reduced.

Petrodollar Recycling. Source: https://talkmarkets.com/content/commodities/petrodollar-mercantilism-explained-in-one-chart?post=60038

One more interesting example of profit utilization for oil rich countries is establishment of national investment funds. By design, they re-invest oil profits to other oil-unrelated sectors. The aim of this solution is to ensure profits when the oil boom starts to come to an end. Threat is, that nominal value of the assets in the fund's portfolio may be reduced or lost as a result of local turbulence, bubble bursting, recession or depression.

Petrodollar system remains in existence today, although we are witnessing its gradual chipping away. It is difficult to conclude otherwise when BRICS countries been de-dollarising for over a decade, reducing exposure to US debt and increasing exposure to alternatives at the same time. That includes gold. In addition they also tend to use their own currencies in bilateral trade relations. In 2022 alone, numerous OPEC member countries have applied to BRICS and China itself is pushing towards making payments for Saudi oil in its own currency, yuan renminbi. More about BRICS in next chapters.

What is dollar offshore

It would seem that petrodollar itself is already a giant on the global scale. Yet, internationalized dollar - offshore, or Eurodollar market - is still missing from complete picture of its dominance. Subject is often being overlooked, either due to a lack of information, lack of formal Fed oversight or simply structural complexity.

Offshore dollar, unlike its onshore version, was an innovation that began to emerge in 1956. The whole thing was created not as effect of institutional planning, but rather by accident. London bankers, with the vigorous support from Bank of England and the British Treasury, created Eurodollar as a new form of dollar-denominated credit instruments that were not subject to US regulation and supervision. In particular so-called Regulation Q, which was rule introduced after the Great Depression of 1929-1933 to limit the interest rates on dollar deposits. That happened however at the time when Western Europe suffered from a post-war dollar famine. Hunger was gradually fading as own European economies recovered and confidence in its own currencies was being gradually restored. But there was also an element of strong interest in USD, coming from behind the Iron Curtain. Indeed, communist countries were interested in a trade exchange in which they could earn dollars, but preferably without direct contact with the US. This, created market situation where due to demand, Eurodollar created by London has been recognized as dollar and later petrodollar itself.

In the 1960s, New York banks discovered Eurodollar mechanism and began to use it to bypass US regulations. Local European market became an extension of the onshore dollar. In the 1970s, with collapse of Bretton Woods, use of the offshore market increased dramatically. This led to a situation in which the representatives of the central banks of G-10 countries recognized emergence of a new creation and started discussion within BIS frameworks, about regulating Eurodollar market. While "old Europe" was in favor of regulation, Bank of England which was main beneficiary of the solution, opted against it. US FED itself had a change of mind several times, unsure whether it was dealing with a threat or an opportunity. Finally in 1974, after experiencing oil crisis, it was decided to use and develop existing eurodollar structures. This was done to such an extent that size of the offshore dollar market is today considered larger than the onshore USD. Creation of this type of arrangement contributed to the emergence of other off-shore markets, including EUR, RMB, GBP and JPY. These however, remained smaller in size either comparing to their own onshore markets and US dollar in any version.

Dollar, or the so-called onshore dollar, acts as a currency of the US, but it is also official means of payment accepted for various reasons by other countries, including El Salvador. Far more importantly, however, it acts as a global payment and credit medium. Internationally, this phenomenon is known as the Eurodollar market, or dollar offshore. Loans made by commercial banks in this way are denominated in USD and serviced by London. Offshore space is thus part of the dollar currency area, but it is located in another monetary jurisdiction, which, with its consent, performs money creation.

Institutional evolution of the onshore and offshore dollar space. Source: S. Murau, The institutional evolution of the US-Dollar monetary area. MMF, money market fund; ABCPs, asset-backed commercial papers; repos, repurchase agreements

USD dominates international finance as a financial, investment and reserve currency. Its use is geographically dispersed, with much of its activity taking place outside the US. While US economy accounts for only a quarter of global GDP, around half of all cross-border loans, international debt and international debt securities are denominated in US dollars. Another 40% of all international payments are made in US dollars. Dominance of the USD is particularly evident in foreign exchange markets, where 85% of all transactions take place in dollars. Finally, USD retains its status as the world's primary reserve currency, accounting for 61% of all official foreign exchange reserves held by central banks. Above figures are based on BIS calculations from 2020 and by no means represent peak of dollar dominance in the world – mora like a decline in role. In 2000 alone, the share of the dollar among central banks' official reserves was 71%.

Share of the US dollar in various branches of global markets. Source: S. Murau, F. Pape, T. Pforr, The Hierarchy of the offshore US dolar system on swap lines, the FIMA Repo Facility and Special Drawing Rights

What is gold

Gold, is an asset with supply side dependent on natural factors, which of course precludes its possible 'printing'. As a commodity with strong monetary history, it remains a pan-national asset. Traditionally, it has been also considered a safe haven - ultimate and final security.

Gold has high molecular 'density' as a metal. This enables storage of more purchasing value in a physically smaller space than in case of fiat money. There are of course, higher-priced commodities that occur naturally less often in earth’s crust, such as palladium. However high technological demand for them, prevents its widespread investment usage in favor of more common gold.

Original perception of gold as valuable metal was influenced by its inclusion in the group of "seven planetary metals", i.e. metals known in antiquity. Technological possibilities of the time to extract from ore and then form onto ornamental, military or everyday use objects, determined human perception to consider rarest to be the most valuable. In case of shimmering yellow metal with physical characteristics that allowed it to be easily shaped, its occurrence was low enough for past generations to perceive it as valuable. And they did so independently in the vast majority of geographically separated civilizations.

Usage of gold as a currency in more or less formally established monetary systems through different civilizations paved the way for its global recognition. On the other hand, due to its purchasing power, it was copper and silver that were being used in everyday transactions, while yellow metal remaining an asset known to royalty, nobles and merchants.

In more modern Gold Standard (1871-1914), Gold Bullion Standard / Gold Exchange Standard (in between wars) and then in Bretton Woods system (1944-1971), gold was already used as a collateral in fractional reserve system, carrying promise of exchanging notes for bullion. In Bretton Woods it was set on ratio of 35 USD per troy ounce (31.1 g). Right to exchange was held by national governments and local central banks representing them.

Source: Compiled by author

In 1971, after suspending dollar’s convertibility to gold - as a result of the Nixon Shock - an attempt was made to revalue metal and keep fixed currency exchange rates in the form of Smithsonian Agreement. However, due to a lack of confidence in overprinted dollar, new arrangement was not feasible. Eventually, in 1973 this new gold-dollar fixed relation has perished and eventually has been replaced by petrodollar system. Solution was perceived at a time as perfect as not being linked to gold and therefore not being bound by fractional reserve scheme. In fiat system with USD as informal currency linked with oil, and with floating exchange rates there was no need for gold, so top-down attempts were made to eliminate it from reserves. Possibility of banning central institutions from buying gold was also being discussed. This was a result of the strong desire to balance reserves with other currencies. At the same time, international circles carried on with idea of pan-national SDR currency basket produced by the International Monetary Fund (IMF), which was an extension of the Keynesian idea of a pan-national trading currency - the Bancor This began a decades-long process of moving significant amounts of gold from institutional to private hands. By comparison, gold in central bank reserves averaged at 25% share of reserves in 1991, but in 2021 it was already only 11%.

Sell-off continued up to and including 2009, and was of course not without effecting price. As we entered new millennium, gold oscillated in the area of USD 300 per ounce. At the end of 2022, it is around USD 1 800. We are therefore dealing with a price appreciation of around x5.

Meanwhile, sell-off has led to accusations against central banks about artificial lowering price of 'royal metal'. As a result, central banks in the Western world entered into a series of agreements called Central Bank Gold Agreements (CBGAs) designed to limit the volumes sold. These agreements, renewed in 5-year cycles, were concluded in 2000, 2005, 2010 and 2015, respectively. As a result of the 2007-2009 financial crisis, market-supporting measures in the form of quantitative easing and increased systemic risks, selling trend reversed. From 2010 onwards, central banks became important buyers of bullion and consequently, CBGAs lost on relevance and ceased to exist.

Currently, for central banks, gold acts as one of many assets held. It should be noted, however, that each one of them follows different reasoning and asset allocation strategy as to the asset held. In this context, gold can be defined as an asset with close to zero credit risk, one of worldwide recognisability, being strategically ultimate hedge and serving its diversification function. Historically strong anti-inflationary factor is often mentioned in the narrative. This however may be disorted, as in medium or short term, numerous tools giving exposure to the gold price and unsupported by bullion at all or just in form of fraction may affect gold’s performance. However all of these characteristics allowed gold to be universally referred to as a safe haven.

Evolution of CBGA. Source: https://bithub.pl/bithub-plus/jak-regulacje-finansowe-zmieniaja-pozycje-zlota/

Bullion has universal recognition. This is supported by the fact that international gold markets, although few in number, are characterized by high liquidity and large capitalization. Most important are of course the US Comex futures market, London OTC LBMA and the Shanghai Gold Exchange. Existence of the above gives market participants various advantages. The most important of course, will be exposure to price without need to actually hold physical volumes. However, even more significant here will be possibility to lend gold holdings in a form of swap or collateral. After all, storage and holding gold in warehouses generates costs, and it is only by actively trading bullion, profit may be generated.

An example of the above would be National Bank of Poland’s presence in London market. Answer to parliamentary interpellation no. 26867 of 2014 states that 98 tonnes of Polish gold held in vaults of Bank of England (remaining 4.9 tonnes were stored in Poland at the time) generated costs of 143k PLN, BUT at the same time revenue of 4.2 mln PLN.

What is gold in international definitions

Since 2010, central banks have remained net buyers of gold. However, gold has not been just left apart and is subject of regulations. Set of Basel III regulations has been created under the auspices of BIS and is an effect of collaboration in between 28 of the world's major central banks plus other advisory institutions. While it is theoretically voluntary, locally its requirements are brought together in the EU Capital Requirements Regulation and the Capital Requirements Directive and have been in force in all EU Member States since 1 January 2014. However, they are implemented gradually with a target date of 2025. In addition to the EU countries, US and UK are also signatories of the above. National Bank of Poland does not count itself among the aforementioned, but in 2021 signed a letter of intent along with a number of European ‘non-eurozone’ banks confirming the willingness and necessity to implement proposed regulations.

Basel III, is reform of prudential rules in the banking sector that began in 2010 in response to the global crisis. During the bailout, it became apparent that commercial banks were exploiting numerous loopholes that allowed them to circumvent mandatory capital requirements. While determination to introduce new regulations was quite strong at first, it gradually began to fade over time. Particularly in the euro area, which after the last pre-covid crisis was unable to recover without the use of quantitative easing tools, i.e. private and sovereign bond purchases by the European Central Bank. Simillar pattern had to be observed in US, where regulations were initially introduced in the form of the Dodd-Frank Wall Street Reform and Consumer Protection Act with Volcker Amendment. Then its implementation was postponed, only to be eventually repealed in part.

Changes initiated in 2019 in Basel III changed the systemic position of gold as an asset, elevating it in bank accounting to same level with currencies and government debt securities – assets considered riskless. Such transfer increased liquidity, but at the same time gained an important place in the perception of gold lovers. In the current and rapidly changing world, gold is expected to serve as a liquidity-enhancing asset on institutional books. Additionally, as a hedge against changes in debt securities yields and currency valuations.

Share of gold as a percentage of central bank reserves, broken down to developed and developing areas. Source: https://www.centralbanking.com/central-banks/reserves/gold/7706256/all-that-glitters-surveying-central-banks-on-gold-reserves

Prior to 1 April 2019, current Basel III framework defined three types of asset classes that banks could hold. Each level applied to different classes and defined the degree of risk in each group. For example, level three was considered speculative assets, while level one was considered riskless. In addition, the relationship between the different levels was established proportionally. Thus, the value of tier three assets should not exceed 250% of tier one assets. This was also reflected in the books of central banks, as the most risky tier three assets could only be declared as 50% of their value. Prior to 1 April 2019, currencies and sovereign bonds were a tier one asset and gold was one of the tier three assets. After this date, re-classification of the different asset groups came into effect, which resulted in gold being placed in tier one. This was a confirmation of the gold’s informal status - marked earlier, shift towards gold in central banks' purchasing policy. Simultaneously it implies three types of benefits for central banks in the context of bullion holdings:

  • An increase in the value of assets held, through possibility to report their full value on balance sheets.
  • Increasing value of gold reserves already held through price appreciation, which peaked when bullion set new nominal price records in August 2020 and March 2022
  • Increase in liquidity with the simultaneous expansion of the safety buffer through the addition of a new asset with zero credit risk and high liquidity at the institutional level.

As part of the changes contained in Basel III, there is another important rule implemented by the European Union and Switzerland in 2021 and applicable to the UK and its LBMA market from beginning of 2022. This is the definitional separation of gold in physical form from derivatives that give exposure to bullion, such as options or futures - known to the market as 'paper gold'. Gold in allocated and physical form will be treated, as a tier one asset. By contrast, gold in unallocated form, or in the form of derivatives just assuring exposure, will belong to tier three. That means legislative separation between bullion in physical form and the investment and speculative instruments market, which is many times larger in terms of capitalisation.

That concludes part one of ‘Gold in concept of common BRICS currency’ series. Next part will focus on de-dollarisation trends among BRICS countries itself.

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