Gold in the BRICS Single Currency Concept p. II
Concept of a common BRICS currency and discussions about potential role of gold in, has been an idea of more or less serious considerations and speculations for last several years. It has a multidimensional significance, as, it concerns changes of a monetary scope, in which the de-dollarisation trend is embedded.
I n first part of our analysis, we provided profiles of US dollar and gold. First, forms internationalised basis of today's monetary system. Second formed monetary basis of previous systems and later served as foundation in fractional reserve. Now acts currently as high liquidity, high market cap asset and safe haven to hedge geopolitical and monetary shocks. In second part of the series, we’ll focus on Euro, its failure and conclusion to be learned, evolution of official central bank reserves and gold allocation among them.
Due to the size of the issue covered, we have decided to divide it into several separate parts forming a common whole. In doing so, we’d like to inform, that distribution of information on gold per se may therefore be uneven.
Euro - early attempt to de-dollarize or just unifying mechanism?
As stated in part one of series – dollar is king. It is most liquid, recognisable fiat currency of the world. It is grease to the cogs of world’s economy and finance. It dominates international finance as a funding, investment, and reserve currency. Usage of the USD is geographically dispersed, with a large share of activity occurring outside of the US borders – among these, it is Eurodollar market which is most prominent. While US economy accounts for only one quarter of global GDP, around half of all cross-border loans and international debt securities are denominated in USD, and 40% of all international payments are made in dollar. Dominance is particularly visible in FX markets, where 85% of all transactions occur against USD. After all, would you like to become market participant, most of internationally tradeable assets are being valued in USD. Finally, dollar retains status of the world’s primary reserve currency, accounting in Q3 2022 for 59% of official FX holdings. This figure can be considered however both as a sign of strength and a sign of failure.
Share of USD in different sections of global markets. Source: S. Murau, F. Pape, T. Pforr, The Hierarchy of the offshore US dollar system on swap lines, the FIMA Repo Facility and Special Drawing Rights.
Holdings of official USD reserves have expanded rapidly following the 1997 East Asian crisis. They had grown from ‘mere’ 1.6 trillion dollars in 1997 to 12 trillion USD by mid-2020. The growth in reserve accumulation was particularly visible in Asia and the Middle East, led by China, Japan, and Saudi Arabia. As a form of self-insurance, FX reserves signal that countries have liquid assets to meet a liquidity shock or sudden reversal of capital flows.
Has that happened in Europe? European Union (in its pre-European Union form) was all in onto US dollar since decades. But in 1999, EU made its founding fathers’ long-term dream to come true. It had introduced its new, long awaited currency – Euro. At that stage only for inter-banking cashless transactions. Coins and notes bearing ‘€’ sign started replacing old franks, marks and guldens in 2002. However idea of common currency within bloc was somehow flawed from the beginning. Buyers of US treasuries had been secured effectively by US Treasury - the treasury of the world’s largest economy, and political hegemon. However buyers of EU bonds, were unable to purchase debt of a whole Eurozone. Instead they could buy debt of a certain EU member, just denominated in Euro. As you can imagine, strong German economy, a powerhouse of EU was still in value, in a cost of weaker Spain, Italy or Greece, where economies succumbed and budgeted expenses and incomes were highly imbalanced.
Eurozone had no common debt market, although idea is being effectively discussed since Spinnelli's report adopted by the European Parliament in 1981, and in the so-called White Paper of the Delors Commission on growth, competitiveness and employment in 1993. However no proper fiscal competences has been transferred to EU from participating countries. The result was an area of single monetary policy that comprised economically heterogeneous countries that had extremely different fiscal policies and were often direct competitors in certain sectors. This reinforced macroeconomic imbalances in the euro area with each passing year. That effectively made Euro unable to compete against dominance of US dollar. Although we could speculate, if that ever was in the basket of ideas behind EUR. Priority was from the beginning leaned towards creating of common market and getting EU countries together, making them depended on each other and tied together.
Initially implementation of Euro created some interesting effect. On 10-year bonds commonly used to assess the attractiveness of investments, difference between German and Greek bond yields which was 6%, fell to just 0.5% in 2001. Not surprisingly, heavily debt burdened countries of the South (Portugal, Italy, Greece, Spain, later to be known under acronym PIGS) chasing much more developed countries of the North, found it difficult to resist temptation to finance such civilizational speed up with cheap money. But what seemed to work in the time of peace, started to fail in the time of liquidity crunch. Global Financial Crisis of 2007-2008 and then Eurocrisis of 2011-2013 showed all flaws and inner daemons within EU. Period before them marked peak for value, weight and recognisabiliy of Euro. After them, we experienced long-term decline of EUR in the form we know.
Speaking of share in allocated reserves, we strongly recommend checking upon illustration below. Emergence of EUR with beginning of new millennium at 18.3% cannot be attributed to great worldwide acceptance of new European currency. It simply equalled joint share of allocated reserves in Deutsche marks, Netherland guldens and other European currencies that EUR replaced. Within couple years it strengthened its international position, peaking in 2007, only to reverse to near year 2000 levels in times closer to us. Dollar has lost couple percentage points to Euro, but later European currency lost its pound of flesh to China, Australia and Canada. That also proves, tend to be field of domination for 4 main reserve currencies (USD, EUR, GBP, JPY) is currently being defragmented.
Source: S. Murau, F. Pape, T. Pforr, The Hierarchy of the offshore US dollar system on swap lines, the FIMA Repo Facility and Special Drawing Rights.
Eurozone’s flaws by design - intentional or accidental?
Without further structural integration within bloc, Euro as a currency won’t be able to thrive on international scale in the times of de-globalisation and decoupling, despite of what Alan Greenspan might’ve thought:
>‘I am absolutely conceivable that the euro will replace the dollar as reserve currency, or will be traded as an equally important reserve currency.’
Such Euro-zone currency, could potentially pose a threat to dominant position of dollar. As long as Euro stick to a role of just local, international trading currency in a bloc (like Franc CFA does in Africa), it makes no threat to position of USD. In this way, it simply replaced several European currencies, but without development of strong defence mechanisms. However, attempts to create strong internationalised Euro could lead to creating conditions and counteractions designed to hurt Eurozone in a form of silent currency war. Just as it happened to Japanese Yen, when it attempted to internationalize in the 80’s. Many scholars and commentators suggest, it happened with strong influence of United States. And it is well presented in the book ‘Princes of the Yen’ by Richard Werner.
As mentioned national economies and regions within EU are not equal, not even to mention totally different budget approaches. Dutch farmer and his Sicilian colleague live in a different jurisdictions, with different types of heard and crops. Application of same policy to two totally separate entities (despite professional similarities) is incorrect approach and may result in totally different effects then intended. European Central Bank in Frankfurt has responsibility for euro monetary policy across the continent. From former central banks of current Eurozone, it inherited rights to regulate interest rates to fight inflation and stimulate economy in times of crisis. However, application of said rules for whole bloc, despite its high inequalities may push Italian farmer onto poverty, while his Dutch counterpart may survive, but only due to higher liquidity. Similar happened to banking sector after the Eurozone crisi. Italian bonds were being considered guaranteed loss in the environment of near-zero interest rates. Only speculators and ECB were making its purchases. On the other hand, German bonds were thriving, even despite of negative interest rates. Couple years later when interest rates are raising, German bonds are still being considered good choice, although whole environment may be considered difficult. However Italian, like all PIGS – lied heavy burden, as these heavily indebted economies now have to pay more yield on coupon.
Hence another issue, related to capital and human transfers. Inhabitants of European Union have a strong sense of allegiance towards its national countries. Those feeling first and foremost a ‘European’, are in deep minority. Nationality related issues are not so common in the times of prosperity, but may arise in a time of financial perils or just be fuelled up by media and politicians like in case of: Brexit. This type of approach is even more visible in capital transfers. During Greek crisis, many individual policy-makers within EU countries made a decision to not to support Greece, as it would affect individual trade surpluses and would be difficult to explain to its own voters. Bailout had therefore been conducted mostly by ECB as a member of so called ‘troika’.
As a result, rich north totally forgot, that their welfare had been built in cooperation to European south. Imbalances in TARGET 2 system - that maintain internal trade balances within Eurozone – is the best example of who economically benefited the most from integration. After all, by dumping labour prices, Germany lowered its inflation exporting it elsewhere. So German worker could have been less productive than his Greek counterpart, who despite popular and critical opinion were not ‘lazy’. Such inflation export had effect on final prices of goods.
In conclusion – idea of European common debt market, has been again taken under serious consideration during Covid-19 pandemic in 2020. However this failed to outlive virus itself.
On internal market, Euro replaced former national currencies and started being widely used. Implementation of any changes to the actual status of such would require legislative changes within EU, which require unanimous support. Taking under consideration how existence of European currency benefits Benelux, Germany and France on account of weaker economies, it seems to be impossible to do Also, that would mean that countries having strong balance sheets or simply keeping its expenses on a leash, would have to accept part of their counterpart’s debts. In the eyes of Euro-sceptics, that would be imposing dominance of EU. In eyes of the North, that would be losing trade profits and taking responsibility for somebody’s debts.
Evolution of foreign exchange reserves - past and present
Having covered Euro, as second most important reserve currency of the world in terms of size, we should discuss actual share of reserves.
Mentioned earlier 12 trl USD in value of allocated reserves, had been a case basically since about a decade. In Q2 2011, world reserves pass cumulatively through 10 trl USD, to never fall again below. For the last decade, we oscillated in between 11- to nearly 13 trl in official reserves. Below dataset is being based on data provided by International Monetary Fund and reflects data for Q3 2022. On 11.5 trl USD we know exact allocation of 10.7 trl (92.88%) of total value. American dollar sits on 59.79%, which is slight recovery from bottoms reached in Q4 2021 at 58.81%. Euro has passed below 20% in Q2 2022 and now represents 19.66%. That inflicts demise on strength and influence of Eurozone. Pound Sterling (4.62%) bounced up little bit to 4.62% since 2020, and Japanese Yen continuous its decline (5.26%) along with long-term demise in value.
Chinese Renminbi is responsible for 2.76% of overall reserves. It is in slow and constant progress, so 3% in comparison to 60% representing USD (both rounded up), doesn’t seem to be much. It should be however as China started from zero levels. China is reluctant to move to capital account convertibility. Its leaders fear that an open capital account could lead to imported crises and weaken control of their economy.
But unlimited access to deep and liquid Chinese capital markets may not necessarily be essential for RMB internationalisation. Rather, the renminbi can acquire that role through its use in invoicing and settling China’s foreign trade and payments. China has established a global network of clearing and payments, such that it is now possible to undertake cross-border transactions in RMB in a wide variety of different jurisdictions. Development of the RMB as a reserve currency had to keep pace with the expansion of trade invoiced in RMB, notwithstanding China’s limited capital account openness. This was and is being achieved by development of Belt and Road initiatives. What helps in internationalistic assumptions for RMB is achievement of larger, gradual dependence over certain markets. And the RMB's inter-nationalisation assumptions are further aided by the achievement of an enlarged, gradual dependence over certain markets. In the eyes of the international community, East Africa or Central Asian republics may not be noteworthy, unless cumulatively as regions. But the capture of large markets, recently decoupled from west, like Russia's should certainly be noted. And this, by the words of its president, has recently declared need to internationalise Chinese currency. More, on Yuan Renminbi, China and the BRICS in full in the next section.
Going back to official reserves – would be fantastic to have official data for all advanced and developing economies. Problem is, that International Monetary Fund stopped publishing such divided data with the end of Q1 2015. Also, reserves by currency tend to be in many cases confidential due to sensitive nature of such data, hence it seems to be rather impossible to obtain such data for most of countries. However comparison of i.e. Q3 2014 – Q1 2015 is possible in the context of developed and emerging markets:
Emerging markets had shown less share of allocated reserves. By the early 2000’s, when China and other emerging markets had started accumulating vast quantities of reserves, it had become untenable – at least officially - to estimate currency composition of their reserves. So the IMF came with a cunning plan – to create new category called unallocated reserves and report there currency composition only of allocated reserves. On the basis similar to: ‘We have a bag worthy 1000 silver oz, but in the bag we have mixed some gold, some silver, string and granny apron. One day we’ll do exact math, and for now we do report value in dollars. One thing did not change— IMF did not reveal which countries failed to report the composition of their FX reserves, i.e., which countries were responsible for the unallocated reserves. Again, with regards to China and certain other economies began reporting the currency composition of their FX reserves to the IMF in 2014. But they did so only in a phased manner to protect the confidentiality of this information.
What also seem to be understandable is difference between higher share of USD among emerging markets, although just by couple percent. Euro and Japanese Yen were not so popular, and relative strength of GBP can be explained, that lot of emerging markets used to be a part of the British Empire.
Keen readers probably noticed already, that one of the protagonists of this analysis seem to be missing…
Case for Gold as an obligatory reserve asset
Gold continues to form an important part of many countries’ stock of foreign reserves. For the period since fall of Bretton Woods and Smithsonian Agreement – which was designed to be its successor - gold was being slowly replaced among reserve assets by other currencies. In 1991 cumulatively it was responsible for 25%. In 2001 it, as result of decades of sales it peaked to just 11%. According to 2020’s data from the International Monetary Fund, yellow metal constitutes 14.6% of total world reserves. One could say it kept stable share between 10-15% at least since the late 1990’s. However previous chapters clearly show that approx. 15% two decades ago vs 15% today means different volume, nearly by 7.5 times if not considering price factor. When doing so, increase in volume remains impressive.
By the end of the third quarter of 2020, advanced economies altogether held around 20% of gold as a percentage of their official assets, while the share in emerging and developing countries was only at 7.4%. Worthy noticing, that since then we have experienced two consecutive years of strong purchases by central banks, especially Asian. We discussed that deeper in our ‘Gold supply and demand trends 2022’ analysis.
Source: BIS Working Papers No 906
However strong presence of Asia among buyers doesn’t mean that collective west has fully lost its gold. According to World Gold Council, official reserves held by central banks amounts to over 32k tonnes of gold, with USA in possession of over 8k tonnes, and EU countries owning collectively over 10k in its vaults. Need to remind, that we analyse volumes belonging to central banks. We therefore skip potential to “mobilise” private gold voluntarily or compulsory.
Looking more closely, it is also evident that individually, advanced economies hold greater amounts of gold than emerging markets as a fraction of reserves. Estimating distribution of the share of gold reveals two modes in the distribution of advanced economies. One approximately between 0% to 10% and another between 60% and 80%. Such divergence is to be explained by large legacy holdings that is inheritance after past times. That explains colonial France, benefiting from international war transfers USA, fearful of war and hyperinflation Germans or always neutral Switzerland. One of the few exceptions would be UK, which sold half of its gold reserves between 1999 and 2002. It has been remembered as Brown’s Bottom (from the surname of then HM Chancellor of the Exchequer).
Another reason lies in protracted growth of the reserve portfolios on emerging market countries after the 2007-2008 global financial crisis. This trend reverses the result of aggregate net selling by central banks and other official in the decade prior to the crisis. Changes in gold holdings tend to accumulate gradually, suggesting that reserve managing generally maintain buy-and-hold strategy for their precious metals. Central banks decision about how to choose an adequate share to invest in gold is not trivial and depends on policy objectives and practice - target duration, risk tolerance metric, etc. Given the volatility of gold returns, having gold among assets – even some small volume - appears quantitatively adequate under most circumstances. However, there is evidence of a potential insurance value of gold in adverse scenarios, which can support higher allocations of gold in cases where the protection against risk is to be considered seriously. Hence vast purchases.
This concludes second part of the "Gold in the BRICS Single Currency Concept" series. In next part, we will focus on BRICS countries, their approach to de-dollarization and role of gold in it.