Our weekly commentaries provide Euro Pacific Capital's latest thinking on developments in the global marketplace. Opinions expressed are those of the writer, and may or may not reflect those held by Euro Pacific Capital.
A New Challenge to the DollarThursday September 28, 2017
In a move that was little noticed outside of the financial world, China announced the creation of an oil futures contract (open to international traders) that will be denominated in Yuan and convertible into gold. This move provides the first official linkage of oil to gold, and more importantly a linkage between the Chinese currency and gold. While the contract volumes that will be traded on this new platform will certainly be minuscule in comparison to those in the dominant markets of New York and London (at least initially), I believe the move is the latest, and perhaps most significant, step that China has taken down the path that could lead to a global economic system that is not fully dependent on the U.S. dollar. The move amounts to a direct challenge to the dollar’s privileged reserve status and could threaten U.S. dollar price erosion.
The move comes at a time when the U.S is particularly vulnerable to an economic challenge. Given the bold, but not particularly diplomatic, efforts of the Trump Administration to push an America First agenda, the U.S. finds herself somewhat isolated. Add to this the widening political polarity in the U.S.,which will make it that much less likely that Washington can take needed action in passing economic reforms to prevent a looming debt crisis. The dollar has been neglected far too long, and its strength may be far more tenuous than many imagine.
By way of background, the United States emerged from World War II as the world’s undisputed economic, financial and military leader. In 1944, at Bretton Woods, the U.S. dollar, convertible into gold exclusively by central banks, was adopted as the world’s main reserve currency. This status meant that the dollar was used to price most commodities, used to transact nearly all international trade. This status further strengthened the dollar and helped make Americans the richest people in the world.
Naturally, such privileges engender jealousy, especially when they are abused. But, whereas the Soviet Union challenged the U.S. militarily, no nation was powerful enough to offer an economic or financial challenge. All that began to change, albeit slowly, in the 1980’s when after the death of Chairman Mao, China adopted capitalism under the guise of communism. Less than 40 years later, the country has boomed to become the world’s second largest national economy with a GDP of some $11.2 trillion in 2016, according to figures from the International Monetary Fund (IMF), or more than that of Japan, Germany and the UK combined. China is currently the world’s largest importer of oil with Reuters reporting that some 212.4 million tons has been brought in through the first half of 2017. Russia and Saudi Arabia are its two largest suppliers. In the still somewhat opaque gold market, it is rumored that China is now the world’s largest holder of gold. More importantly, China is still growing far faster than the United States, and may likely become the largest economy in the world by the middle years of the next decade. Clearly such an economic change could invite a monetary one.
Many Americans are blissfully unaware that through the power of the printing press (and its digital age equivalents), the Federal Reserve has depreciated the U.S. Dollar against gold by more than 98 percent since the Bank was chartered in 1914. The decline went largely unnoticed because most other governments engaged in the same covert robbery. When President Nixon broke the dollar’s last link to gold in August 1971, the debasement accelerated rapidly. And President Trump’s just concluded deal with Democrats to suspend the Constitutional debt limit, removes the last road blocks that would prevent even greater dollar depreciation. That deal allowed the U.S. Treasury to borrow a staggering $317 billion, the most ever in a single day, which pushed the official U.S. funded debt past $20 Trillion for the first time.
In October last year the IMF, the central bankers’ central bank, expressed concern that non-financial sector debt had risen to $152 trillion or 2.25 times global GDP. The avalanche of computer generated money that has been dumped on the global economy has created the illusion of great stock, bond and real estate wealth. But while the elites bathe in the riches, the underlying reality of declining living standards and social unrest are laying the groundwork for changes. Those nations with surpluses, which have been making loans to the debtor nations, are showing the strains of this open–ended endeavor.
These factors place China in a potentially powerful position versus the United States. According to data from the Treasury Dept., China is the holder of $1.17 trillion in U.S. Treasuries, the second largest stockpile in the world, after the Federal Reserve itself. Like many other surplus nations, China has shown increasing concern over the U.S. monetary debasement policies and has called for an overhaul of the international monetary system.
By moving into the top position as largest oil importer, China has developed the power to challenge the universal dollar pricing of oil that has been in place since the early 1970’s. By creating a domestic oil contract denominated in Yuan and traded internationally, China will be able, potentially, to divert the petrodollars now held by oil–producing countries towards its Yuan, thus eroding much of the current crucial support enjoyed by the U.S. dollar. If successful with oil, China could create similar contracts on other internationally–traded strategic commodities (such as copper) to extend its possible attack on the U.S. dollar.
However, the world does not yet trust fully China or its currency. But by making the Yuan convertible into gold, even in this narrow sense, China now presents its currency in a much more attractive light. Many nations with large holdings of depreciating dollars and euros may be tempted increasingly to diversify into gold–backed Yuan, placing it and the Chinese government in an increasingly powerful position in international monetary affairs.
America faces serious problems from North Korea, large deficits and a looming crisis in underfunded social security, Medicare and pensions. Worse still, America faces acute social division. In the civil war, Americans killed each other in large numbers in order to preserve the Union. Today, Americans are divided politically and the gulf seems to widen on a daily basis. Unfortunately, we appear polarized not by a cause, but increasingly by hatred to a degree previously unimaginable. Only last week, a Senate Committee grilled a potential judge about her religion. This week political division even cast a shadow over the national Football League, which had always seemed to be beyond the scope of politics. This is the worst possible environment in which to expect citizens to pull together to endure the hardships of increased poverty from any future possible collapse of the dollar, dollar credit and dollar paper financial assets.
China recognizes our great divide and doubtless seeks to leverage it to advantage. It is said that the greatest use of power is to force your enemy to submit without firing a shot. It would not take much for China to trigger some future collapse of the U.S dollar. Such a move could result in financial and economic strain on the United States, a nation that has grown accustomed to plenty but torn increasingly by social strife. While the United States is locked in a rhetorical battle with North Korea (in a conflict that – save for nuclear weapons – would hardly matter on the world stage), China is taking an important step towards achieving future economic superiority without any open use of military force.
It is with this in mind that we continue to advise prudent holdings with international diversification achieved by means of overseas equity holdings and precious metals based on suitability requirements.
John Browne is a Senior Economic Consultant to Euro Pacific Capital.
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