Making Cents of the Currency Crisis

It is hardly surprising that at such a time the price of gold continues to break new records, while the IMF's SDR is back in fashion

Panellists:

Eisuke Sakakibara, former vice-finance minister for international affairs of Japan
Robert Lloyd-George, chairman, Lloyd-George Investment Management, Hong Kong
Kenneth Courtis, former vice-chairman, Goldman Sachs (Asia) and co-founder of Themes Investment Management
Ernest Kepper, president, Asia Strategic Investment Associates, Japan
William Thomson, chairman of Private Capital, Hong Kong, director of Finavestment, London

Moderator: Anthony Rowley, Tokyo correspondent for The Business Times

Rarely, if ever, has a conjunction of weakness in the world's two main reserve and transaction currencies (the US dollar and the euro), such as is being seen at present, occurred just at a time when natural disasters have also put the Japanese yen under a cloud. It is hardly surprising that at such a time the price of that classic store of value, gold, continues to break new records, at least in nominal or non inflation-adjusted terms while the IMF's "fiat" currency, the SDR (Special Drawing Rights), is back in fashion. The Business Times convened a panel to discuss what lies behind this unique currency crisis and what the future holds.

Anthony Rowley: The gold price has soared and there is much talk of a return to some sort of gold standard. Professor Sakakibara, what do you think about the role of gold as a monetary anchor and as an investment?

Eisuke Sakakibara: I don't think there is any possibility of returning to the gold standard. It is true that because of the (weakness of) the dollar people are holding gold as a kind of reserve asset. That phenomenon will probably continue for some time. But the gold standard is a system we abandoned a long time ago and I don't think it is possible to return to it. Given the amount of gold that exists in the world and the need for liquidity, it could not serve as an anchor for all currencies. If we restrict liquidity by attaching currencies to gold there will be substantial shrinkage, which probably will lead to deflation the world over.

Anthony: So, will the gold price rise further?

Eisuke: In dollar terms it will. In terms of the yuan or other Asian currencies, I'm not so sure. What we are seeing is a continuous decline of the dollar vis-a-vis gold.

Anthony: Robert, I know you are a "gold bug". Where do you see it going?

Robert Lloyd-George: My view is that the gold price is heading to US$5,000 an ounce by 2014, at which point there may well be a crisis with the US dollar and a return to the gold standard in some form. What is happening is that many countries that are getting richer at a rapid pace are buying more gold, both at the central bank and individual saver level, in China, India, Russia, Mexico, Indonesia, and perhaps some Middle Eastern countries. This shift in world wealth is going to have a big impact on the choice of gold as an investment instrument in the next few years.

Ernest Kepper: I'm bullish on gold even at its current levels. It could reach US$2,000 an ounce in the next eight months and US$4,000 an ounce in the next few years. Under any scenario, gold will go higher. In the event that there is a return to some sort of gold standard, gold could reach anywhere from US$3000-US$30,000 an ounce, depending on how you configure such a standard. Given plans to increase the debt ceiling in the US by trillions of dollars, I expect there to be a return to a gold standard within five years; and I expect double-digit inflation in the US by early next year.

Kenneth Courtis: Some investors increasingly see gold as a "currency". The popping of what I call the "Bush Bubble" took the world economy to the edge of a vast catastrophe and it also effectively smashed the global economic and financial equilibrium which had been in place since the Bretton Woods system finally imploded four decades ago. We do not know today what the new equilibrium will be. What we do know is the mushrooming of debt was not only central to the US bubble; it is also one of the dominant characteristics of the Japanese and many European economies. Even then, with the exception of Japan and a few others, public sector debt is a small part of the "Himalaya" of debt bearing down on the world economy. Vastly more problematic for most developed economies is private sector debt - particularly in the banking and household sectors. Private sector debt is above 300 per cent of GDP in many OECD economies. Many investors looking at this situation rationally conclude that the probability of debt of this magnitude being paid back, dollar-for-dollar, is extremely low. The logical conclusion is to invest in hard assets, which will hold their value as paper assets are devalued through inflation. As this process unfolds, there will be an increasing clamour for gold to play a new role in the world monetary system. I would see then gold playing a reference role rather than an anchor to a new global monetary system.

William Thomson: Gold has appreciated steadily over the past decade by about 20 per cent per annum and performed admirably as a portfolio insurance policy. We now see growing interest on the part of emerging economy central banks to increase their low gold reserves given the vicissitudes of the main alternatives - the US dollar and the euro. But I do not see gold having any wider official role than as a reserve asset that cannot be debased by the machinations of central bankers.

Anthony: Let's turn from soaring gold to sinking dollars. Will the US dollar continue to lose credibility and will there be a third round of quantitative easing (QE3) by the US Federal Reserve?

Eisuke: I think the gradual decline of the US dollar will continue for another decade or so. But there is nothing else to replace it as a key currency. The euro cannot take the place of the US dollar other than in Europe. This is a very unstable situation. There may be a continuation of QE2, so whether you call it QE3 or not, easy monetary policy will continue for some time in the US because the recovery there is recognised to be fragile. The US dollar will continue to depreciate vis-a-vis currencies such as the Singapore dollar, the Thai baht, and the Japanese yen but (the US dollar's value) will be controlled by Chinese authorities vis-a-vis the yuan.

Robert: The US dollar is clearly losing credibility, but there is no immediate alternative. I believe that deflation is impossible to sustain in a democracy, and therefore we will have a QE3, or further stimulus if there is any weakening in the economy or market. This means the US dollar will continue to be weak, commodities will be strong and there will be more and more upward pressure on other currencies such as the Canadian dollar, Australian dollar, Norwegian kroner, and so on.

William: The US dollar has abused its reserve currency status and has lost much credibility in the past decade. It is always managed with the interests of the US at heart rather than the global community. I don't believe there will be a formal QE3 unless the US economy deteriorates markedly. But equally I do not expect the Fed to shrink its bloated balance sheet anytime soon. It is quite possible that the US dollar will rally modestly now that QE2 is ending but it remains vulnerable to fresh declines in the autumn and beyond while US fiscal and monetary policy remains broadly accommodative.

Ernest: The trillions of dollars Washington wasted trying to buy jobs have now run out and the illusory recovery those dollars bought is fading, as is growth in jobs, consumer spending, and gross domestic product. The Fed will continue printing money when its quantitative easing programme is supposed to end in June. President Obama is running for re-election, and the only option this president has For the economic recovery is to print money as Congress will not support any new stimulus bills. Since job growth is far too weak to stop printing money now, QE3 is guaranteed and hundreds of billions more US dollars will be printed. This will result in rising consumer prices, a plunge in the US dollar, and increases in cost of living.

Anthony: So much for the US dollar, but the euro doesn't look to be in exactly robust health either. So, what's the story there?

Eisuke: I think the euro crisis is structural. It is very difficult to overcome the problem in a short period of time. Since World War II, there has been a steady progress of integration of European countries but it looks as though this trend has been reversed in the course of the past year or so. Weak, peripheral countries like Hungary or Latvia, and now Greece and Ireland, seem to be dropping out of the integrated European Union. Sure, they won't leave in a short time but the problem is structural.

Anthony: So what has to be done, and could the euro area break up do you think? Also, what of the role of the euro as a reserve currency?

Eisuke: Monetary consolidation has been achieved in Europe and a single currency has been created, so the only remaining integration process is fiscal integration but I don't think German citizens would like to support Greece and other European nations through fiscal measures. The euro area will not break up immediately but this crisis will linger on and maybe four years from now, or six or seven years, some kind of decision may have to be taken.

Kenneth: At the centre of the European debt crisis, as it currently stands, is a fundamental issue of solvency, by which I mean that Greece, Portugal, and Ireland are incapable of generating enough savings to escape the debt trap in which they are now complete prisoners. It is this combination of a solvency and a liquidity crisis which makes the European situation so very problematic. For now, the wall between Portugal, Ireland, and Greece on one side, and Spain, Belgium, and eventually Italy on the other is holding. But should it crack and others become completely ensnared in this double solvency and liquidity crisis, then the finances of France and of Germany itself would be severely tested.

William: Greece cannot pay its debts as they stand. It should reschedule or leave the euro. The same applies to some degree to Portugal and Ireland. But more likely is there will be more euro-fudge ahead of the French elections in 2012 and the German elections in 2013. Longer term, some of the weaker members will either have to leave the euro or, slightly more likely, there will be moves toward a fiscal union with the EU issuing bonds for its members much as the US Treasury does for the US.

Ernest: I'm not sure that extending loans to Greece would avert a crisis of the euro. If Greece leaves the EU, I think the euro would get stronger. I think both Greece and the EU would be better off if Greece did default, because a "haircut" (shaving of debt obligations) of 20-50 per cent is required to achieve debt sustainability. Bailing out countries is really just a backdoor way to bail out banks on the back of taxpayers and the currency. It might have a chance if it was just Greece, but it is a case of Portugal and Spain too and Spain is too big to save. This is the biggest bubble of all time, the bubble of government debt, and I think that the bubble will burst.

Anthony: Let's move to Asian currencies. What role do you think the yuan might play in future?

Robert: I think the yuan is moving toward a key position in the world monetary system and that it is an unstoppable and important trend. I am fascinated by the accelerating pace at which it is internationalising for trade, and also for savings and investments. Everyone I know in Hong Kong has a Hong Kong dollar account and now a yuan account also.

Kenneth: Over the longer span, the yuan will play a significant role - in trade and investment, and once the yuan becomes fully convertible, as a reserve currency. There is already a vast appetite for yuan assets. Think of the so-called dim sum bonds, the offshore yuan bonds which have started to come increasingly to the market in the last year or so. It is virtually impossible to get your hands on them, so aggressively do yuan bulls grab them at issue. After the baby steps of the last two years, China is taking bigger and bolder measures to internationalise its currency. But there is still a long way to go before it has a fully convertible currency.

William: It is inevitable and desirable that the yuan's use as a trade and reserve currency should expand. This is beginning to happen with bilateral trade arrangements and internationalisation can be expected to grow rapidly in coming years. I expect China to increase its gold reserves (officially only 1,000 tons but probably much higher) substantially over the next decade or so to match those of the US (8,000 tons) or the ECB (12,000 tons) and thereby boost the currency's credibility further. The yuan will eventually be a reserve asset and its usage, especially in Asia, is bound to grow.

Eisuke: Maybe in 10 or 20 years from now the yuan will play a crucial role but in order for that to happen, China has to establish convertibility and to relinquish various currency restrictions. It will take time but I think China is probably thinking in terms of the next 10 to 15 years (for this to happen).

Anthony: What about IMF Special Drawing Rights (SDRs), do you see this as the global reserve currency of the future?

Eisuke: The SDR cannot be a reserve currency. This is a man-made currency and it could not replace either the US dollar or the euro. The IMF could allocate SDRs so that countries that have been given an allocation could convert those SDRs into US dollars or euros. That would increase liquidity in some countries but (the SDR in itself) could not serve as a reserve currency.

Anthony: If the SDR is not a viable alternative reserve currency, what is the alternative to the US dollar?

Eisuke: A multi-currency system of the US dollar, euro, and possibly some Asian currencies. But some kind of volatility or disruption could take place (under such a system).

Anthony: What of the yen? Will it sink into relative obscurity as the yuan emerges alongside the US dollar and Europe?

Eisuke: East Asian economies are being integrated quite significantly and I think that in 20 or 30 years it is not impossible to have some kind of Asian currency (based on) the yen, yuan, and other Asian currencies - an Asian version of the euro.

William: By 2060, the UN expects Japan to be only the 20th-largest country with a population of 94 million. Faced with problems of managing demographic issues, Japan is going to face incredible challenges to stay competitive. It also has a gigantic outstanding debt. This does not argue for the yen being a significant player in global markets.

Kenneth: The yen has never been a significant international currency. One of the conditions to having a significant international currency is that there is a local money market that is active, dynamic, large, and open. Japan has pretty much missed the boat on this one. It had the potential to be the Wall Street of Asia, generating for itself vast income from financial services. That chance is now gone.

Anthony: What role in future for emerging market currencies?

William: The Singapore dollar is probably the new Swiss franc. Other than that, maybe the Brazilian real, the Indian rupee, and (less likely) the Indonesian rupiah. The Australian and Canadian dollars will remain interesting - well-managed currencies of well-managed economies.

Kenneth: Some emerging market currencies are already playing a regional role. For example, the South African rand serves as a reference for parts of Africa. Brazil also plays a similar role for part of Latin America. Some emerging market currencies are also sought for diversification away from the major currencies and for regional investment plays - the Brazilian real, the rand, Turkish lira, Singapore dollar, Malaysian ringgit, and the Taiwan dollar. Thailand and Malaysia appear to be intervening heavily in markets in an attempt to hold markets at current levels. But should flows of funds to emerging markets continue to increase, then it will become difficult not to allow currencies to adjust in a way that reflects the shifting fortunes of the world economy.

Robert: History tells us that political and military power account for the domination of a currency. For the past 200 years, the leading currency in the world has been based on a democracy and open trading system. This "imperial" character of the major currency indicates that we cannot expect any single emerging market currency to dominate. Therefore, gold may, by default, come to occupy a much more central role, as it has in past history, but we need a major crisis to affect that transformation.

Anthony: On that note of gold's continuing ascendancy, we must end.