The ‘gold bugs’ assert that at all times and in all circumstances gold remains money. For some irrational reason the ‘paper bugs’ cling to their increasingly worthless colored coupons asserting their importance as currency.
The Great Credit Contraction has begun and in the macro sense there is no practical solution to the end of the current worldwide monetary system. But in the micro sense the individuals and companies that will survive, thrive and prosper will be those that are liquid. It will be those who can make payroll.
GOLD IS MONEY AND CURRENCY
On May 20, 1999, Alan Greenspan testified before Congress, “Gold is always accepted and is the ultimate means of payment and is perceived to be an element of stability in the currency and in the ultimate value of the currency and that historically has always been the reason why governments hold gold.”
For these reasons gold, silver and platinum belong in the cash portion of the balance sheet. The precious metals are the ultimate form of currency. Unlike their comptition, the colored coupons, the precious metals can never become worthless, are always accepted and are the ultimate means of payment.
The ‘gold bugs’ will always be able to purchase something while the ‘paper bugs’, if they have physical notes and not mere digits in a database, are eventually left with an instrument that only has a single use after defecation. What intrinsic value!
GOLD ANTI-TRUST ACTION COMMITTEE
During the 1990’s Mr. Rubin had devised the gold leasing scheme with the intent being elucidated by Dr. Greenspan’s testimony in 1998, “Nor can private counterparties restrict supplies of gold, another commodity whose derivatives are often traded over-the-counter, where central banks stand ready to lease gold in increasing quantities should the price rise.”
GATA’s alleged central bank gold price suppression scheme may include the COMEX’s participation. Mr. Robert Landis, a graduate of Princeton University, Harvard Law School and member of the New York Bar, has asserted that “Any rational person who continues to dispute the existence of the rig after exposure to the evidence is either in denial or is complicit.”
GATA alleges that the central banks have less than half the physical gold claimed. The central banks carry gold in the vault and gold out on loan as the same line item. In effect, they report cash and accounts receivables as the same thing. Ever tried making payroll with an accounts receivable?
It seems some countries are getting a little nervous and demanding their phsyical gold. For example, the IMF by-law F-1 states, “Gold depositories of the Fund shall be established in the United States, the United Kingdom, France, and India.”
With the lack of transparency it makes one wonder whether India’s recent ‘purchase’ of 200 tons of gold from the International Monetary Fund was a bona-fide purchase or the taking of physical possession of ‘paper gold’ they had previously purchase on the open market and whether this was done of the IMF’s free-will or through coercion because of the ancient rule that possession is 9/10th’s of the law? Perhaps this is why India, not China, got to purchase this large block of bullion.
But such is just speculation, like the tungsten rumors, based on circumstantial research and there are no real credible and verifiable sources that I have been able to find but it does highlight the issue: actual physical gold is tremendously limited relative to the amount of colored coupons.
ADVICE TO THE OIL MAJORS
Nearly a year ago on 16 December 2008 in Oil Majors Should Just Buy Real Gold I wrote:
Combined these five companies [Exxon (XOM), Chevron (CVX), Total (TOT), British Petroleum (BP), Conoco Phillips (COP)] had current assets exceeding $300B. … The entire eligible COMEX stockpile represents an immaterial 0.36% of the current assets of the five oil majors. The oil majors could drain the COMEX with a rounding error. It would be 14% of what Exxon Mobil was spending per quarter buying back stock. Why buy back stock when oil is so cheap compared to gold? Why not just buy physical gold and truck it away?
What has happened since then?
At the end of Q3 2009 Exxon (XOM) had $57.3B of current assets; Chevron (CVX) had $35.5B in current assets with $7.6B cash on hand; Total (TOT) had $48.4B in current assets and $13.8B cash on hand; British Petroleum (BP) had $66.7B in current assets and the runt,ConocoPhillips (COP), still possessed $22.3B in current assets. Combined these five companies had current assets exceeding $250B and cash on hand exceeding $50B.
While the risk of a potential COMEX failure to deliver gold is a possibility for brevity I will not explain the mechanics nor current state of the warehouse.
The approximate two million ounces of registered gold in the COMEX inventory represents about 62 metric tons or a mere $2.3B. For compaision, Bloomberg reported on 17 November 2009 that The Bank of Mauritius bought 2 metric tons for about $71.7 million. Mauritius had a 2008 GDP of $8.65B or about .5% of the 2008 total revenue of the five oil majors.
On my article ‘How the Treasury Bubble Will Burst and Why‘ at Seeking Alpha I received a comment from Alan Brochstein, CFA and fellow Seeking Alpha Gold Standard Contributor who provides analytical services for hire. He said, “Trace, sorry, but this makes absolutely no sense…” This is not surprising considering his 8 Dec 2008 article ‘Own Gold? Time to Fold‘ where he stated, “Gold remains a sucker’s bet…”
On 8 December 2008 gold closed at $772.25 and by 27 November 2009 gold closed at $1,177, a 52.4% gain. Not bad for a different currency; it makes one consider whether the FRN$ is in hyperinflation.
PLATINUM AND SILVER
Platinum, a tangible asset, is incredibly safe and has now, with GoldMoney, gotten more liquid. There is a miniscule amount of platinum compared to the illusions in the liquidity pyramid. For example, the entire annual worldwide platinum production is valued at about $8B compared to the five oil major’s $50B of cash.
While no one really knows what the total above ground silver stock is; Ted Butler, a noted silver analyst, suggests there are about one billion ounces which is about $20B.
In 2008 the five oil majors repurchased about $54.2B of stock. Exxon with $35.4B, Chevron with $6.8B, Total with $1.3B, British Petroleum with $2.6 and Conoco Phillips with $8.1B. The average price of gold in 2009 through October was about $941.
So let me get this right. Instead of holding increasingly worthless colored coupons the oil majors could have diversified their currency holdings to ensure they could make payroll and with about a third of what was spent on the share repurchases could have bought the entire annual production of platinum and the entire above ground stockpile of silver. Or assuming the average price of gold they could have bought about 1,791 metric tons of gold.
The 1,791 metric tons of gold would make the five oil majors the fifth largest holder behind the United States, Germany, the IMF and France, but who knows how much physical gold the Western central banks really have, and have about twice the 1,054 tons of the sixth place China.
At the current price of gold the $54.2B of stock repurchases from five measly companies will only yield about 1,432 metric tons of gold or about 359 less tons than the hypothetical. For comparison Venezuela is the 16th largest holder with 363.9 tons and the United Kingdom is the 17th largest holder with 310.3 tons.
This is one reason the ‘new gold monetarists’ should be taken seriously. Even on CNBC, a starving vampire squid (Neilsen ratings are down 52% year over year) which hates gold like werewolves hate silver, had a serious discussion about the ‘new gold monetarists‘ which included the quote, “That is what the new gold monetarists are saying. If you take all the world’s GDP and divide it by the amount of gold that is above ground that is available then you get a price that is somewhere between $11,000 per ounce and all the way up to $50,000.”
Too many people have too much faith in worthless irredeemable colored coupons and their companion digital counterparts. The Federal Reserve and other central banks are failing with quantitative easing. And after all, the worldwide monetary system is just a confidence game and when confidence is lost it does not so much collapse as evaporate. For example, auction rate securities, mortgage backed securities, Bear Stearns, Lehman Brothers, AIG, the Kazakhstan tenge, the drooping Vietnam dong, the British Pound or the FRN$ (more than 50% loss in a year is pretty bad!).
The current worldwide monetary system is failing. Why will another fiat system not replace it? The market will not permit such irrational behavior. The monetary authorities are on the defensive. They have lost the confidence of the market and are unable to regain it with more secrecy, more bailouts and more of the same. The market is forcing them to do what everyone in the past has had to do. They are being forced to show the market the money. Real money and not some colored coupon currency. Money that is a real and tangible asset that can be put in someone’s hand or trucked away to a different vault.
Sure, what the new gold monetarists say seems incredible and may lead some financial professionals to declare ‘this makes absolutely no sense’. But this population of financial professionals has been systematically miseducated to despise precious metals and be ‘paper bugs’. But as confidence continues evaporating those same professionals will demand that precious metals return to the center of financial life. On the macro scene society will learn some very real and very hard lessons. But on the micro scene there are tremendous opportunities to benefiit from the largest transfer of wealth the world has ever experienced.
The future is clear. Gold will return to its historic role as the center of gravity for the Western and worldwide monetary system. Sure, the Establishment, costumed officials and financial professionals do not welcome the change. But it is not their choice because the market will force their hand and the market is more powerful than all of them combined.
After all, it will be the companies and governments with the monetary metals in the cash portion of their balance sheet that will be able to make payroll and those without will simply evaporate. The number one killer of businesses is cash-flow. Remember the first rule of panic: do it first!
DISCLOSURES: Long physical physical gold, silver, platinum and no position the problematic SLV or GLD ETFs or XOM, CVX, TOT, BP or COP.
I dropped in on the St. Louis Tea Party event Saturday at Kiener Plaza in St. Louis. Typical sub-par cell phone photo with special glare augmentation A crowd photo by Julie Stone:
My guesstimate — and I’m not great at these things, so I could be way off — is 1,000-1,500 people attending the event. Far fewer than the Tax Day Tea Party in April, but still a helluva turnout for a political event, especially on a holiday weekend.
I was joined by Libertarian congressional candidates (both announced for 1st District, so we’ll be having a contested primary!) Robb Cunningham and Julie Stone. We passed out a stack of Missouri Libertarian Party newspapers. Here’s a photo of Julie handing one of the papers to a guy:
The bad news:
In St. Louis, at least, the organizational end of the Tea Party movement (founded by Illinois Libertarian Party activists) has become a wholly-owned subsidiary of the Republican Party. Local Tea Party coordinator Bill Hennessy has stated his case for “taking over the GOP” instead of going third party, and his suggested tactics for getting the rogue Tea Partiers back into Republican lockstep.
Several of the speakers regurgitated the same talking point (quoted from memory): “It’s not about Republican or Democrat, it’s about conservative or liberal.” Of course, by “conservative” they meant “Republicans and a few pet Democrats who can be counted on to vote for the most expensive and damaging big-government program, foreign military adventurism.”
All of the introduced/touted candidates were Republicans, all of the targeted public officials were Democrats. The issues talking points were 100% conservative/Republican red meat (ObamaCare, Cap-and-Trade, the evil unions). Obviously those issues get some overlap with the sentiments of libertarians, constitutionalists and other pro-freedom folks, but absent was anything that didn’t pass the Rush Limbaugh “dittohead” orgasm test.
Even though the St. Louis County Libertarians contributed $100 for the event (to help with the rental of “port-a-potties” — and we took the liberty of posting a sponsorship flier on one), we received zero mention from the stage during the two hours that I was there. Nor did any other third party or independent candidate.
In format and agenda, it was 100% a Republican Party event.
The “leadership” and the “membership” are two different things, of course. We got a reasonably warm greeting for our literature, and several people made it a point to photograph, or come up to discuss (always positively), my sign: “Voting Republican for smaller government is like f–king for virginity.”
I suspect that the Tea Party movement is done as a force for liberty. That’s certainly the case to the extent that its “leaders” succeed in duping supporters of smaller government into voting Republican next year. My impression, though, is that most of the Tea Partiers fall into one of two groups: Those who were already Republicans and who just might have caught on a bit through their exposure to the LP, Campaign For Liberty, etc., and those who were already third party and don’t plan to allow themselves to be co-opted.
So, a lot of sadly blown potential, but probably not too much damage done, and perhaps even a little bit of good accomplished. Requiescat in pace for something that might have been an amazing breakthrough if the damn Republicans hadn’t tied it down, slit its throat and sucked the blood out of it.
More photos at Facebook, courtesy of Julie Stone.
Sheikh Makhtoum won’t go to debtor’s prison, but short of that, Dubai’s all-but-sovereign default is an epochal event in its story. I wrote a column in Financial Express titled Dubai’s great crash where I draw on this episode to think more clearly about (a) International financial centres and (b) Puffery. On this subject, also see Reality catches up with the Gulf’s model global city by Roula Khalaf in the Financial Times, and ‘The Sheikh’s New Clothes?’ Dubai’s Desert Dream Ends by Stanley Reed in Business Week.
One hears talk about Dubai giving up crown jewels, like the airline, in exchange for a bailout. I think the time for that bailout was six months ago. Today, with a funding gap of $80 billion, the crown jewels are not big enough. But six months ago, it was possible to think of a deal where ADIA bought up the crown jewels for (say) $40 billion and Dubai would have tided over the storm. Or maybe this is big, and runs beyond just the crown jewels: see Enough glitzy debt: time for regime change by Jo Tatchell in The Times.
This episode is an opportunity to think about exchange rate regimes. What if Dubai had used a floating rate instead of a fixed rate? This would have worked in two ways. First, it would have been a stabiliser. When bad times came, capital would have started leaving Dubai, the exchange rate would have depreciated, thus making real estate or hotel rooms in Dubai cheaper in the eyes of foreign customers. (Conversely, in good times, the exchange rate would have appreciated, thus reducing the attraction of going to Dubai). The key intuition (RBI speechwriters please note) is that exchange rate fluctuations stabilise the economy. Without a flexible exchange rate, adjustment in Dubai was forced on to the labour market, the real estate market, etc., which are all places where adjustment is more disruptive and is resisted more.
The second interesting feature of this thought experiment is linked to borrowing. A fixed exchange rate encourages and even subsidises dollar denominated borrowing. For society, the low cost of borrowing (the USD interest rate) is paid for by the loss of monetary policy autonomy. If a flexible exchange rate were used. Mr. Makhtoum would have been more careful and would have borrowed less.
Retail executives were holding their breath on Friday, looking for indications that the recent recovery would extend into the holiday shopping season. Macy’s CEO Terry Lundgren went on the record with the Wall Street Journal Saturday to assert that early indications of both traffic and sales are pointing to “very good signs” for the December shopping season.
Online market reports from Coremetrics showed the average amount online shoppers spent on Friday rose 35% from last year’s Black Spending Friday. Top statistics included:
- Online Apparel retailers saw sales jump 28.6% from last year.
- Web-based jewelry sales reported nearly 25 percent surge.
- Online department stores did phenomenally well job reporting a 151.7 percent jump.
Overall consumer electronics are taking an early lead in sales volumes. Best Buy CEO Brian Dunn said that shoppers are in “a buying mood” and that “our crowds were materially bigger than last year.”
Toys “R” Us also pointed to big crowds favoring electronics. CEO Jerry Storch said that not only are electronics a big hit but with respect to early sales results: “So far we’re pleased. Friday morning we averaged over 1,000 people per store waiting in line, and we’ve been doing brisk business ever since.”
In general Friday’s results appear to be positive for holiday retailers. Given the big online surge on Friday that continued into Saturday, Cyber Monday is likely to follow suit. University of San Diego economics professor Alan Gin remarked over the weekend, “I think things will be surprisingly on the up side.”
Tuesday’s Hardtalk on BBC World News (link) discussed the political, economic and social aspects of communism versus liberal capitalism with Slavoj Zizek ,a philosopher and professor at European Graduate School.
Mr. Zizek discussed the role of liberal capitalism in the modern age. He condemned communism as a failure of the mankind and reaffirmed the liberal capitalism as the greatest invention of the mankind. The topic discussed was the future of liberal capitalism. In arguable words of Mr. Zizek, liberal capitalism, although dynamic and powerful in delivering ends of political and economic freedom, is doomed to fail and it thus requires new politico-economic alternative, divisible at the intersection of market and the state. Despite the interactive debate, I would like to add some points to the discussion which were, in my opinion, either mismatched or misinterpretated.
The evolution of liberal capitalism throughout the course of human history has been emphasized by the expansion of economic, political and human freedom. The greatest inventions in human history were not conducted under dictatorial political regimes. But they were conducted during the age of limited government and free innovation environment. Anytime the powerful wit of government was enforced, innovation and discoveries suffered. Although Mr. Zizek recognizes the failure of totalitarian regimes to stimulate intellectual creativity, his analysis of liberal capitalism inherently neglects its role.
The ability of individuals and firms to pursue their own goals in liberal capitalism is enabled not because of the design of desirable goals but because the free-market capitalism evolved as an undesigned system of ideas under strong rule of law. If liberal capitalism, as Mr. Zizek argues, would be doomed to fail, the individuals never witnessed an unparalleled increase in prosperity and in the 20th and 21st century.
What has distinguished communist political regimes from liberal democracies are the institutions of economic freedom. There is a clear and remarkably positive empirical relationship between economic freedom and standard of living. The experience has shown that political liberty is a neccesary but not sufficient condition for prosperity. Both, the neccesary and sufficient condition for the pursuit of prosperity is economic freedom. Without economic freedom, when governments replace the rule of law with the rule of man, and heavily interfere with free-enterprise activity, these countries are doomed to stagnate. Totalitarian political ideology, claiming to create heaven on earth, has always turned towards the hell on earth.
During the interview, Mr. Zizek argued several times that liberal capitalism can eat itself and fail in a similar vain as communism did. The Soviet Union and the communist block certainly hadn’t failed because of the lack of technological investment, but because communist political ideology erased the system of incentives. Even today, when several politically totalitarian countries sustained high growth rates, the superiority of liberal capitalism is even more obvious. The motion behind the economic miracle of Gulf countries, such as UAE, Bahrain and Qatar, is the institutional arrangement that promotes solid economic performance under robust system of law, market economy and incentives that allocate scarce resources into the most appropriate uses. In the interview, Mr. Zizek described Dubai’s miserable labor conditions as “labor concentration camps” where workers from other countries reside. Although this view sounds very compelling to Marxist philosophers and political thinkers, no government agency forced foreign workers to go to Dubai and work there.
In fact, the economy of United Arab Emirates went through a remarkable restructuring with the creation of the robust financial and service sectors. As productivity growth and capital investment soared in recent decade, wage rates in Dubai are much higher than in other Arab countries. Still in doubt? Ask foreign workers in Dubai how many of them would leave the place and returned to work in their home countries; and why they don’t do that. In addition, in Mr. Zizek’s home country, labor conditions for foreign physical workers mostly from ex-Yugoslavia are not the envy of the world despite the most regulated labor market in the world.
There is also a wide array of case studies from recent economic history that show how economic freedom crucially determines the wealth of nations. In 1955, Hong Kong was a miserable place flooded with refugees from the mainland China. In 1960, Hong Kong’s average income per capita was 28 percent of that in Great Britain. In 1996, it rose to 137 percent of that in Britain. Neither the dictatorial political regimes led to the economic boom in Hong Kong, nor the desire to create heaven on earth. It was a set of strong rule of law of British origin, limited government spending and free markets that propelled Hong Kong to the climb up the ladder.
Mr Zizek arguably enforced the proposition that global financial crisis led to the crisis of liberal capitalism. Although the global financial crisis led to the recession, high unemployment and deflating prices, it certainly has not put the existence of liberal capitalism into doubts.
The origins of the last year’s financial crisis go back to the New Deal and presidential time of Jimmy Carter and Bill Clinton whose administrations, as benevolent social engineers, enforced numerous acts to boost home ownership. Back in 1996, president Clinton signed Community Reinvestment Act which forced banks to allocate housing borrowings to low-income neighborhoods. In the aftermath, Fannie Mae and Freddie Mac securitized risky sub-prime mortgage loans to save banks from default. Meanwhile, they inflated debt-to-equity ratio to 60:1. It means that for deposit of USD, there were 60 USD behind in debt that nobody was willing to bear.
In addition, the monetary policy of the Greenspan era kept low interest rates for too long which causeed an asset bubble and led to the decrease of mortgage values It led to the federal bailout of Bear Sternes and the failure of Lehman Brothers. It also triggered innumerable quests for federal bailout of financial institutions. Thus, it would be foolish to speak about the crisis of liberal capitalism after the financial meltdown. Is liberal capitalism to blame? Of course not. It is rather the greedy political apetite for destructive policies that compromised the stability of the world economy for the sake of short-term political goals.
Mr. Zizek wisely avoided the question of the post-communist politico-economic status of Slovenia after the collapse of Tito’s Yugoslavia. True, Slovenia’s superior economic performance in Yugoslavia was mainly due to its export orientation and higher growth compared to the rest of Yugoslavia. At the beginning of the independence in 1991, Slovenia was, by all measures, the most developed former communist country; far ahead of countries such as Czech Republic, Slovakia and Estonia. Today, Czech Republic virtually caught-up Slovenia’s level of standard of living. In 2008, Czech Republic’s GDP per capita was 94 percent of that in Slovenia. In 1991, it was merely of 60 percent of that in Slovenia. The politicians, of the same “market socialist” politico-economic beliefs as Mr. Zizek, designed the statist economic policy based on high tax rates, state-owned enterprises, weak rule of law and rigid market structures. Today, Slovenia’s economic and political system more closely resembles Russia’s mafia state than a liberal society based on economic freedom, rule of law and limited government. In a great part, thanks to the political ideology of “market socialism.”
The excellent research edifice at the Bank of International Settlements have conjured up one of those papers which needed to be written (by Claudio Borio and Piti Disyatat) on the back of the myriad of different monetary policy responses we have observed in the contex of the economic crisis. The abstract and conclusion look as follows;
(my emphasis throughout)
The recent global financial crisis has led central banks to rely heavily on “unconventional” monetary policies. This alternative approach to policy has generated much discussion and a heated and at times confusing debate. The debate has been complicated by the use of different definitions and conflicting views of the mechanisms at work. This paper sets out a framework for classifying and thinking about such policies, highlighting how they can be viewed within the overall context of monetary policy implementation. The framework clarifies the differences among the various forms of unconventional monetary policy, provides a systematic characterisation of the wide range of central bank responses to the crisis, helps to underscore the channels of transmission, and identifies some of the main policy challenges. In the process, the paper also addresses a number of contentious analytical issues, notably the role of bank reserves and their inflationary consequences.
In the wake of the current financial crisis, monetary policy will probably never be the same again. Central banks have been forced to review their implementation frameworks and to try out policies that, only a few years back, were not on their radar screens. They have been operating in unchartered waters, outside their “comfort zone”. In the process, unconventional monetary policies have become the focus of much discussion and heated debate. In this paper, we have provided a unified framework to think about and classify unconventional monetary policies, considered the analytical issues they raise, with particular reference to the transmission mechanism, and briefly assessed some of the key policy challenges.
We have stressed several analytical points.
First, unconventional monetary policies fall under the broader category of balance sheet policy, whereby the central bank uses its balance sheet to affect asset prices and financial conditions beyond the short-term interest rate. Thus, they are not unconventional in their essence, with foreign exchange intervention being a very familiar form of such policies.
Second, balance sheet policies can be decoupled from interest rate policies. This reflects the fact that the level of the short-term interest rate can be set independently of the amount of bank reserves in the system. Third, the main channel through which balance sheet policy operates is by altering the composition of private sector balance sheets, exchanging claims that are imperfect substitutes for each other. By altering the risk profile of private portfolios, such as through the purchase of less liquid or risky assets or by being prepared to lend at more attractive terms than the markets, the central bank can reduce yields and ease financing constraints.
Fourth, because of this, in our view the outsized role often attributed to banks’ excess reserves in discussions of balance sheet policy is not warranted. Since excess reserves are very close substitutes with short-term claims on the central bank or the government, what the central bank buys and the credit it extends are more important than how these operations are financed. Finally, balance sheet policy should be the considered in the broader context of the consolidated public sector balance sheet. Importantly, central banks have a monopoly over interest rate policy, but not over balance sheet policy.
While we have not examined in depth the effectiveness of balance sheet policies, it would be hard to deny that they have helped to stabilise conditions and cushion the fall in aggregate demand. There is evidence that central bank purchases of government bonds have lowered their yields, although they seem to be subject to “diminishing returns”, once the surprise factor wears off. And policies targeting interbank markets or private sector securities have been successful in narrowing risk spreads and supporting borrowing activity there.
At the same time, balance sheet policies raise a number of challenges for central banks. As central banks move away from the simplicity and well-rehearsed routine of interest rate policy, they face much trickier calibration and communication issues. As they substitute for private sector intermediation, they may favour some borrowers over others, tilting the level playing field, and could risk making the private sector unduly dependent on public support. As they purchase government debt, they come under pressure to coordinate with the public sector debt management operations. And as their balance sheets expand and they take on more financial risks, central banks risk seeing their operational independence and anti-inflation credentials come under threat in the longer term. As a result, questions about coordination, operational independence and division of responsibilities with the government loom large. These costs suggest that unconventional monetary policies should best be seen as special tools for special circumstances. The costs also point to the need for appropriate governance arrangements, designed to limit the risk that the central bank anti-inflation priorities are undermined in the medium term. And they put a premium on early exits, as soon as economic conditions permit.
I have only scanned the paper and thus not really given it the attention it probably deserves, but one of the things I found most interesting, (especially in the light of the my recent inquiry into the matter with respect to the ECB), is that while I agree that exit strategies is first and foremost a communication exercise they will also become a concrete operational challenge.
More generally, the discussion on the transmission channel from unconventional monetary policy as split into two between the signalling channel and the broad portfolio channel (operational/market channel) is interesting and provides a good framework through which to understand the current initiatives by monetary policy makers. The paper also pulls out the classic, as it were, about how the Fed and the ECB differs in their response because the former has focused extensively on the non-bank sector (asset backed securities and government bonds) whereas the latter has mainly focused on the the banking sector (i.e. through fixed-rate full-allotment refinancing operations with maturities of up to 12 months).
Again, it is difficult to argue with the underlying argument here in the sense that it is clearly borne out in the data. The problem with the ECB, as I have argued before, is the extent to which banking finance is indirectly funding the purchase of government bonds and thus what happens to sovereign spreads in the Eurozone when the refinancing offers taper off into 2010. That is a subject for a different entry. For now, I leave you with this instructive paper from the BIS; it is well worth a look.
In recent months, a sense has emerged that the exchange-traded currency futures market in India is more liquid than the corresponding contract traded OTC (i.e. the forward market). As an example, we examine a dataset from NSE of 28,797 observations of data – one observation per second – from 3 November 2009, for the November expiry. The effective spread for a transaction of $1 million (i.e. 1000 contracts) is calculated, in the units of paisa. This dataset has the following summary statistics:
In other words, 95% of the time, the spread on NSE for a $1 million rupee-dollar futures transaction was below 2.344 paisa. The median spread, for a $1 million transaction, was 1 paisa. This spread dropped below 0.5 paisa with only a 5% probability.
These numbers are significantly superior to those found on the OTC forward market, where, as a thumb rule, dealers feel that a $1 million transaction typically involves a spread of 2 paisa. This suggests that the liquidity at NSE is roughly 2x superior to the OTC market. The superiority of the execution at NSE is likely to be greater than 2x when we consider the opacity and execution risk of the OTC market. To the extent that order flow has shifted away from the forward market to the futures market, there could be a dynamic story here of the futures spread getting tighter at the expense of the forward spread.
This situation is unexpected. In the international experience, the currency forward markets is more liquid than its exchange-traded counterpart. This is despite the fact that futures markets has desirable features including near-zero counterparty risk, transparency, contracts standardisation and open public participation. The key reason for the domination of the OTC market appears to be historical. The OTC market came first, had entrenched liquidity, and the network externalities of liquidity hold the users in place.
In thinking about India’s currency futures market, it would be useful to compare and contrast with Brazil’s experience. Brazil is an interesting peer to India for reasons of a large GDP, democracy, rule of law, institutional quality, etc. It is also the only country of the world, prior to India, where the currency futures market became more liquid than the currency forward market.
In Brazil, currency futures trading began in 1991 – a seventeen year head start when compared with India. While Brazilian macroeconomics is now remarkably healthy, Brazil has had a turbulent history with many crises, high and volatile interest rates and inflation. The futures market, with daily marking to market, and therefore lower collateral requirements, offered a cheaper way to take positions in the currency. Nevertheless, there is reason to believe that several (sometimes unrelated) regulations contributed to tipping the balance in favor of futures contracts, so much so that today there is essentially no OTC market to speak of. The dealers on the forward market now provide OTC contracts to their customers but unwind their positions in the futures market (See Note 2). The regulatory pressures which moved liquidity from the OTC market to the futures market were:
- Access to spot markets was limited for several decades as a tool to control capital flight. Both domestic and foreign residents had easier access to futures markets than to spot markets. This led to greater number of players, and more liquidity in futures markets. Access to spot markets in Brazil is still far from free, for both domestic and foreign residents. India is in the same boat, with a futures market that is accessible to citizens but a spot market which is not.
- Until 2005, banks were subject to unremunerated reserve requirements on foreign exchange exposures exceeding pre-specified limits. These reserve ratios did not apply to futures positions, thus driving trading to futures markets.
- Until December 2007, Brazil imposed a financial transactions tax, called CPMF, on all debits on bank accounts. This levy applied to profit and loss payments on exchange traded contracts, not to their notional amounts, thus pushing activity to exchanges.
- OTC derivatives contracts are not netted, whereas contracts with the exchange or clearing house are netted by the latter. This means that the tax on cash flows, PIS-COFINS (See Note 3), de-facto taxes OTC transactions at a higher rate than exchange traded derivatives.
- Brazil has reporting requirements for OTC transactions – all transactions with domestic counterparties must be reported to regulators, in order for them to be considered enforceable. This levels the playing field in terms of the reporting burden of exchange traded versus OTC transactions. India has not yet done this.
- Pension funds are required to use only standardized derivatives contracts.
- The central bank, Banco Central Do Brasil, uses the futures market for doing currency intervention. This gives liquidity to the futures market, and also ensures that the OTC community has to look very carefully at the price on the screen so as to capture current information. India has not yet done this.
While some of these rules were removed in the 2000’s, after being in place for several years, their consequences have outlasted them. There is a path-dependence in market liquidity. These kinds of market rules matter in getting liquidity on the exchange off the ground. Once the exchange becomes liquid, the network externality of market liquidity sucks in further order flow and preserves the domination of the exchange even after these rules are removed.
1 The author is a senior analyst at the Bank of Canada. The views expressed here are personal. No responsibility for them should be attributed to the Bank of Canada.
2 The material in this note is a summary of information provided by Brazilian economists as well as that contained in Dodd and Griffith-Jones (2007), Brazil’s derivatives markets: hedging, central bank interevention and regulation, and Kolb and Overdahl (2006), Understanding futures markets, sixth edition, Blackwell Publishing.
3 The PIS and COFINS are federal taxes on revenues, charged on a monthly basis.
MOF has setup a working group on foreign investment:
To review the existing policy on foreign inflows, other than Foreign Direct Investment (FDI), such as foreign portfolio investments by Foreign institutional investors (FIIs)/ Non Resident Indians (NRIs) and other foreign investments like Foreign Venture Capital Investor (FVCI) and Private equity entities and suggesting rationalisation of the same with a view to encourage foreign investment and reducing policy hurdles in this regard while maintaining the Know Your Customer (KYC) requirements.
To identify challenges in meeting the financing needs of the lndian economy through the foreign investment. Foreign investment for this purpose to be understood broadly and can include investment in listed and unlisted equity, derivatives and debt including the markets for government bonds, corporate bonds and external commercial borrowings.
To study the arrangements relating to the use of Participatory Notes and suggest any change in the policy if required from KYC and other point of view.
To reexamine the rationale of taxation of transactions through the STT and stamp duty.
To review the legal and regulatory framework of foreign investment in order to identify specific bottlenecks impeding the servicing of these financing needs.
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To suggest specific short, medium and long term legal, regulatory and other policy change; in respect to foreign investment keeping in view of the suggestions expert committee reports such as the Committee on Fuller Capital Account Convertibility, the Committee on Financial Sector Reforms and the High Powered Expert Committee on Making Mumbai an lnternational Financial Centre.
Recent days have seen continued rebounds in housing, corporate profit reports and consumer confidence.
Two reports early this week point to continued progress in residential housing resales. On Monday the National Association of Realtors implied that the home-buyer tax credit will likely sustain the housing market throughout next year. In October, first-time buyers used the tax credit and combined it with record low mortgage rates to push home sales to their highest level in 2 1/2 years. Home sales are now 37 percent above their bottom in January and the seven-month supply of inventory is quite modest. We saw bidding wars break out earlier this year in select areas, but now those competitions are becoming more widespread.
On Tuesday, home prices continued to show improvement according to the Case-Shiller report. The report data continued a long strong string of improvements: Year-on-year rates continue to improve; quarter-to-quarter rate shows steady improvement and those areas that were especially hit hard like the West and pockets of Florida have turned markedly higher.
An analysis of corporate profits is also quite rosy. Tuesday’s government release shed light on huge corporate profits: up 16% since the end of last year. What is particularly noteworthy is that even though we’ve just made it through a strong recession, profits in US firms have essentially doubled in the past 8 years.
And a consumer confidence report out on Monday took everyone by surprise. Heading into the holiday season, consumer confidence is back on the rise. The Conference Board consumer confidence index rose to a level not forecast by even the most optimistic forecasters. Most had expected a downturn in confidence.
While many expect that the holiday consumer season will be light, many indications point to an economy and a consumer that are ready to believe in a brighter 2010.
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On 26 November 2009 the State Bank of Vietnam devalued the dong by about 5%. This is the third instance of currency devaluation in two years. The FRN$ is likewise being devalued against gold.
A few weeks ago I observed that those buying gold in Vietnam are paying a premium and that:
Gold is money and is reasserting itself as currency in Vietnam. After 18 months of failed policies the helpless government has retreated from the import restrictions because the market is more powerful than governments.
The State Bank of Vietnam set a dong reference rate for tomorrow that is 5.2 percent lower, at 17,961 per dollar, compared with 17,034 today, it said in a statement on its Web site. Policy makers narrowed the dong’s daily trading band to 3 percent, from 5 percent, effective tomorrow, and increased the benchmark interest rate for the first time since January, to 8 percent.
GOLD PARTY GETTING STARTED
As I observed on 9 September 2009 when the gold party was getting started, with the price at $995.75:
200 day relative price of gold is at 1.08x … Based on seasonal trends gold and silver will be strengthening, with the strongest months in September and November
This upleg in gold and silver will have significant strength because of the long period of consolidation just like in 2004 and 2006 which provided the foundation for the uplegs in 2005 and 2007 that took gold from $400 to $700 and $650 to $1,000, respectively. If the current upleg is similar to the previous two then the 200 day relative prices for gold and silver at the top of this upleg would be about 1.5x and 1.7x, respectively.
This puts $1,300 gold and $25 silver within range without greatly exceeding previous trading norms
GOLD PARTY DUE FOR A BREAK
On 25 November 2009 Reuters reported:
Gold struck a record high for a second time this week, rising above $1,178 an ounce on Wednesday, as the dollar slipped and a newspaper reported that India was “open to buying” more gold from the International Monetary Fund.
Gold has jumped nearly 13 percent since the beginning of this month as investors poured money into the precious metal after India’s central bank announced it had bought 200 tonnes of bullion from the IMF.
The current price of gold is about $1,175 per ounce with silver at $18.70. Like I predicted November has been a strong month for both of the metals. The 200dma for gold is $967.86 and $14.73 for silver. This puts gold at 1.217x its 200dma and silver at 1.27x its 200dma.
WHAT AND WHEN TO BUY
Usually in a strong bull market silver will trail gold and then rapidly play catch up. The vast majority of silver’s gains happen in a relatively very short period of time. If gold is like owning a cruise ship then silver is like owning a speed boat.
Because gold and silver have moved so quickly so fast, seasonality and the need for consolidation of these rapid gains therefore it is likely prudent to protect some gains while still maintaining exposure to the upside; for example, using put options. While over halfway there from when I predicted; I still think $1,300 gold and $25 silver is within range but there will likely be some correction and consolidation between here and there.
Thus buying gold is not nearly as attractive as buying silver or even buying platinum which is up $340 per ounce since I recommended platinum about four months ago. I am still extremely bullish on platinum and if acquiring a physical store of the precious metals and given an efficient and cost effective option, such as with GoldMoney, between platinum, gold or silver then I would recommend platinum.
SUPER DROOPY VIETNAM DONG WHEN PRICED IN GOLD
With the 5.2 percent devaluation against the FRN$ and with the FRN$ losing nearly 13% against gold in November alone and $358 or 43% over the last 12 months the only conclusion is that the Vietnam dong is taking a beating when priced in gold. In other words, it has gone from 18.4M dong per ounce in January to a high of 28.85M or about 57%!
With Vietnam’s widening trade deficit, the current account deficit, the demand for dollars and gold instead of droopy Vietnam dong, the global economic slowdown which will dampen exports (surely one of the reasons for the devaluation) and evaporating foreign exchange reserves therefore the monetary policy and condition of Vietnam will continue to erode which will place further pressure on the already droopy Vietnamese dong.
Vietnam is having a terrible time attempting to maintain their monetary policy. Economic law is being applied and gold is playing its prominent role like it always does. The government can resist but resistance is futile.
Likewise the FRN$ is evaporating before the just heat of gold. Gold is nowhere near a bubble which is difficult to blow when when so much of the demand is fully paid for and not subject to margin call or default.
But the real bubble is the FRN$ and demand is showing the first significant hints of declining. After all, it is becoming the carry-trade currency. Americans with the monetary metals will be as fortunate as Vietnamese because all the barbarous relics of fiat currencies are evaporating. The Great Credit Contraction has arrived and grinds on.
DISCLOSURES: Long physical gold, silver, platinum and no position the problematic SLV or GLD ETFs.
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