Gold and Fiat currencies

Over the last few years, the public and institutional confidence on fiat currency has been tested owing to unprecedented rise in Gold prices. Spot gold traded at London has gained almost 7 times since 2000 and posted a historic high of $1921 an ounce during 2011. This is almost 665% rise from around $250 an ounce during 2001. During this period the US dollar value has dropped over 30%. The value of fiat currency is on faith and backed by economic fundamentals. It is called legal tender money with no intrinsic value and not backed by any reserves. Historically, most currencies were based on physical commodities such as gold or silver, but fiat currency is based solely on faith.

As most fiat currencies are under pressure owing to slowing global economy and EU debt crisis, the demand for gold is on rise from both retail and official sector. As per a poll by UBS on Sovereign Institutions, gold will be one of the most sought reserve asset by central banks for next 25 years and that US Dollar will fall from its pedestal as the sole reserve currency.

Already emerging economies along with China and Russia have been increasing their holding of Gold. Chinese official gold holdings have increased by over 75% to 1054 metric tons since the 2008 recession while Russia has doubled to 918 tones. Mexico has raised their holdings to 125 tons from just 3.69 tones. Korea, Saudi Arabia, Argentina, India, Thailand, Turkey, Kazakhstan have also increased their gold holdings substantially during this period.    

As most western central banks have frittered away their gold, central bank of these emerging economies are quietly buildings up their reserves. Most importantly, what are published are the official purchases and few believe that a large part of these Central Bank purchases of Gold Bullion are not been disclosed.

Both China and Russia have boosted their domestic production of gold wherein large chunk of the same is believed to be purchased by central banks. As per a report from Bloomberg, Venezuelan Central Bank director, Jose Khan, has said that country will boost its gold reserves through purchasing more than half the gold produced from its rapidly growing domestic gold mining industry. The GIC is also intended to increase their gold holdings to help shield their billions of dollars of assets from turbulence in global currency markets.

From retail sector also, demand is robust. Demand for gold backed funds rose 136 tones in Q3 2012 and recently the holdings at the giant SPDR Gold Shares ETF rose to a new record high at 1,343 tones.  Hedge funds still favor precious metals as billionaire George Soros raised his holdings by 50 percent in the third quarter, fellow billionaire fund manager John Paulson's massive gold holdings were steady, and Windhaven Investment Management raised its overall gold holding by nearly 500% to about $4.5 billion.

Gold is on demand from every nook and corner which suggest a possible currency shock. The debt crisis of the Euro zone is far from over, despite the EU winning the noble peace prize this year. As possibility of Greece and most importantly Spain exiting the Euro zone is not too low, concerns are on the high that debt troubles will spread to other larger and peripheral economies in the region. Moreover, the most common problem in the EU peripheral nations is high unemployment which is conjugated with negative growth outlook. In Spain, unemployment rate has been around 25% with youth unemployment raging around 50%.  In Portugal and Ireland it is base unemployment ranges over 15% and in Greece around 23%. In such a situation, it is very likely these countries will continue to see social unrest along with political instability. A tight fiscal policy, cut in social spending along with raising taxes is expected to further add fuel to the issue which is eventually turning catastrophic for the Euro.

On the other side of the Atlantic, US also faces issues of rising debt, broadening fiscal deficit along with slowing growth. US debt outstanding exceeds USD 16 trillion. A percentage point rise in interest rates over time adds almost $160 billion to annual debt financing. Out of the total debt, almost 45% is owned by foreigners and mostly by China and Japan. The most concerning factor now a days is that sovereign bonds are not perceived as risk free and there is a general awareness among people that at some level of financing cost, debt becomes unsustainable. One can refer to the situation to PIIGS.

Another risk to dollar is the Chinese, Russia and Iran’s interest to replace dollar with another form of currency reserve or linked to SDR, the international reserve asset created by the IMF in 1969 that has the potential to act as a super-sovereign reserve currency. Recently, the Russian President Dmitry Medvedev said that he hosted talks with Chinese leaders about turning the yuan into a convertible reserve currency, part of a broader goal to move international reserves assets into emerging-markets currencies and away from the dollar. However, this will be a gradual shift. As per data from the US Treasury Department, Chinese have reduced their holding of U.S. debt to $1.16 trillion from $1.31 during June 2011.

The currency war seems far from over and it will continue this decade as well. The relative valuation metrics fails to paint an accurate portrait of the condition of fiat currencies while gold can be sketched as an accurate barometer. The conceptual graph in figure 1 shows the relative performance of euro and the US dollar with gold prices since 1995.

As investors over the world, awaken to the fact that a persistent global debt crisis paired with competitive pressure of fiat currencies leaves none of the affected currencies as viable safe havens, the world will increasingly look to gold and/or Silver  as the ultimate safe have asset. Wish to quote what Former Fed Chairman Alan Greenspan said “You always have to ask the question why is it that central banks hold so much gold which earns them no interest and which costs them money to store. The answer is obvious: they consider it of significant value, and indeed they consider it the ultimate means of payment, one which does not require any form of endorsement.”