The end of the de facto petrodollar standard has
profound and lasting implications for the US dollar, oil, and gold. The US
is the epicenter of the global financial crisis and economic downturn, but the US continues to
exercise disproportionate control of the oil trade and to enjoy the unique
status of the US dollar as the world reserve currency. The inflationary policies of the US
government and Federal Reserve have damaged the US dollar to the point that it
is increasingly seen as a destabilizing force in the world economy. To make matters worse, it was principally the
US that manufactured the financial
derivatives that still menace the global financial system (China
has opted out). There is growing
recognition that the US
economy is on an unsustainable course and this fact has fueled an international
movement towards a new world reserve currency.
China has emerged as a major player in the currency chess game
and in the gold market, and China
is the second largest consumer of oil. China is the largest US creditor holding $797.1 billion in US Treasury debt
and a net creditor nation with reserves equal to $2.273 trillion. Nonetheless, China is leading the charge against
the petrodollar standard and the US dollar's privileged status as the world
reserve currency. China is not merely
seizing the opportunity presented to it by the global financial crisis but is
pursuing an ongoing economic strategy that includes a larger domestic market
for its own goods and services, greater influence over the global economy, a
stronger yuan, and a secure energy supply.
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"The good fighters of old first put themselves
beyond the possibility of defeat, and then waited for an opportunity of
defeating the enemy. To secure
ourselves against defeat lies in our own hands, but the opportunity of
defeating the enemy is provided by the enemy himself." - Sun Tzu, The Art
of War, circa 610 BCE
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Developing and implementing a
new world reserve currency is a nontrivial proposition and it will take time. However, in practical terms, the key factor that
stands in opposition to a new reserve currency is the petrodollar standard. The petrodollar standard allowed the US to print vast quantities of US dollars
without high domestic price increases because steady international demand strengthened
the US dollar, thus moderating prices in the US, e.g., the prices of oil and of
gold. The petrodollar standard, which
can be undone in a relatively short period of time, is the Achilles' heel of
the US dollar's world reserve currency status.
What is more important, however, is that ending the petrodollar standard
will put massive upward pressure on prices in the US: a fact that few have recognized.
While the US monetary base
has roughly doubled since the start of the financial crisis in 2008, the money
created to recapitalize US banks remains in the banking system and has yet to
influence prices in the US (aside from the prices of inflation hedges such as
gold and silver, which are in high demand).
The most broad measure of the US money supply (M3), no longer
officially measured, has actually declined according to Berkeley,
California-based Shadow Government
Statistics. Thus, the most useful monetary
inflation analysis is that of Paul van Eeden, President of Cranberry Capital,
Inc. Mr. van Eeden's Actual Money Supply
(AMS) model indicates a 12-month moving average of 8.44%.
Chart courtesy of Paul van Eeden
The average monetary
inflation rate, estimated at approximately 8% per year over the past 38 years, compounded
annually, shows that the US money supply increased by roughly 1,863% since 1971. However, according to the US government, prices in the US have increased only 533% since
1971, a 1,330% differential. The number of US dollars exploded on a global
basis to accommodate the growth in US dollar transactions, i.e., international trade,
especially oil, and currency reserves.
China is the second largest US
trading partner and the primary source of the chronic US trade
deficit. As trading partners, the
Chinese and US economies are linked by the US dollar, but compete for oil, currently
priced in and purchased with US dollars.
China
needs more oil and wants to buy it with Chinese yuan. By buying gold and encouraging gold
ownership, the Chinese government is betting against the US dollar and
positioning the yuan to become a universally accepted transaction medium. China is quietly diversifying out of
US dollars, buying resources and hard assets.
Ending the petrodollar standard will allow China to buy oil in yuan and
make the yuan a more viable currency internationally while, at the same time, clearing
the way to take on a larger role in the global economy.
Currencies are being debased
throughout the western world in the hope of saving banks, stimulating economic
activity and restoring trade. Until the US
reverses course, or until a new reserve currency is in place, gold will continue
to shine. Gold investment and central
bank demand will likely remain strong because gold can function as a commodity,
as a currency and also, unlike the US dollar, as a store of value immune from the
hazards of currency devaluation caused by monetary inflation. As the only financial asset without counterparty
risk, the historical reasons for holding gold, all but forgotten during the
1990s, have never been more clear.
The end of the petrodollar
standard and eventually of the US dollar's world reserve currency status
combined with increased demand for oil and gold, particularly on the part of China, is a fundamental
restructuring of the global economy already in progress.
US Dollars, Asian Tigers
While commodity prices,
measured in US dollars appear to be rising, one of the fundamental forces
behind the upward trend is the decline of the US dollar. Commodity prices are not rising as much in
real terms as is suggested by their nominal prices because the US dollar is
declining in value. As the US dollar
falls, the prices of commodities, measured in US dollars, rise.
The perfect storm for the US
dollar comprises the consequences of past decades of monetary inflation
punctuated by the dot-com and housing bubbles; excessive levels of debt in the
US economy (hampering a US economic recovery); the poor condition of US banks
whose balance sheets, still burdened with toxic assets, continue to deteriorate;
an expanding Federal Reserve balance sheet that includes toxic assets; extraordinary
spending by the US federal government driven by Keynesian economic policies and
by what are most probably economically unworkable socialist programs; rapidly
declining foreign appetite for US debt; quantitative easing ("money printing");
near 0% interest rates and a growing US dollar carry trade; not to mention the imminent
end of the petrodollar standard, and the eventual end of the US dollar's status
as the world reserve currency. At the
start of the global financial crisis and economic downturn, the US dollar
rallied in a global flight to the then perceived safety of US dollars and US Treasury
bonds. However, pressures on the US
dollar have mounted and it has begun a precipitous decline.
Chart courtesy of StockCharts.com
What is important about the
US Dollar Index (USDX) is that other currencies in the basket (the Euro, the
Japanese yen, the British Pound, the Canadian dollar, the Swedish krona, and
the Swiss franc) are also loosing value as a result of inflationary central
bank and government policies, but not as quickly as the US dollar.
The USDX was created in 1973,
two years after the US dismantled the Bretton Woods system (where the value of
the US dollar had been pegged to the
price of gold and other currencies were pegged to the US dollar) and one year
after former US President Richard Nixon opened relations between the US and
China. Today, the sleeping giant, noted
by Napoleon, is wide awake, and Asian currencies are
rising against the US dollar. China
is issuing yuan denominated bonds and growing Asian demand for key commodities,
particularly oil, can be expected to maintain upward pressure on prices
measured in US dollars.
The economic might of the four
Asian Tigers (Hong Kong, Singapore, South
Korea, and Taiwan) would have been
inconceivable when the USDX was created. Today, the Group of Twenty (G-20) Finance
Ministers and Central Bank Governors includes representatives from China,
India, Japan, South Korea, and Indonesia, and the International Monetary Fund
(IMF) includes the so-called BRIC countries (Brazil, the Russian Federation,
India, and China) in addition to Japan and oil producers Saudi Arabia and
Venezuela. Whether the USDX remains
today an accurate or meaningful measure of US economic power from a global
perspective is unlikely. In any case, US
and European economies and banks are currently in quite poor condition compared
to those of Asia; a fact that does not support
rising currency values for western countries.
China's population of 1.333 billion, compared to roughly
308 million in the US,
represents the largest emerging market in the world, and China's already
substantial consumption of resources is growing rapidly. With a population 4.3 times larger than that
of the US, Chinese
consumption need reach only 23% of that of the US,
on a per capita basis, to equal total US consumption. Conversely, if the Chinese were to consume
half as much as Americans on a per capita basis, total Chinese consumption
would be more than twice that of the US.
Changes in the behavior of Chinese consumers already have the potential
to create disruptive shifts in commodity markets on a global basis, and China's
rising influence is only just beginning to be felt, e.g., in the gold market.
The S&P Goldman Sachs
Commodity Index (GSCI), which contains 24 commodities (including energy,
industrial and precious metals, agriculture, and livestock), is designed to
minimize the impact of events that affect individual commodities and to respond
in a stable way to world economic growth.
Chart courtesy of StockCharts.com
Interestingly, from a
technical perspective, the GSCI chart exhibits a clear inverse head and
shoulders pattern followed by a breakout to the upside. Spurred by the financial crisis, China began
putting its massive reserves to work in wide ranging global
investments, systematically trading
its US dollars for resources and other hard assets.
China's Seven Dragons
The five dragons of the
ancient Chinese zodiac (fire, earth, metal, water, and wood) are suggestive of China's tremendous
natural resources, which include coal, iron ore, oil, natural gas, mercury,
tin, tungsten, antimony, manganese, molybdenum, vanadium, magnetite, aluminum,
lead, zinc, uranium, as well as the world's largest hydropower potential.
Chart courtesy of Mint
Software, Inc.
Together, Asian countries account
for 60% of the earth's human population and control major portions of world
resources such as corn, cotton, gold, rice, rubber, silver, water, and wheat to
name only a few.
If the Chinese calendar had
been invented more recently it might include more specific varieties of each
animal, such as a gold dragon in the metal category and an oil dragon in the
earth category, thus there would be seven celestial dragons rather than five.
The Oil Dragon
Total Asian demand for oil,
lead by China's 7,880,000 bbl/day,
exceeds US
consumption. In fact, the consumption of
just China, Japan,
and the four Asian Tigers is greater than that of the entire EU. Taken as a whole, Asian demand for oil is
more significant for the price of oil than the US or the EU. The price of oil in 2009 has risen as Asian
economies began to recover, despite lower US consumption. Rising Chinese demand for oil is now a fixed
feature in the otherwise changing global economic landscape. A weaker US dollar and a stronger Chinese
yuan serve to guarantee that China
will have the oil it needs.
Although not as hard hit by
higher oil prices as less developed countries (which could be priced
out of the market entirely) would be, the US economy could be crippled by
high oil prices. As shown by the West
Texas Intermediate Crude Oil index (WTIC), the price of oil is rising sharply.
Chart courtesy of StockCharts.com
Both the US and China import roughly twice
as much crude oil as they produce.
With a weaker dollar, US oil imports, currently roughly $400 billion
annually, will represent a larger external drain on the US economy,
which could prove to be disruptive. The reactionary
US
strategy is to increase domestic oil production and to develop alternative
energy sources in order to reduce dependency on foreign oil. Unfortunately, US oil production cannot increase
quickly enough or to high enough levels to ameliorate the impact of much higher
oil prices. Presently, there is no
alternative energy technology that can supply enough energy at a low enough
cost to have a significant impact on US oil consumption in the near
term. An anemic US economy combined with a weaker currency means
that the US
is ill equipped to absorb inevitably, much higher oil prices.
The Gold Dragon
Oil is the most important
factor of the US dollar's value for two reasons. Since the founding of the Organization of the
Petroleum Exporting Countries in the 1960s (currently Algeria, Angola, Ecuador,
Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab
Emirates, and Venezuela), oil has been priced in and sold in US dollars
worldwide. Since the Bretton Woods
system ended, the effect of the OPEC cartel's price fixing actions has been to
establish an implicit commodity-based value for the US dollar. In other words, after the Bretton Woods
system, the value and the world reserve currency status of the US dollar was
implicitly supported by oil rather than gold.
Any nation accepting US
dollars in trade knew what the value of US dollars was measured in oil.
Once oil is no longer priced
in US dollars, the US dollar, in practical terms, will no longer be the world
reserve currency, i.e., US dollar transactions will decline sharply on a global
basis. This conclusion has already been
recognized by central banks. In the
second quarter of 2009, US dollars accounted for only 37%
of new central bank assets, compared with 70% in the past. Rather than US dollars, central
banks favor Euros, Yen, and gold. Central
banks have also become net buyers of gold or are repatriating
gold reserves.
Following the replacement by
Iran (the third largest oil producer) of the US dollar with Euros
for foreign trade in September, 2009, rumors
emerged of secret talks between Arab states, China, Russia, Japan and France,
allegedly regarding replacing the US dollar with a basket of currencies
including the euro, Japanese yen, Chinese yuan, and gold. Talks between Russia
and Iran
regarding conducting oil transaction in rubles were officially acknowledged
a few days later by Russian Information Agency Novosti (RIA Novosti). Neither development is at all surprising
because world leaders have been calling for the replacement of the US dollar as
the world reserve currency since 2008. It's
safe to say that all of the BRIC nations, especially China
and Russia (the world's 8th
largest oil producer), oppose the petrodollar standard and are in favor of a
new reserve currency (Brazil's
largest trading partner, formerly the US,
is now China).
It seems unrealistic to
imagine that currencies tied to growing economies with higher production and
lower levels of debt would not be preferred over those of stagnated economies. If political strength follows economic
strength, the petrodollar standard will soon take its place in history
alongside the defunct Bretton Woods system.
Setting aside all other considerations,
the price of gold would be $815 per ounce today based only on US dollar
monetary inflation using Paul van Eeden's AMS model, i.e., 30% below the spot
price (approximately $1,060 US at the time of this writing). Mr. van Eeden has accounted for the increase
in gold over time.
Chart courtesy of StockCharts.com
It is worth noting that the
price of gold, when adjusted for inflation, is nowhere near its 1980 peak. The current situation is fundamentally
different from the brief but acute 1980 gold price bubble. John Williams of Shadow Government Statistics maintains
that the US
government has understated inflation and recently said that "If the
methodologies of measuring inflation in 1980 had been kept intact, gold [adjusted
for inflation] would have to hit $7,150
to be the equivalent of the 1980 record,"
According to data from the World Gold Council (WGC)
and metals consultancy GFMS, demand for gold is currently greater than the
supply by as much as 1000 tons per year. The WGC and GFMS have correctly identified two
distinct economic spheres comprising gold supply and demand. In the western economies, jewelry and
industrial demand are weak, but investment demand is strong, while outside the western
economies broad gold demand continues to grow.
India remains the
largest buyer, while gold demand in China is rising. China has been aggressively adding
gold to its reserves and has not only made it legal for Chinese citizens to
own gold but is encouraging gold ownership.
The potential influence of increased, long-term Chinese demand on the
price of gold cannot be ignored.
Monetary inflation and supply
and demand considerations are not the whole picture. There is a much deeper reality. For nearly four decades, gold, priced in US
dollars, was implicitly linked to oil and the resulting demand for US dollars
moderated the affects of monetary inflation on prices in the US.
The end of the petrodollar standard and the resulting global decline in
demand for US dollars will cause the price of gold to rise significantly. The value of the US dollar changed qualitatively after 1971 when it became an
irredeemable pure fiat currency, no longer backed by gold; a fact that has been
masked by the petrodollar standard.
Higher demand for gold also reflects
a growing recognition that the US dollar and other currencies currently being
devalued are not reliable stores of value.
In fact, the US dollar has not been a store of value at all for 38 years
during which massive quantities of fiat money, including trillions of
petrodollars, flooded the global economy.
The weakness of the US dollar exposed by the financial crisis, i.e., its
inability to function as a reliable store of value regardless of its utility as
a transactional medium, points exactly to the strength of gold. The decline in international demand for US
dollars, rejected as a failed store of value, indicates strong demand for gold
in the foreseeable future.
18th-century French
philosopher and writer Voltaire once said that "paper money eventually returns
to its intrinsic value - zero". Understandably,
Voltaire failed to consider a world where all money was purely transactional
rather than a store of value, and where the relative values of currencies were managed
in a loosely coordinated manner by central banks and governments through
manipulation of the money supply, interest rates, etc. In theory, such a world could function
indefinitely provided that currencies were relatively stable; provided that
currencies were widely accepted and interchangeable; provided that large trade
imbalances did not destabilize the system; and provided that currencies were
not debased excessively, i.e., in a reckless or irresponsible manner, which
would lead to a variety of economic problems.
However, Voltaire's inability to imagine such a world may be insufficient
cause to dismiss his observation.
It seems possible that Voltaire's
superficially antiquated understanding was precisely that "paper money" can
never function in the long run as a store of value, i.e., that it will inevitably,
either by accident or by design, be mismanaged, and that it will always,
eventually, be rejected, thus rendering its intrinsic value clear. History certainly supports Voltaire's view in
that fiat currencies tend to perish. As
recently as 1999, referring to the sale of British gold reserves, Alan
Greenspan, then Chairman of the US Federal Reserve, said that "Fiat money paper
in extremis is accepted by nobody. Gold
is always accepted." As the Chinese
discovered in the 11th century, money has a qualitative dimension and for
"paper money" that dimension is confidence. In contrast, because it is a tangible asset that
required an investment of human labor and other resources to produce, the value
of gold does not ultimately, in extremis, depend solely on the unreliable subjective
feeling of confidence.
Xiangqi (Chinese Chess)
There is increasing
international recognition of the fact that there is no foreseeable end point to
the devaluation of the US dollar. The
inflationary policies of the US
federal government and Federal Reserve have all but exhausted confidence in the
US dollar both at home and abroad, above all as the world reserve
currency. This entirely rational loss of
confidence is the root cause of expanding multinational efforts to end the
petrodollar standard and to eventually establish a new world reserve currency.
A reversal of the escalating challenge
to the petrodollar standard and the movement away from the US dollar as the
world reserve currency would require oil producers and industrialized nations,
including China, to rally in support of the US, but it is precisely this group (a
group that includes OPEC members, the BRIC countries, members of the G-20, and voting
members of the IMF), that is seeking to free itself from US dollar hegemony. Rather than attributing the petrodollar
standard and the status of the US dollar as the world reserve currency to the wealth,
power and influence of the US, critics assert that the wealth, power and
influence of the US is illegitimate and that it is the result of undeserved privileges;
privileges that have been abused at the expense of nations that do not enjoy
unfair advantages and that must now be forfeited.
Skeptics regarding the rise of
China as a major economic
power doubt that China
can profit from a weaker US dollar through a stronger yuan or develop a
sufficient domestic consumer market quickly enough to offset reduced exports. However, while China contributes to US consumption
as an export-dependent supplier, as well as a financier, their exposure to
losses resulting from a declining US dollar is limited. A stronger yuan would mean that, after a
period of adjustment, China
would import more goods and services and that, in real terms, wages of Chinese
workers would increase, thus supporting a higher standard of living. What is more important is that a stronger
yuan, implicitly backed by growing gold reserves (not to mention by a large and
fully modern navy), is exactly what will guarantee China's oil supply.
The struggling US economy, burdened with excessive levels of debt,
cannot support a sustained rise of the US dollar against the currencies of growing
economies in Asia. Growing demand for resources, especially oil,
as well as gold, contrasted with the inflationary policies of the US, will maintain
the upward trajectory of commodity prices measured in US dollars indefinitely. In the near term, the end of the petrodollar
standard will cause a sharp decline in the value of the US dollar and a marked increase
in the prices of oil and of gold measured in US dollars.
Posted
Oct 23 2009, 01:29 PM
by
Ron Hera
Filed under: Federal reserve, US dollar, Asia, Asian Tigers, USDX, Oil, central banks, G20, BRIC, China, petrodollar, Gold, natural resources, GNX, money supply, WTIC, IMF, OPEC, Bretton Woods