Last month James Rickards increased his presence in the media. It coincides with him promoting his new book. I try to follow his thoughts and reports as he is connected with people in the central bank, the World Bank, and Pentagon circles.
What grabbed my attention is his thoughts about the shape of the future IMF governed the monetary system. Rickard’s is definitely not a prophet but where he draws the line may be similar to what we are going to see in the near future. What you will read is a combination of his suggestions, opinions of myself and people who I occasionally consult investment decisions with.
Insolvent central banks
For the last 40 years, we have seen constant growth of indebtedness on every level: individual, corporate and public. The expansion of financial sector being a result of legal manipulations and deregulation and inception of a market for derivatives led to the first serious crisis in 1998 when a hedge fund managed by two Nobel Prize winners went bankrupt. Long Term Capital Management thanks to a bad decision and huge leverage generated loss of few billion USD. To prevent the domino effect of bankruptcies the debt was bought by investment banks from Wall Street. Back in the days, it was an unprecedented bail-out.
The level of debt and leverage rose continuously until next crisis in 2008 when Wall Street banks were in trouble. Instead of letting them go bankrupt effectively cleansing the system, the FED printed out of thin air 800 billion USD and bought all toxic assets from those banks. It didn’t end there. Between 2009 and 2010 Bernanke without consent from Congress and any other supervisory body printed another 16 trillion USD (more than the USD GDP then) and gave it as a credit to banks in the US, Japan and Europe. Only in 2011 we could hear about it but the case was quickly silenced. This already shows that central banks are beyond anyone’s control.
Later central banks accumulated various assets to help their shareholders (commercial banks) and to prevent the total collapse of the monetary system from which they benefit the most. Today balance sheets of central banks are very rich:
a) Government debt – today bonds are the guarantee of a loss. For the last 30 years, central banks had a good run as yields were falling and the price was going up. With today policy of ZIRP (and sometimes NIRP) it will take a very small change in price for the bank to face insolvency.
b) Commercial debt – central banks stepped in because there was no buyer for corporate bonds. This can postpone cascade of bankruptcies and debt restructuring that could result in the fall of a few big investment banks. In other words – another worthless asset.
c) The debt secured by a real estate mortgage. Added to the list to again prevent the collapse of the system. Worthless.
d) Equities and real estate investment funds. After central banks were forced by swaps to increase the supply of a local currency, they acquired a surplus of USD. They invested this capital in equities and REITs. Contrary to the previous groups of assets this one has a significant value. The problem here is that volatility of price is dependent on the mood in financial markets.
e) Gold – the majority of investors don’t know how much gold each central bank has. We can only look at official statistics but those are far from reality. Chinese constantly publish lower numbers than actual data. Germany on the other hand, has decent reserves. Berlin’s gold is deposited in London and New York. In the case of any systemic problems it is hard to imagine anyone would be given their reserves. This would increase sovereignty at the expense of the hegemony across the Atlantic.
With today’s prices, government bonds are the clear majority. With very high leverage of central banks, an increase of yield by 2-3% puts the bank on the verge of collapse, at least theoretically. We are talking about theories as there is no central bank audit on the horizon. There are no controls over them. A bankruptcy of a central bank would be initiated when a new design is ready for implementation. Those who will benefit from that change are probably working on a new monetary system as we speak: order out of chaos.
Another IMF bail-out
The only chance for buying a little time, Rickards thinks, lies with the IMF. The IMF is the issuer of the SDR – supranational currency with no backing in material goods. The SDR basket is no different than any other fiat currency. The issuer can without any control print the amount needed.
For the moment, the value of SDR amounts to 200 billion USD which is a rounding error on a global scale. The situation may change in the face of another global crisis. Just like Rickards said, if the SDR basket works is only because no one understands that it is just the same form of fiat money.
Another monetary crisis will most probably touch also central banks with their toxic assets bought systematically from insolvent governments (bonds) or commercial banks (junk assets). Under those circumstances, the IMF being supranational institution can offer a solution for such turbulent times. Ultimately no crisis should be left unused.
To decrease the central banks’ debt the IMF can just take over the worthless assets in exchange for freshly printed SDRs. Slowly the IMF currency would gain function of a reserve currency after the USD. The dollar’s role simultaneously should be reduced in a controlled manner in international trade and as a currency reserve of governments and central banks. The USD finally reduced to the national currency level would share the same fate as British pound.
The supply of the SDR then grows with each IMF’s move. Later, few countries could gain the ability to issue debt denominated in the new currency and international corporations implement a new way to settle their deals according to the SDR basket.
Why would anyone accept the SDR?
Let’s divide reasoning into two groups: threats and incentives.
a) Destruction of a local currency.
A change of a monetary system is not an easy task. In the beginning, we need a crisis. An inflationary crisis coupled with an economic depression. The result: people need to require the government to do ‘something’. From one side we have a destruction of a local currency, hyperinflation and an economic depression with all their consequences magnified by mainstream media. On the other hand, we have the proposition to join a new ‘better’ system.
b) Takeover of national wealth
The overwhelming majority of debt is denominated in foreign currencies. The respective country doesn’t have the ability to print this currency in order to pay its obligations. When the danger of bankruptcy is looming (no creditors willing to rollover the debt), creditors supported with international organisations can ask for repayment or surrendering of national assets (highways, electricity networks, railroads). The alternative is a resignation of what is left of sovereignty and pegging the local currency with the SDR ‘just like other countries’.
a) Partial reduction of debt
Every single time we transferred into a new system, part or all of the debt was being reduced. This time, should be no different. At the end of the day, the majority of national debt is owed to commercial and central banks and they can exchange it for a sum of SDRs from the IMF. The IMF can write off that debt using other solutions like revaluation of owned gold reserves.
In the case of monetary problems and potential instability and debt reduction – the choice is obvious. Politicians can boast that they achieved the best deal which reduces public debt to 40-50% of country’s GDP. Long-term consequences of a total loss of control over the currency won’t be found in the mainstream media, I can assure you.
Similar debt reduction (but only for the chosen ones) will be offered at the corporate level. It has been a visible trend for months now that global corporations are buying their own stocks financing it with a big amount of dollar debt. Nowhere in history can we find the scale of buybacks comparable to the last stage of the bull market. Their debt is now substantial and we can assume that their obligations could also be reduced to increase stability for the future.
b) End of currency volatility
For the last 40 years, we had a flexible exchange-rate system. This enabled a manipulation of exchange rates by commercial banks and introduced a lot of uncertainty with increased risk. Pegging currency with the SDR would fix the exchange rate which – under the control of the IMF – can be re-evaluated once per year of two.
Key role of China
During last decade, China accumulated the biggest currency reserves in the world. You shouldn’t be surprised why they are the biggest proponent of replacing decaying USD by another form of the world reserve currency. When you have few billion dollars you can spend it on corporations, real estate or commodities. The problem starts when you own few trillions.
The introduction of the SDR could enable China to diversify their reserves. Let’s say that during first ‘print’ China would receive 5% of the world’s pool of SDR. If the equivalent of 1 trillion USD is printed, 11% of what the biggest central banks printed in 2008, it would be enough to deliver liquidity and ensure China diversify towards SDR.
China already keeps some SDRs in their reserves. From the new issue, they would receive an equivalent of 50 billion USD. In the liquid market, it won’t be a problem to exchange a share of dollar reserves for SDRs. On top of that, new surpluses should be deposited in SDRs rather than USD. Liquidity should be on the rise as corporations and ‘sovereign’ states will have to issue their debt (at least a share of it) in SDR instead of local currencies. I’m sure international treaties and deals will see to that. The PBOC is already inviting the biggest Chinese corporations to issue SDR-denominated debt.
The fact that China is the biggest spokesman for SDRs is confirmed by opening second SDR trading platform in this country. The first one is managed by the IMF.
SDR and trust
This new currency is far from being different when it comes to fiat money. Just like Rickards pointed out very few understand how the system works. The SDR is nothing else but a variable of exchange rates of USD, EUR, JPY, GBP and since September RMB (Yuan). Maybe with time more currencies are going to be added like CHF, CAD, AUD or Indian Rupee. Still this is fiat money with no backing in a physical collateral.
Central banks and the IMF for years tried to install disgust for gold in people’s minds and stop the historic role of money, gold has. Today most investors treat gold as a commodity equal to crude oil. The Perception is slowly changing. If people behind the system are able to live without gold then the old system of ‘paper’ dollars will be changed into new electronic SDRs. Thanks to that they will buy themselves another decade.
Unless people resist and put bigger trust in gold the new system will not use it. The SDR with partial backing in gold is not the same SDR destined to share the fate of any fiat money.
For gold to be a part of the new system its price has to be higher – 7-10 thousand USD per ounce. This can initiate inflation and devalue lion’s share of paper debts. A higher price of gold can help financial institutions to repair their balances after losses of a written-off debt. What is more, in this new non-inflationary system, with low debt levels and high price of gold, investors would lose interest in precious metals. This can give the creators of the system control over currency creation and gold which it is based on.
We can speculate about time and shape of this new system. I showed you the shape and sketched its boundaries. The hardest part is always pinpointing the time frame. Changes that serious are not going to be implemented quickly. Also, the operation of such scale needs society’s approval and for this, we need to have a crisis. The aforementioned calamity can sometimes get out of hand and make few banks fall. This might result in people’s savings being lost and overall opposition against eliminating cash – one of the biggest goals of entities behind the shape of the new monetary system. As you can see there is a multitude of variables and this is why I believe that the SDR as an international currency will be taken seriously not earlier than in 3 years and not later than in 10 years’ time. Unfortunately, the time frame is quite wide.
The crucial part of the SDR’s role in the new system is the fact that any country accepting their currency being pegged to SDR, inevitably loses its monetary sovereignty. The end result in the micro scale can be observed in Greece. After losing monetary independence to the ECB the country itself is in freefall.