GavekalResearch The Daily

October 21, 2020

Page 1

A Smoking Gun
Charles Gave Throughout my career, I have always found that it pays to bear in mind
cgave@gavekal.com Jacques Rueff ’s notion of US “imperial privilege.” Put succinctly: the US
has long been the only country able to settle its current account deficits in
its own currency. So, when the US runs a current account deficit, it pumps
large quantities of US dollars abroad, many of which flow into the foreign
exchange reserves of countries running current account surpluses. These
countries then take these dollars and buy US treasuries, which are held in
custody for them by the Federal Reserve. In effect, the US current account
deficit finances the US budget deficit.
For years, the system worked like a dream. Historically, around one-third of
the dollars exported via the US current account deficit came back to the US
as foreign exchange reserves, with the bulk of the rest likely being used by
the private sector to fund purchases of US assets and as working capital to
finance international trade.
But in recent years, I have found myself scratching my head. The US has
The US has continued to run large current continued to run enormous current account deficits, but the reserves of
account deficits, but these are no longer foreign central banks held in custody at the Fed have fallen steeply. As the
being recycled into US treasuries chart overleaf illustrates, over the last seven years, something over US$1trn
to the same extent has gone “missing” in this fashion, as shown by the divergence between the
blue and red lines.
Now, admittedly US$1trn isn’t what it used to be, but it is still a tidy sum of
money. The discrepancy is far too big to be explained away by a simple dollar
deleveraging movement, such as we saw in the early 2000s. Something else
must be going on.
I think I may have an idea what. And—no surprise—it has something to do
with the future of the US dollar as a reserve currency.

Checking The Boxes

Our short take on the latest news
Fact
US building permits rose 5.2%
MoM to 1.553mn in Sep, from
1.476mn in Aug
US Redbook retail sales rose
2.5% YoY for the week ended
Oct 17, from 1.2%
Eurozone current account
surplus widened to €19.9bn in
Aug, from €17.0bn in Jul
Taiwan's export orders rose
9.9% YoY in Sep, from 13.6%
in Aug
Consensus belief
Higher than 1.500mn expected
N/A
N/A; 12m cumulative surplus
€224bn (1.9% of GDP), versus
€265bn (2.2%) in Aug 2019
Above 8.0% YoY
Our reaction
Low mortgage rates encourag-
ing housing market activity
Economic reopening supporting
consumption; absence of new
fiscal stimulus not a concern
Travel restrictions weighing on
service exports; foreign invest-
ment returns lower
Electronics orders remain
strong; up 30% YoY despite
impact of US Huawei sactions

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Foreign central banks no longer enjoy the
implicit guarantee of US gold holdings
The Daily
October 21, 2020
Page 2
In the past, reserves held in custody at the Fed for foreign central banks
benefited from a double guarantee: (i) they could always be drawn down at
any time should the country that owned them find itself facing a balance
of payments crisis, and (ii) they were implicitly backed by the large gold
holdings of the US Treasury.
The first of these guarantees began to look dubious when the US government
decided to weaponize the US dollar (see BNP, Big Brother And The US
Dollar). And the second guarantee diminished greatly over the years, as
the value of the US gold inventory fell from more than 100% of the foreign
central bank reserves deposited at the Fed to bottom out at less than 10%.
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Foreign central banks now appear to be
recycling their dollars into gold...
...which suggests they are sterilizing the
stimulative effects of their own surpluses
and of the US current account deficit
This is bullish for gold, bearish for growth
The Daily
October 21, 2020
Page 3
Foreign central banks don’t mind that their reserves at the Fed are not backed
by gold as long as the US pursues a “responsible” monetary policy. But if the
Fed begins to follow a reckless “Keynesian” monetary policy (see Managing
Money In A Keynesian Environment), it is another matter entirely. Foreign
central bank reserve managers are the ultimate rentier. So, they can hardly be
expected to sit back contentedly and do nothing should the US in its wisdom
decide to proceed to the euthanasia of the rentier.
The probability is that foreign central banks have taken their excess dollars
and have started to buy gold (or in the case of China, rather than buying
dollars from the state-owned banks, the central bank has ordered them to
use the dollars to buy gold on its behalf, which amounts to the same thing).
If this is correct, and non-US central banks have bought some US$1trn in
gold in the last few years, it implies that slightly more than 10% of the world’s
stock of gold has changed hands, going from private hands into central bank
vaults—whence it will not return.
This is troubling, not least because in the current environment, the private
sector players who are monetizing their holdings of gold are likely doing so
out of desperation in order to service bad debts. And because so many debts
are bad, commercial bank lenders will not take any money recouped on them
and lend it back to the real economy. Instead they will hold it as reserves.
The result is that the banking multiplier outside the US collapses, and
the international velocity of money collapses. In short, in order not to be
euthanized by the Keynesian policies of the Fed, the central banks of the
world’s current account surplus countries are being forced to accumulate gold
to sterilize the excess savings produced by their own economies. In effect,
non-US central banks are now in the business of sterilizing the stimulative
effect that the US current account usually has on growth in the rest of the
world, with all the deleterious effects that implies.
If all this sounds far-fetched, it shouldn’t. It’s what France did in the late
1920s and early 1930s under the gold standard, running an undervalued
currency and using the resulting current account surpluses to accumulate
large amounts of gold, which vanished into the Banque de France’s vaults.
France’s actions then were one of the main causes of the Great Depression. I
fear something similar now.
On the upside for investors, if central banks continue to run down their US
dollar reserves and accumulate gold until the coverage ratio for their dollar
reserves at the Fed is a more comfortable 50%, it implies a tripling in the gold
price from its current level.
This may be a small consolation, however, as it becomes increasingly clear
the world monetary order is reverting to a gold standard. I once asked Milton
Friedman what was wrong with the gold standard, and he answered, “Oh,
nothing. But we can do much better.”
It seems we failed.
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