By Alasdair Macleod
June 29, 2020 "Information
Clearing House"
This article describes how China can escape the fate of
a dollar collapse by tying the yuan to gold. There is
little doubt she has access to sufficient gold.
Currently, her interest is to preserve the dollar, not
destroy it, because it is the principal means of Chinese
foreign interests being secured .
Furthermore, a
return to sound money requires China to reverse its
interventionism under Xi, returning to Deng Xiaoping’s
original vision. Sound money can only last if the
relationship between the state and the wider economy is
properly addressed.
Of all the major
economies, China’s is best placed to implement a sound
money solution. At the moment it seems unlikely the
necessary reforms will be forthcoming; but a general
collapse of the global fiat currency regime presents the
opportunity for reassessment and change.
Introduction
In last week’s
Insight I examined the position of the US
dollar, given the Fed’s current monetary policies, and
concluded that the Fed’s dollar is likely to become
valueless by the end of this year. The consequences for
other major currencies — the euro, yen and pound — are
that they are likely to fall with the dollar. This is
because they adopt the same monetary policies, the same
macroeconomic fallacies, and through the Bank for
International Settlements, G7 and G20 meetings agree to
continue to be bound by common policies. While the
intention is for all to survive by working together,
instead it ensures that they all sink together.
The maverick nations are Russia and China. Russia is
obviously working towards protecting her currency with
gold — there is no controversy there. China’s position
is more complex. Her leadership relies on the inflation
of bank credit through state-owned banks to finance her
infrastructure plans as well as in financing the massive
uplift her non-financial private-sector economy has
enjoyed since 1980. Yet, she has made aggressive moves
to ensure her population owns physical gold and has
invested in mine production, making her the largest
national producer by far, while ensuring virtually no
gold leaves the Chinese mainland.
Having more or less gained control over the world’s
physical market, China is the greatest hoarder of gold
on the planet. She appears to understand the importance
of gold to monetary stability while at the same time
playing the West’s neo-Keynesian games.
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China’s gold
The most controversial aspect of
my previous comments about China’s gold ownership is
about the level of undeclared bullion. But the strategy
has always been clear. In 1983 the Peoples Bank was
given a monopolist mandate by the Communist Party to
manage the state’s acquisition of gold and silver, while
private ownership remained banned. This fitted in with
the Peoples Bank’s monopoly of managing foreign currency
dealing, confirming that in 1983 at least, the
leadership and its advisors regarded both gold and
silver as primarily money.
Nineteen years elapsed before the Peoples Bank opened
the Shanghai Gold Exchange, permitting members of the
general public for the first time to buy and take
delivery of gold and silver. Following advertising
campaigns, the market for 24 carat gold jewellery
exploded, and together with investment gold, since 2002
withdrawals from the SGE’s vaults have been about 17,500
tonnes, admittedly not adjusted for scrap resubmitted
for refining. To be consistent with gold policies after
the SGE opened for business, those nineteen years must
have been used by China to acquire significant
quantities of undeclared bullion. But other analysts
assume that the public held some gold illegally before
2002 as well, so about 17,000 tonnes net of scrap for
private ownership seems about right.
The opportunity for the state to build a bullion hoard
before 2002 was there. Following the bull market ,which
culminated on 21 January 1980, gold entered a 19-year
bear market taking it from $850 on that afternoon’s fix
to a low of $256.8 in July 1999. But by January 2002,
gold was still on the floor at under $280. And there
were substantial sellers: portfolio disinvestment by
Swiss banks, the largest private depositories at that
time, left them holding virtually no gold.[i]
Central banks and official sources reduced their
holdings of monetary gold by 3,450 tonnes, but more
importantly gold leasing by them supplied an estimated
10,000—16,000 tonnes into the market (Veneroso, 2005).
Meanwhile, demand was soaked up by the expansion of
derivative markets, principally LBMA forwards and Comex
futures. In all those years global mine output added
43,800 tonnes. Various parties must have absorbed the
gold that wasn’t absorbed by jewellery, which probably
accounted for about 25,000 tonnes.
US policy was to rub out monetary history by denying
gold as having any monetary role and to be replaced by
the Fed’s unbacked dollar as everyone’s reserve
currency. A new generation of Harvard-educated Arabs
went with the neo-Keynesians, preferring stocks to gold,
the opposite of that of their forebears who disliked
financial assets, including foreigners’ currencies. But
these were also the formative years for China’s adoption
of capitalism.
The Chinese leadership, having a high degree of control
over its population, is given to long-term planning in
the form of five-year plans with longer-term underlying
objectives. It is inconceivable that these plans would
have omitted a gold strategy, particularly since
regulations were put in place giving the Peoples Bank
its mandate to build national reserves.
Given all the foreign exchange dealings of the Peoples
Bank, handling inward investment in the eighties and
growing exports in the nineties, it could easily have
accumulated 20,000 tonnes of gold at contemporary
prices, representing approximately 10% of foreign
currency flows across the bank’s trading desks.
Traditional secrecy in gold markets would have provided
cover. All the Peoples Bank needed to do was acquire an
average of 1,000 tonnes a year, which given the bullion
flows and market dynamics in gold’s great bear market
would have been achievable without attracting attention.
It is only on the basis of this understanding that we
can apply a 20,000-tonne ball-park figure to the
unknowable. And since 2002, China continued to import
gold in addition to its growing mine supplies to ensure
its population ended up with significant quantities of
gold as well. Whether intentioned or not, the leadership
has ensured large quantities of 24 carat gold are in
public circulation, which is important in the event that
gold backing for China’s currency is implemented.
In the event of a general fiat currency collapse, many
nations have sufficient gold to operate a gold exchange
standard, admittedly at higher gold prices than those
that prevail today. That is not the problem. In
government, treasuries and central banks, there are very
few who understand economics proper, being sold entirely
on neo-Keynesian macroeconomics. Neo-Keynesian
macroeconomics is a belief system unfounded on reality
and their Zeus, or Jupiter, is inflationism. Their
lesser gods all owe fealty to this one overriding
directive. Before sound money can be introduced, they
must all be swept from their temples.
China’s worship of inflationism is less institutionally
embedded and should be easier to overturn, particularly
since Marxist philosophy predicts the end of capitalism,
which today would be manifest in the collapse of the
capitalists’ currencies. The ability of the Chinese to
escape the monetary fates of the West is in theory still
there.
China’s interest in the dollar
With all its gold, by monetising
it China could kill off the dollar tomorrow.
Undoubtedly, this financially nuclear option has become
a backdrop to her strategy in the ongoing trade and
financial war against America. But the idea that by
using this undoubted power over the dollar China gains a
simple victory if through her actions the dollar is
destroyed understates a more complex situation. It is
not in China’s interest on many levels, not least
because of her ownership of dollars is about $3.4
trillion, of which only $1.5 trillion is invested in
Treasuries, agency, corporate and short-term debt in the
US. The balance is actively used in loan finance to
China’s commodity suppliers, those involved with the
belt and road initiatives and other states with which
China desires to gain influence.
Destroy the dollar and China’s heft around the world is
destroyed as well, because only a small proportion of
China’s loan-influence is in renminbi. In that sense, if
the dollar collapses America gains a geopolitical
benefit over China, her means of international influence
being crippled. The Chinese leadership will be acutely
aware of the consequences of the dollar’s demise and
therefore will do nothing to encourage it. Indeed, if
the dollar begins its collapse in the foreign exchanges,
we could find China increasingly calling out the Fed on
its inflationary policies. But then the Fed’s problem is
and will continue to be an inability to stop its
addiction to unlimited inflationism.
Unfortunately, a banking crisis is embedded in the
script, which will have fundamental effects on all fiat
currencies, some more than others. And since
international banking is overwhelmingly a dollar affair,
after a short pause the consequences are bound to weigh
heavily upon it as the reserve currency. This credit
cycle unwind is a Category 5 compared with 2008—09’s
Category 2 or 3. It is only after such a cataclysm that
China will have no alternative to abandoning all
attempts to support the dollar and its means of buying
overseas influence. China will then need to secure its
own currency.
It will require a return to gold backing — the nuclear
option so far avoided. While the cost will be writing
off trillions of dollars and its means of securing
overseas influence, there will be a monetary vacuum to
fill. And compensation will be found in an increase in
the value of China’s declared and undeclared bullion
stocks, as well as the enrichment of its gold-holding
people.
Establishing a sound currencyTo
appreciate what is vital for a currency to be sound
requires certain conditions to be satisfied. These are
the three immutable ground rules for a gold-backed
currency, all of which must be obeyed:
• The state currency must be an accountable gold
substitute; that is to say every unit of currency
expansion must be fully backed by gold at the fixed
exchange rate.
• It must be freely convertible into physical gold on
demand by everyone.
• It must be freely convertible for the settlement of
domestic transactions and imports and exports.
To these we can add an addendum, and that is to reform
the banking system so that there is no expansion of
unbacked bank credit.
If the Chinese obeyed these rules to the letter, not
only would their gold-backed currency lead to a quantum
leap in the progress of its own economy, but given
China’s undoubted economic power the yuan would become
accepted as the foreign currency of choice for most of
the world and it would encourage other nations to adopt
similar gold exchange standards.
The proof is found in a nation of ten million which two
hundred years ago in less than a century dominated
technology and international trade, saw its population
increase threefold as prosperity spread and
life-expectancy increased, encouraged other nations to
adopt gold standards, and by 1914 had built over 80% of
the world’s shipping afloat. That small nation was the
United Kingdom. Just think of the potential if China
repeated the exercise.
Sound money works best with free
markets
The impediments to the
implementation of the sound money rules defined above
are, however, substantial. It requires the relationship
between the state and its people to be fundamentally
reformed and instead of state control a laissez-faire
philosophy must be adopted. The whole point behind sound
money is to remove it from state control so the
temptation for inflationism, which is leading visibly to
the destruction of the current global monetary system,
is removed.
The money that people use for their current and deferred
consumption is rightly their affair, and not the
state’s. This is why every time the state takes control
of money away from its people it eventually fails, and
the monetary function returns to the metals trusted by
people through millennia. Today, we face no less than
this transformation, the return to the peoples’ money
and the destruction of statist fiat currencies.
Of the world’s significant economies, China appears best
able to plan for monetary reform. Even so, it will not
be easy and requires the completion of the new
capitalist mindset courageously introduced by Deng
Xiaoping. Instead, under President Xi China has drifted
away from Deng’s vision towards internal suppression and
increasing state control. He must recognise that central
planning in China has had its day and it is time to give
his population its economic freedom.
If only he can recognise it, Xi’s vested interest now
lies in that direction. It will not be easy, and there
is no certainty he will grasp the opportunity. But if he
decides to do so, it requires the following issues to be
addressed.
The state and the economy
Being a burden upon it. the state
must reduce its role in the economy to the barest
minimum to absorb less than 20% of GDP, preferably even
less than 10%. Welfarism must be abandoned, or at least
reduced until its financial burden on the state is
minimal. In this respect, China is better placed than
more mature advanced economies. The World Bank estimates
China’s government spending in 2018 was 14.7% of GDP,
which compares with the US’s 34%.
China scores highly in this respect.
Functions of the state to be
restricted
In a sound-money free-market
economy the basic state functions are to establish and
administer laws to ensure certainty in contracts, to
provide national defence and domestic law and order.
China discriminates in her laws, is territorially
ambitious with respect to Taiwan and the South China
Sea, and internal policing is oppressive. There is no
sign of change in these regards, which affects
international relations adversely. If China dropped its
claims to Taiwan and respected Hong Kong’s independence,
international relations would immediately improve.
Persecution of the Uyghurs is indicative of a
heavy-handed statist response to the threat of Moslem
terrorism. In these respects, China scores badly and in
a new sound-money regime would only gain significant
influence with its trading partners if these attitudes
were reformed.
Mercantilism must be abandoned
China adopts a mercantilist
approach to economic management, which coupled with an
iron-fist control over the population has had some
successes. But it is one thing for a reforming
government to take an impoverished population and
provide a framework and monetary stimulation to lift it
out of poverty and another to continue the process. In
China’s case, anything was better than Mao and Deng
seized the opportunity.
In its early stages a mercantilist approach can have
obvious objectives, which leads to national capital
being deployed with effect. But being based on monetary
expansion, even then capital is misallocated through
monetary distortion, which only becomes obvious later.
As a continuing state policy, it leads eventually to
substantial tribulations and inefficiencies, and China
has had its share of these.
The error is to regard the state as capable of being
fundamentally motivated by profit. A misleading
precedent for mercantilists was the East India Company,
which ran India as its fiefdom until the Indian Mutiny.
But that was a company which was mandated to produce
profits for shareholders.
A government is necessarily a bureaucracy, not suited to
an entrepreneurial role. China will need to address the
relationship between the state and its role in the
economy if a yuan gold standard is to be freely accepted
through trust and trade, and for the maximum benefit of
its economy. In fairness, China is abandoning support
for zombie companies, but it still tries to pick
winners, so is hardly neutral.
Regulation must be abandoned,
allowing the public to set the parameters of its own
demand.
Originally the means of control
adopted by fascist governments, widespread regulation of
economic activities has become the standard of modern
government policies. The assumption is that the consumer
must be protected from avaricious businessmen. The
result is cronyism.
Instead of suffering from the West’s cronyism, China
promotes businesses on a purely nationalistic basis, a
policy which has now backfired in a crony world. The
exclusion of American technology from China’s “Made in
China 2025” strategic plan has intensified American
hostility and is undermining Chinese technology’s
international business. This would not have happened if
China had a non-interventionist policy towards her
domestic market. That has to change.
Banking must be reformed
The Achilles’ heel of the West’s
banking system is the fraudulent issue of bank credit,
which is no different in principal from central bank
inflationism. Even in the days of the gold standard the
expansion of bank credit increased currency in
circulation without being backed by gold. There were, in
effect, two types of currency; fully backed gold
substitutes and fiat currency the product of unbacked
bank credit, but indistinguishable from each other in
circulation.
The expansion and subsequent contractions in bank credit
created a destructive cycle of bank lending,
particularly following the 1844 Bank Charter Act in
English law, which set the subsequent international
standard. This must be stopped. In the case of China,
most banking is provided by state-owned banks, so if the
state is determined to maintain a sound yuan it should
present few difficulties in eliminating bank credit
expansion.
The provision of monetary capital must be backed by
savings and it is for the market to establish a balance
between immediate consumption and its deferral. And
here, China is in the fortunate position of having a
strong savings culture, unlike the US and UK along with
most members of the eurozone, where after allowing for
consumer credit saving hardly exists.
Accumulation of private wealth
to be embraced
The replacement of unbacked bank
credit expansion with genuine savings as the source of
investment capital requires the state to take a positive
view on the accumulation of private sector wealth. Being
a young modern economy, in this regard China is better
placed than nations with more mature economies and
ingrained socialism, where wealth is regarded as a
morally justified source of tax revenue.
Progressively increasing tax rates mitigate against the
acquisition of wealth, and China will need to reform its
income tax regime to a flat tax rate. Since government
spending is under 15% of GDP, with a reasonable personal
allowance a flat income tax of 20% should allow for a
balanced budget and other taxes to be eliminated over
time. State spending targeted to an eventual 10% rate of
state spending relative to GDP would allow the income
tax rate to be reduced and held to a 15% rate and the
abolition of all other taxes.
Income tax should be applied at the same rate on all
sources of income. To make income from savings tax-free
is a distortion of the market. Post-war Japan and
Germany made it easy to avoid tax on savings interest,
and their economies became savings driven and highly
successful. But in China’s case, where a very high
savings rate already exists, not only is such a policy
unnecessary, but it leads to unwelcome imbalances in
foreign trade which so long as other fiat currencies
exist are politically destabilising in the longer term.
Digital money
China is almost certain to be
tempted to adopt a centralised cryptocurrency approach,
a forerunner of which is reportedly in trials at the
moment. It is thought by many that application of this
technology may well find a place in a new form of gold
substitute.
Other commentators suspect that China’s motivation is to
maintain control over its citizens’ spending. If this is
the case it would be a mistake, and at odds with an
objective to maximise the nation’s economic potential
for the benefit of its citizens by returning to free
markets. However, state-issued crypto technology is too
young at this stage to be relevant to the successful
establishment of a gold substitute currency.
The return to sound money
So far, we have established that
of all the major economic powers, China is well placed
to adopt a durable gold exchange standard. The most
significant hurdle is the Communist Party’s control
freakery over its people. Under wise leadership, this
can be addressed, more likely during a monetary crisis
when political objectives can be radically changed, than
at any other time.
Otherwise, China has sufficient bullion reserves and
gold ownership is widespread in the population. Silver,
which is more naturally the money of the people is also
widely available for coinage. Furthermore, there is
reason to hope that the state is not as beholden to the
neo-Keynesian macroeconomic inflationism as are other
leading nations.
We have established that it is not in China’s current
geopolitical interest to introduce a gold standard that
undermines or destroys the dollar. For this reason,
China will only do so once it is clear that the dollar
is in the early stages of an unavoidable inflationary
collapse, and the risk of the yuan going down with it
must be urgently addressed. An increasingly certain
banking crisis, likely in the next month or so, and a
reappraisal of the dollar’s prospects and the debt trap
of rising interest rates being sprung on western
governments is likely to determine timing.
To be successful in defending the yuan from the
gathering global monetary crisis, when the decision is
taken to go ahead the following announcements should be
immediately made.
1. The State is transferring its
undeclared bullion to monetary reserves, announcing a
figure which we believe could exceed 20,000 tonnes. At
the same time, it announces the yuan will be backed by
gold from a defining date, perhaps a month hence, the
rate to be determined by the markets in the intervening
period. The purpose is to let the gold price rise to an
appropriate level for a yuan exchange rate to be fixed.
2. Following the defining date the
quantity of yuan in circulation will be set by market
demand, and any increase in the quantity will be fully
backed by gold reserves held and allocated for that
purpose by the Peoples Bank.
3. The announcement will also state
that conversion terms will be offered for all government
debt (currently about 40 trillion yuan) into a new
perpetual loan, interest payable at the holders’ choice
in yuan or gold at the yuan/gold fixed rate, which will
be set at the defining date.
4. All holders of yuan will be free to
exchange their yuan for new gold coin at the rate set on
the defining date. In due course silver coins at
sterling proof will also be issued as circulating
currency, the rate set designed to ensure their
continued circulation.
5. All exchange controls to be removed
with immediate effect.
6. China’s withdrawal from all
international cooperation at G7, G20 meetings etc.,
currency and economic management being no longer
appropriate.
7. Digitising plans, if any, will be
discarded as unnecessary for the circulation of a
gold-backed yuan.
8. Consultation with the banks will be
initiated to phase in over an appropriate period a
restructured banking system. The objective will be to
separate deposit-taking as a custodial function from
investment funding of bonds and equities on an agency
basis. Until these new provisions are in place, the
expansion of bank credit will be frozen after which it
will not exist.
The markets can then set a gold exchange rate which will
be adopted as the fixed rate of exchange for the yuan.
The return of a monetary function to silver is likely to
reduce the gold/silver ratio to 20 or perhaps less, and
allowance should be made for a settled relationship
between gold and silver that might take a little longer
to establish on a lasting basis. Only then can silver
coins return to circulation
There can be little doubt that a move to a gold yuan
will have a profound effect on remaining fiat
currencies. As noted above, a short period of time
between announcing these plans and their implementation
will be required for markets to adjust. It is likely
that fiat currencies would face downward pressure on
their purchasing power, and China must be seen to be
protecting her own interests by returning to sound money
and not deliberately undermining the dollar.
The consolidated perpetual loan has many advantages. It
never has to be repaid. The coupon, reflecting gold’s
rate of interest as well as issuer risk, could be set,
at say 2%, and the conversion price set at 50 per
notional 100 gold-yuan of the bond. Those prepared to
back the Chinese government and its sound money regime
would be rewarded for the risk by a running yield of 4%.
As the government’s rating improves with the success of
the return to gold, the price would rise towards par,
giving early investors a solid reward. The wealth
creation for holders becomes a solid contribution to
providing capital for a progressing economy.
Other nations, particularly those in Asia, are likely to
follow China in implementing their own gold exchange
standards, and all nations will be then faced with a
stark choice: do they hang on to their welfare states
and their growing difficulties in financing them, or do
they stabilise their currencies? If China does adopt a
proper gold exchange standard, she would neutralise all
America’s geopolitical power, whether America follows
suit or not.
And finally, China should cease to provide the
statistics beloved of neo-Keynesian macroeconomists, for
they only serve to provide reasons for state
intervention.
Notes
[i] Source: Gold Wars —The Battle
Against Sound Money as seen from a Swiss
Perspective: Ferdinand Lips pp. 116
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