RBI Votes Against the Dollar?

Time will tell whether this is a first step in a long stampede or a more innocuous portfolio rebalancing BUT, the Indian central bank made some pretty significant waves in currency markets yesterday. How? It unloaded roughly $7B of its US currency reserves and exchanged it for gold

Gold prices on Tuesday surged to an all-time high after India’s central bank bought 200 tonnes of the precious metal, swapping dollars for bullion as the country’s finance minister warned the economies of the US and Europe had “collapsed”.

India’s decision to exchange $6.7bn for gold equivalent to 8 per cent of world annual mine production sent the strongest signal yet that Asian countries were moving away from the US currency.

Pranab Mukherjee, India’s finance minister, said the acquisition reflected the power of an economy that laid claim to the fifth-largest global foreign reserves: “We have money to buy gold. We have enough foreign exchange reserves.”

He contrasted India’s strength with weakness elsewhere: “Europe collapsed and North America collapsed.”

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p>While the amount in question ($6.7B) is relatively small in currency circles (India holds $285B in reserves & China has dollar reserves >$2T), it is a highly symbolic move that their faith in the dollar and/or their need to tie their fate to it may have shifted a few notches of late. What could it mean?

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Well, according to the canary in the coal mine argument, the rationale for shorting the dollar is relatively straightforward — fiat currencies are ultimately backed up by faith that the issuing government will be able to extract the stated value from its taxpayers over time. For the past 60-odd years, the US dollar has been backed by a stable government and an unmatched per capita GDP and as a result, other countries would often rather prefer to hold dollar reserves than any other currency. For all of Uncle Sam’s foibles over the last 60 yrs, you could be reasonably sure that he’d be there in essentially the same shape / form & able to pay up when your 30 yr t-bill came due.

Lately, however, the US deficit picture in particular is a potential signal that the relationship between government and taxpayer is likely to change –

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p>The problem, as Milton Friedman famously noted, is that deficits like this are ultimately resolved by 1 of 3 things -

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  • Spending cuts
  • Increased taxes
  • Inflated currency

Far from reducing spending, the Obama administration is emphatically pushing the curve upward (the deficit chart above for ex., most notably does NOT include any of the proposed health plans). To be fair, even the picture for pre-Obama unfunded liabilities isn’t very pretty (one guestimate for this figure is $76T – for comparison, our current annual GDP is $14T). He’s just arguably making an already bad spending prognosis much worse.

Increased taxes are not only politically difficult but the magnitude of the increases necessary to meet current obligations – much less the new ones – are tough to imagine. The perennial political hope is that a 1980s-esque scenario emerges where an economic growth inflection point drives increased tax revenue without necessarily increasing tax rates (or even, in Reagan’s case, more revenue with lower tax rates).

In lieu of either of these scenarios the remaining option, short of default, is currency inflation – basically start the printing presses, grow the money supply, and inflate your way out of debt & other assorted economic liabilities. It’s a dangerous but politically expedient option and not something that sovereign 3rd party countries enjoy being on the other side of. Depending on your proclivities, charts like this demonstrate that option 3 is precisely what Uncle Sam has started doing via the ever-expanding Fed balance sheet –

And so, to avoid waking up to a world where the billions of dollars they have in the bank are suddenly worth less, the Indian central bank has potentially decided to place more of its faith in good old fashioned gold. Will other countries follow suit? Tough to say – there are a variety of issues not the least of which is the potential that gold is experiencing it’s own bubble and the RBI may have bought at the proverbial top of the market. Perhaps the move isn’t a total commitment to an alternative reserve strategy but rather a signal to the US to clean up our fiscal ship?

A Gold Bubble?

The worst case scenario, of course, is that India continues to divest away from Dollars and that the move is copied by other countries – particularly China. Should that happen, the effects on the US would be pretty severe — $$’s held by other countries in the form of reserves are effectively low interest loans they’ve extended to us. Without it, servicing our debt would rapidly become our biggest fiscal outlay and any new programs eyed by Congress would become even bigger pipe dreams.

Still, actually replacing the dollar as a long term reserve is far easier said than done – for starters, there simply isn’t enough gold out there to truly replace a substantial % of reserves with metal (total annual gold production world wide is ~$90B / yr). So, if you really wanted to drop your $$’s, you’d have to find a different currency to replace it with. And then, the equation gets tough – do you really want to bet that the Govt of China, for ex., will be around in more or less the same shape & ready to pay up when a 30 yr Chinese note comes due? The Euro sounds interesting but its track record is pretty short and the several constituent countries have had a decidedly mixed record managing their currencies. Even worse, many of those countries have fiscal houses that are in far worse long term shape than the US – particularly due to ailing demographics and massive government bloat.

The RBI is following usual central bank protocol and keeping their options open -

A decision by the Reserve Bank of India to buy 200 tonnes of gold from the IMF for 6.7 billion dollars does not reflect a preference for the metal over the dollar, the finance minister said Tuesday.

..The purchase “doesn’t mean we don’t prefer the dollar any more or like gold any better,” Finance Minister Pranab Mukherjee told reporters in New Delhi.

Some analysts expect central banks around the world to diversify their holdings and purchase more gold as a shield against a weakening dollar.

On the other hand, maybe all of this shouldn’t be interpreted as a reaction to the US as much as a shift in preferences within India. Perhaps the Indian government is just indulging in the well known desi fetish for Gold? Finance Minister Mukherjee notes one particularly emotional trigger that may be at play

The government today said the RBI’s move to buy 200 tonnes of gold from multilateral lending agency IMF provided a healing touch to the nation’s pride that was dented about two decades back when the country sold its gold for a few hundred million dollars.

“It has much more significance because for many of you it is not the remote past,… how the sentiments of the country felt outraged when we had to pledge gold to Bank of England just for borrowing few hundred million dollars to maintain our essential import requirement,”

Never underestimate post-colonial rage

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48 thoughts on “RBI Votes Against the Dollar?

  1. good summary. It’s probably a combination of “losing faith” in the strong-dollar policy of the past, fears of future inflation due to printing of dollars, euphemistically called “quantitative easing”; the argument about “national outrage over mortgaging India’s gold reserves” is not compelling…

  2. India is extremely sensitive to inflation. This is not surprising since many households can still spend up to 50% of their monthly income on food. As the dollar depreciates, oil is likely to go up in price, even if demand for it remains flat – simply because it will take more dollars to buy a barrel of oil. Since fertilizers and petroleum go hand-in-hand, the costs of agricultural inputs may go up. So, take a weaker dollar and couple it with India’s poor internal infrastructure, which raises the cost of everything – the RBI may believe that gold is a good hedge against the dollar. Especially when all the other fancy hedges that were sold by Wall Street blew up in people’s faces.

  3. It doesn’t matter how much gold you have, when the dollar looses its value. Shit is going to hit everyone pretty bad. Nukes are a better hedge than gold.

  4. There’s a view that gold can be the new reserve currency. India would be well placed if the bankers could find a way to use the 40,000 tons or so of the metal that are estimated to be in private hands, but until that happens it’s best to boost government stocks. I am disappointed they left the other 200 tons on the table.

  5. Did nobody tell Pranab babu what happens when you switch away from the dollar, or try to? Tsk tsk.

    What I dont get about betting on gold is, that it is based on the assumption that if one currency/economy/nation collapses, the gold will still be worth something somewhere. Is that still true when economies are so linked together, and will it hold true if and when the time comes?

    Gold is pretty and all, but wouldn’t it be better to stock up on a more useful metal/resource? Uranium/Plutonium etc are useful things, inspite of their half life. Oil is another commodity that is only going to get scarce, and luckily is cheaper right now compared to the inflated price of gold.

    How about buying a country in Africa? China seems to be going that way sneakily.

  6. Amazing isn’t it, we didn’t hear a peep about deficits when they were piling up for the last eight years, especially after a surplus. Talking about spending the President just signed a ~$690 billion annual defense bill, and we are quibbling about a $1 trillion over ten years health care bill?. To paraphrase Asterix and Obelix the Gauls, SPQA

  7. Milton Friedman and the New Classicals aren’t exactly covered in glory in their ideas of how such crises cannot arise, or in their paucity of ideas when we hit ZIRP, or the zero rate bound on interest rates. The one option to tackle deficits which you left out, which is tied with inflation, is “growing out of it”. Deficits and huge debt loads can seem manageable if the denominator, i.e. the GDP, grows at a healthy clip over the medium-term, which could result in, hopefully, orderly inflation and devaluation of the dollar, further helping industry to be competitive locally and offshore.

    Krugman’s been plugging away about this for months now, and though he can be disagreeable he’s very hard to disagree with…if you don’t like him, I just got 4 words for you: Japan, the last 2 decades.

  8. Talking about spending the President just signed a ~$690 billion annual defense bill, and we are quibbling about a $1 trillion over ten years health care bill?. To paraphrase Asterix and Obelix the Gauls, SPQA

    It reflects kind of a tunnel vision by analysts too. If you’re concerned about America’s long-term strategic and economic power, investments made in healthcare and education equip us to be more competitive in the long run than the marginal dollar spent on defense. It’s capital accumulation over consumption.

    Uranium/Plutonium etc are useful things, inspite of their half life.

    You can thank Madam and her pet Prime Minister for effectively precluding that from being a realistic possibility. There are controls now on what kind of fissile materials India can import. With IAEA inspectors running around you can’t stockpile that much material without eyebrows being raised and a ruckus ensuing.

    Gold bugs should keep in mind, though, that gold doesn’t have any more intrinsic value than the cotton-fiber paper we print our greenbacks on. Gold functions just like any fiat currency, we value it because we all agree it has value. So if you want to switch to gold or any other “real” currency, know that you’re valuation of it is every bit as ephemeral as a fiat currency. The only difference is that the government can no longer control the money supply. So get ready for supply and demand shocks and currency valuations that have nothing to do with economic fundamentals. Find a new lode of gold somewhere? BAM! Inflation. Economy grows faster than you can mine gold to keep up? Well now you’re in for a self-reinforcing deflationary spiral.

    Yea, I’ll stick to my unbacked greenbacks, thanks. Honestly I’d rather we use our gold to make shiny, pretty things rather than forming it into bars and leaving it to sit in a vault somewhere. At the very least we could extrude it into overpriced HDMI cables no?

  9. all of these issues make me remember how odd the concept of “money” is in the first place. It seems like all our value of money comes from the whims of what is coveted momentarily.

    It’s bizarre to think about. Especially since we all depend on money so much.

  10. Yep. SBI also unloaded $$ a few weeks ago just 2 days before the dollar drop began, effectively saving themselves Rs 3 billion in losses.

    The signs have been out there for a while and just getting more obvious as we trot along. The USD is going to drop significantly.

  11. The USD is going to drop significantly.

    Being someone with student loans to pay off, I’m going to file this under “not a problem.” Yay for devaluing my debts!

    Long run, though, inflation is going to be necessary. Don’t fear it, we had a huge asset bubble and since letting prices hit bottom was a political non-starter the only alternative is to drain the swamp by letting the currency devalue to a level commensurate with the actual value of our overinflated assets. The tricky thing is managing the inflation to make sure it doesn’t spiral out of control. You want it to happen slowly enough to not be too much of a shock to the system and all signs point to this being quite likely.

    I also don’t get the kvetching over us not being as much of a reserve currency as we were before. Being the reserve currency is a huge burden. You have to be a square dealer and hawkishly monitor and stabilize the value of your currency while letting others, like China, engage in all sorts of flim-flam to artificially depress the value of their own to get an unfair competitive advantage.

  12. Gold bugs should keep in mind, though, that gold doesn’t have any more intrinsic value than the cotton-fiber paper we print our greenbacks on. Gold functions just like any fiat currency, we value it because we all agree it has value. So if you want to switch to gold or any other “real” currency, know that you’re valuation of it is every bit as ephemeral as a fiat currency.

    Regardless, in India’s case, there are significant benefits to be had from getting gold into the system due to the large private stocks. Most credit ratings, public as well as private would be vastly improved and borrowing costs would be lower if lenders could see that their investments were secured by gold. Lower borrowing costs would in turn boost the economy and improve the standard of living.

  13. Lower borrowing costs would in turn boost the economy and improve the standard of living.

    Depends on what that money is going into. Is it being spent on productive assets like infrastructure, public services like health and education, and economic production or is it being spent on short-term give aways and being skimmed off and deposited in Zurich?

    Lower borrowing costs are good, but the extent to which they will translate to tangible benefit for the people will depend on the government’s willingness to spend with national interests in mind rather than patronage.

  14. If the Indian govt could, it would exchange all its dollars for gold, or almost. India is v. very cautious about holding paper or building asset bubbles. Gold isn’t likely to ever become a bubble asset, because it is not fungible, except may be with Platinum, and Silver and like nobles, and is scarce, and has survived a history of millennia. There’s a good reason why India has the largest private hoard of gold in the world, and is a humongous consumer market for the stuff. For China and the US, the large dollar holdings and deficit are like two very hungry tigers holding each other by the tail. There’s got to be a soft landing. So all the talk by China of a G-2 and a new reserve currency. But the rest of the world knows China’s bluff when it sees it. China’s investment driven economy has to at some point turn to consumption or else it is going to be very difficult to drive growth with its dollar hoards. The US can switch between consumption and investment like no one else can or has ever before. Which is why hte world wouldn’t mind calling China’s bluff should it threaten to dump the greenback. Like that store robber brandishing a gun screaming, “This is real, see,” shooting himself in the foot, “see it works, it hurts.” It can kill too.

  15. I can’t really attest to the validity of this theory, so I would take it with a grain of salt. But I have heard that part of the reason gold ever became a standard of international trade was because of the Greek and Roman desire to trade with India. They really didn’t have much to exchange for all our spices and textiles, but apparently our ancestors absolutely loved to cover themselves in shiny stuff. So the value of gold was always reliable in Europe because the ancient Indians could never have enough of it. Once Rome fell the standard of using gold and silver persisted.

    Once again, don’t take it as gospel, but it’s funny to me that our very own aunties’ trying to one up each other could have been responsible for setting up one of the foundation stones of global finance.

  16. You can thank Madam and her pet Prime Minister for effectively precluding that from being a realistic possibility. There are controls now on what kind of fissile materials India can import. With IAEA inspectors running around you can’t stockpile that much material without eyebrows being raised and a ruckus ensuing.

    Meh… we went from not being able to import anything to getting something. Sounds like a win to me.

    And on the IAEA inspectors – they’re only going to be running around civilian facilities. I suppose this interferes with our ability to disappear some uranium and use it for big sexy bombs, but who gives a shit. We have enough domestic resources for weapons (albeit from shitty <1% ore that costs more). Energy independence is the priority and none of these conditions interfere with developing nuclear power

  17. Sorry.. formatting issues

    We have enough domestic resources for weapons (albeit from shitty under-1% ore that costs more). Energy independence is the priority and none of these conditions interfere with developing nuclear power

  18. Meh… we went from not being able to import anything to getting something.

    India is an enormous market that, most importantly, has international credibility as a responsible nuclear power. Given time, France and Russia would be more than willing to play ball and the US would have been compelled to join lest it be left out.

    Energy independence is the priority and none of these conditions interfere with developing nuclear power

    Curbs on thorium research, however, will. That and the necessity of maintaining a minimum credible deterrent, which we still haven’t actually built.

  19. I am not sure of the view that money’s value is tied to “economic fundamentals”. It is true that most highly valued currencies are of countries with reasonably good economic indicators (except UK), but it is unclear whether this relation is a necessary one. Or whether having good fundamentals is a sufficient condition for having a widely accepted currency.

    It is possible that the US could have mountains of debt, and still the dollar could be in demand, simply because the dollar is/has-been in use more, for instance to buy oil. So the demand for the dollar could be like the demand for Windows, where just because it has been around for a while, and is on most machines around the world, it will be used more, in spite of questions about its quality/performance. In this sense, the dollar would be more like the QWERTY keyboard or the English language, a convention that has gained worldwide acceptance.

    Most of the current discussion assumes the notion of a currency “mirroring” the economy. Maybe currencies are less like mirrors, and more like tools. This is true of the origins, and much of the history, of currencies. I guess we will soon find out which of these views (mirror/tool) holds in the current situation. The shift to gold implicitly assumes the tool view — it is moving to a more widely accepted tool, not a move to something with ‘inherent’ value.

    Tailpiece: The dollar is not fiat money — it is backed up by plutonium, and a willingness to use it.

  20. India is an enormous market that, most importantly, has international credibility as a responsible nuclear power. Given time, France and Russia would be more than willing to play ball and the US would have been compelled to join lest it be left out.

    Um, France and Russia are also members of the NSG. If the US won’t unilaterally start exporting outside the group (we had a secure an exemption from the NSG) I have a hard time believing France or Russia would

    Curbs on thorium research, however, will. That and the necessity of maintaining a minimum credible deterrent, which we still haven’t actually built. I may have missed this. What curbs?

  21. Gold will not feed India’s massive hungry population.

    http://www.dailyfinance.com/2009/10/13/india-hungry-for-global-power-or-just-plain-hungry/

    “The growing excitement over BRIC obscures a key problem in India. Although the country is enjoying more prosperity than ever, it continues to have severe problems with feeding its population. In India, 46 percent of children up to age three are malnourished, according to a report from the Institute of Development Studies, and an average of 2,000 to 3,000 children die of starvation every day. Overall, 25 percent of India’s citizens don’t get enough to eat on a daily basis; this is a higher percentage than sub-Saharan Africa.

    India’s malnutrition woes offer an important warning. Early childhood malnutrition is directly connected to a host of lifelong problems, including low IQ and antisocial behavior, studies have shown. That means that India’s next generation of workers — today’s children — may become a drain on the economy. Can India sustain its impressive year-over-year economic growth if its children are going hungry?”

  22. Depends on what that money is going into. Is it being spent on productive assets like infrastructure, public services like health and education, and economic production or is it being spent on short-term give aways and being skimmed off and deposited in Zurich? Lower borrowing costs are good, but the extent to which they will translate to tangible benefit for the people will depend on the government’s willingness to spend with national interests in mind rather than patronage.

    One thing we can be sure of is that much of the gold in private Indian hands is not being put to productive use and a lot of it was bought with unaccounted money. From that perspective, it may well be in Zurich for all the good it does.

  23. Gold is the only currency that has withstood the test of history. But gold is not going to save any country in a world where service/manufacturing based economies will soon dominate. Gold will, however, outlast the dollar. The decline of the USD is tied to the fact that this country has transformed from Rosie the Riveter into a Prada wearing princess while the rest of the world profits from her shopping sprees.

  24. I don’t know if the on-upness of aunties caused hoaring of gold. I always figured that transportablity of wealth was easiest with gold in a era of frequent external attacks, internal conflict, famine and flood.

  25. The USD is going to drop significantly. Being someone with student loans to pay off, I’m going to file this under “not a problem.” Yay for devaluing my debts!

    I didn’t get this. I have a student loan and I am worrying about the falling USD. When I was a student I borrowed more(from India) due to a strong USD and when I am paying back the USD is comparatively weak and I will end up paying using more $’s.

  26. Indian government is showing the classic sign of the retail investor who buys at the top and then when the prices crash, sells at a loss (often sells near the bottom) :-)

    The last time gold was anywhere near this high, it was in 1980s and when it crashed, it stayed at 75% lower price for 25 years. The same thing is going to happen again. A sign that Gold is approaching top is the ADs on TV where British accented man is selling you Gold bullion. The general hysteria about buying Gold is a classic text book sign of a top of an asset class.

    And Milton Friedman ??? Hasnt 2008 taught us anything??

  27. The dollar is not fiat money — it is backed up by plutonium, and a willingness to use it.

    Would that make it barely legal tender? Bernanannke would be wise pegging the dollar to the price of weapons grade plutonium to keep it fiat and cut interest rates while he’s at it to finish Greenspan’s job. The US has no capital exports anymore besides rappers, jock armaments, beefed up cars, and reality television (sort of) so it should be no wonder people are not investing in the dollar. India should be dangling no-bid contracts at the US for satellite parts and bollywood franchises, but no, instead they want to play the long term flavored short-term gold speculation game. The US (and the EU too though slightly less so) has been playing with a bunk hand for the last 11 years and everyone knows it in spite of their bluffing through emergency bill/bailout/stimulus overhyping. Dancing days are here again, break out the lassis, cry now/cry later.

  28. Never underestimate post-colonial rage

    One hopes the hon’ble finance minister was just playing to the gallery and that this wasn’t really a factor!

  29. The US has no capital exports anymore

    Tech still brings in a lot of moolah, unless I’m totally off the mark. A lot of hardware manufacturing is outsourced no doubt, but software must bring in a lot of $, even though a lot of the ‘consumption’ happens domestically.

  30. Someone is actually seriously quoting Milton Friedman after the Great Recession and the massive despair and destruction his “anything goes” worldview has caused? (Milton, the man who declared outrage after Hong Kong defended itself by buying stocks on its own market when western hedge funds were attempting to take their entire system down. The government had apparently had violated “free market” principles.)

  31. To be fair

    well, to be fair, somebody forgot to mention the Great Recession which required significant fiscal stimulus to barely edge out of, and that still hasnt been enough to stanch unemployment. deficit needs to be fixed, especially to dig us out of the pre-obama deficit hole – especially tragic since it was created during a time of growth. but to do that, fixing health policy would be an excellent long term step. but just one step among many. taxes will need to be increased once the economy turns around. the question is will president palin be willing to do that – and i think we all know the answer to that one.

    as for rosiah’s comment, milton friedman’s greatest enemies have been his so-called disciples who follow cliff’s notes versions of his theory without actually understanding it. chicago will be the death of friedmanism, even the good parts.

  32. Indian government is showing the classic sign of the retail investor who buys at the top and then when the prices crash, sells at a loss…

    Not quite, this isn’t for speculation or even investment, this is among other things to increase India’s shareholding in the IMF, and shore up India’s Rupee. For the land that invented Infinity, speculation even would mean thinking in terms of centuries, or as Mao is supposed to have said whether the French Revolution is a success, “It’s too early to tell.”

    And Milton Friedman ??? Hasnt 2008 taught us anything??

    It would if economics were a science. In fact if it were, Friedman would have been over with the flat earthers and the proponents of ether drift and caloric theories.

  33. For the land that invented Infinity, speculation even would mean thinking in terms of centuries, or as Mao is supposed to have said whether the French Revolution is a success, “It’s too early to tell.”

    What is this mumbo-jumbo? This is not historical analysis we’re talking about, we’re talking about the market. And as has been observed before, the market can stay insane far longer than you can stay solvent. The first part of your comment is probably right, but this kind of mysticism detracts from any credibility you might seek.

  34. Akash on November 4, 2009 9:29 PM · Direct link The USD is going to drop significantly. Being someone with student loans to pay off, I’m going to file this under “not a problem.” Yay for devaluing my debts! I didn’t get this. I have a student loan and I am worrying about the falling USD. When I was a student I borrowed more(from India) due to a strong USD and when I am paying back the USD is comparatively weak and I will end up paying using more $’s.

    It depends, If you want to pay it immediately, the US dollar isnot in too bad a shape. If you want to pay in the future,india’s inflation is worse than US’s inflation(which is quite low, and don’t expect it to go too high, since FED can always mop up the excess liquidity), so even then you don’t have a problem,if you go by the economist magazine data(last week or two i think) the IIRP predicts the currency exchange rate for the near future( 1/2 years) to be 1$=80+ rupees(which might be highly exaggerated since, economics is rarely that accurate). So overall you aren’t in that bad a shape

  35. What is this mumbo-jumbo?

    None. Unless you think that an idea such as infinity is magic. It isn’t. Nothing mystical. It’s just that a country like India that measures time by the 1000 isn’t buying gold to make a quick buck. Much in the way India has always been the largest private gold market, the government too will buy as much as it can, when it can.

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  37. I agree with the analysis above but feel that the move toward gold is highly suspect. It is true that it has stood the test of time yet you have to realise that basing your economy on gold can have bad results. That is why FDR shifted from gold. The only thing we need to do now to screw India’s economy is that everyone goes to the bank and asks for gold in change for currency. Currency is the legally binding tender for gold anyway. With the gold reserves nil india gets screwed. The only thing we can do to prevent that is to reduce inflation and to keep the market happy, something notoriously hard to do.