Goldline International

By Joseph C. Battaglia, Executive Vice President

By a continuing process of inflation governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.

Keynes, John Maynard, The Economic Consequences of the Peace, 1919. p. 235.

These words from the famed British economist perhaps best summarize our economic future. As our government continues to pump trillions of dollars into our economy, the specter of rampant inflation, perhaps even hyperinflation, becomes more and more real. And with inflation comes the loss of purchasing power that will affect all of our pocket books.

Inflation, in its most basic terms, refers to the general increase in price of consumer goods and services. You see it when you pay more for the necessities of life like food and clothing. Maybe American columnist Franklin P. Adams summarized inflation best when he said, “There are plenty of good five cent cigars in the country. The problem is they cost a quarter.”

Federal Reserve Chairman Ben Bernanke, one of the principal architects of our current government bailout, described how our government creates inflation through unrestrained spending:

[The] U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a papermoney system, a determined government can always generate higher spending and hence positive inflation.

(11/21/02, The Federal Reserve Board, “Remarks by Governor Ben S. Bernanke Before the National Economists Club”).

So how does inflation confiscate your wealth? If the government runs its printing presses so much that inflation is 10%, then goods and services will cost you 10% more money. For example, your $100,000 of savings will now buy $90,000 worth of goods. That other $10,000 has been “confiscated” by our government’s devaluation of the dollar.

For the average American, a 10% loss is both real and frightening. People with money in the bank, who live on fixed incomes or whose incomes do not rise with inflation will see their dollars buy fewer goods. And for most, there are few avenues available to make up the shortfall.

How real is this threat of inflation? First, consider our current government spending and national debt. As Sheldon Figler, author and master blogger for the notable GlobalEconomicCrisis.com, explained:

Massive quantitative easing by the Fed is pouring trillions of U.S. dollars into the money supply, essentially conjured out of thin air. This is being done without transparency, the rationale being that frozen credit markets require a vast expansion of the money supply in an attempt to get the arteries of commerce flowing again. Similarly, the U.S. government is spending vast amounts of money it does not have, with the Treasury Department selling unprecedented levels of government debt in a frantic effort to fund the wildly expanding U.S. deficit. These two forces, quantitative easing and multi-trillion dollar deficits, are the core ingredients of an explosive fiscal cocktail that I believe will ultimately lead to hyperinflation.

(5/25/09 Huffington Post, “U.S. Economy Risks Dire Prospect of Hyperinflation”).

In terms of numbers, our current national debt is approximately $11.3 trillion. The projected deficit for fiscal year 2009 is $1.752 trillion. Over the next ten years, another $9.3 trillion may be added to the national debt.

Marc Faber, who correctly predicted the current gold bull market in 2000, also believes that we are facing the certainty of hyperinflation. Speaking to Bloomberg TV, Mr. Faber said:

I am 100 percent sure that the U.S. will go into hyperinflation… The problem with government debt growing so much is that when the time will come and the Fed should increase interest rates, they will be very reluctant to do so and so inflation will start to accelerate.

(5/27/09 Bloomberg.com “U.S. Inflation to Approach Zimbabwe Level, Faber Says”).

Mr. Faber went on to predict inflation levels similar to what the African nation of Zimbabwe experienced: a jaw-dropping 231 million percent.

Even the Congressional Budget Office (CBO) has warned of the possibility of future inflation:

In contrast, the massive amount of monetary stimulus during 2008 and 2009 has raised concerns about rapid inflation in 2010 or subsequent years. The Federal Reserve has engineered a huge increase in liquidity in the financial system to mitigate the contractionary effects of the credit crunch. Because reducing the federal funds rate—its most commonly used policy tool—was clearly insufficient to alleviate the problems in financial markets, the Federal Reserve took actions to ease conditions in credit markets more directly. It reduced the terms for lending to depository institutions; cooperated with foreign central banks through currency swaps; and, for the first time since the 1930s, extended credit and other support to nondepository institutions. That increase in liquidity will need to be drawn down as the economy recovers, in order to avoid the possibility that demand will run ahead of supply and create inflation.

(5/21/09, CBO Testimony Before the Committee on the Budget, House of Representatives, “State of the Economy”).

Not everyone agrees that inflation is on the horizon. Economist and Nobel Laureate Paul Krugman wrote in the New York Times that the United States was in little jeopardy of inflation. Mr. Krugman recognized, however, a significant risk related to our national debt.

Is there a risk that we’ll have inflation after the economy recovers? That’s the claim of those who look at projections that federal debt may rise to more than 100 percent of G.D.P. and say that America will eventually have to inflate away that debt — that is, drive up prices so that the real value of the debt is reduced.

(5/28/09, NY Times, “The Big Inflation Scare”).

From my perspective, this risk is far greater than Mr. Krugman gives credit.

At the end of 2008, the federal debt was equivalent to 41% of Gross Domestic Product (GDP). The CBO projects the debt will increase to 82% of GDP in 10 years. With no change in policy, it could hit 100% per cent of GDP in another five years.

If the United States debt equals 100% of our gross domestic product, among other things Standard and Poor’s will likely downgrade our credit rating from AAA. This means governments and investors will demand even higher returns on their treasury bills and savings bonds before investing in the riskier government debt. Thus, the government has a strong incentive to lower the debt-to-GDP ratio. This is especially true given the growing movement to replace the U.S. dollar with a different reserve currency.

To combat this problem, as Mr. Krugman and others note, the United States could inflate its way to a lower debt-to-GDP ratio. Essentially, the government would fuel high inflation which, as we discussed above, increases the prices of goods and services. This would similarly inflate the United States’ GDP (which is the market price of goods and services produced by our economy) and lower the national debt to GDP ratio.

Professor and economist Paul Taylor, writing in the Financial Times, states that the United States would need approximately ten years of inflation averaging 10% to cut the debt-to-GDP ratio in half. “But it would not be that smooth – probably more like the great inflation of the late 1960s and 1970s with boom followed by bust and recession every three or four years, and a successively higher inflation rate after each recession.” (5/26/09, Financial Times, “Exploding Debt Threatens America”).

In addition to economists, some savvy investors are preparing for inflation. The Wall Street Journal reported that a hedge fund which saw significant profits for its investors when it bet against the stock markets last year has now created a fund that is betting on high inflation (the minimum investment for the fund will be $25 million). The fund will focus on commodities and stocks such as oil drillers and gold miners. (6/1/09 WSJ, “Black Swan Fund Makes a Big Bet on Inflation”). As the Wall Street Journal noted, “Unlike last year’s sudden market implosion, inflation isn’t an unimaginable event that few currently anticipate. In fact, many fear inflation right now amid government efforts to goose the economy. Universa’s bet, however, is that inflation will reach levels few expect.”

Analysts forecasting new record gold prices are also citing inflation and a falling dollar as two of the principal drivers. For example, the global head of marketing strategy at the JP Morgan told Bloomberg Television he believed gold could reach $1,300 within the next year or so because of inflation hedging and lack of supply. (5/12/09, Bloomberg.com, “Loeys Says Recession is Over, Sees Oil Rising Above $70:Video”).

Standard Bank Group stated that a breakout in gold may lead to a “minimum objective” at $1,250. (Bloomberg.com, “Gold May Target $1,250 Peak, Standard Says: Technical Analysis”). While we view gold and other precious metals as a long term investment, these projections signal a strong belief that inflation and a weak dollar are on the horizon.

Indeed, the allure of gold in these troubled times led Northwestern Mutual Insurance Company to acquire gold for the first time in 152 years. The third-largest U.S. insurer acquired $400 million as a hedge against asset declines. Northwestern’s CEO explained that “Gold just seems to make sense; it’s a store of value… In the Depression, gold did very, very well… The downside risk is limited, but the upside is large…” (6/1/09 Bloomberg.com, “Northwestern Mutual Makes First Gold Buy in 152 Years”).

In my view, investors need to consider whether they should follow Northwestern Mutual’s lead and diversify their portfolios with gold. With gold being one of the assets classes which traditionally moves in tandem with inflation, this diversity may serve you well especially if we are at the beginning of our troubled economic times.

By Philip Klapwijk, GFMS

China announces that it has purchased more gold for its reserves

In late April China decided to tell the world that it had been quietly accumulating gold. The head of the State Administration of Foreign Exchange (SAFE), which controls the bulk of China’s foreign reserves, announced that the nation had increased its official gold holdings by 75% or 454 tons since the end of 2003 to a current level of 1,054 tons. This increase makes China the sixth largest gold holder globally, after the United States, Germany, the International Monetary Fund, France and Italy. For years there had been rumors that the country’s central bank, the People’s Bank of China (PBOC) had been buying gold, with the intention of protecting itself from possible collapses in the value of foreign currencies, especially the US Dollar. As news of China’s gold buying reached the market, gold prices jumped to a three-week high of $907.50 (basis the London p.m. fix) as investors speculated that China would continue to buy gold as part of a plan to diversify its reserves. (Note: The PBOC is responsible for holding official foreign exchange and gold reserves, while the SAFE is in charge of operations and management of these reserves.)

Background Information

Largely due to gold having been the basis of monetary systems through to the 1960s, the yellow metal has continued to take up a significant portion of central banks’ official reserves (a global average of 10% at end-March 2009). According to GFM S data, at end- 2008 official sector gold holdings accounted for over 30,000 tons, a figure equivalent to more than 11 years of global mine production. Given this information, the importance of official sector activity to the gold market and for the price of the metal is self-evident. Moreover, history provides the evidence to support this. First of all, the shift by the official sector from a broadly neutral position in the 1970s and 1980s to substantial net sales in the 1990s and through to the current decade was a factor (among others) that resulted in gold prices falling well below the $300 mark in the late 1990s. More recently the “anti-gold” climate that was prevalent throughout the 1990s and in the early part of the current decade seems to have come to an end. Although the official sector remains a net seller overall, sentiment towards gold, as suggested by comments made by central bank officials, as well as the appearance of small-scale purchases by certain countries, has shifted to one considering the metal as an important reserve asset. This change in sentiment has been boosted by the prolonged period of US dollar weakness, coupled with gold’s strong performance and demonstrable portfolio diversification properties.

What were the reasons for buying gold?

It seems that the principal reason why the PBOC has increased its gold reserves is the need for the central bank to diversify its reserve portfolio. From the 1990s onwards, China has built up huge foreign exchange reserves, the majority of which are held in US Dollars, as a result of a series of large annual current account surpluses, high levels of foreign direct investment in China and inflows of ‘hot money’ from overseas investors. Since replacing Japan as the world’s largest holder of foreign exchange reserves in early 2006, China’s accumulation of the same has accelerated. For instance, at end-March 2009, the country’s holdings of foreign exchange reached around US$ 1.95 trillion, almost twice those of Japan and accounting for more than 20% of the global total. One result of this massive accumulation has been that gold’s share of China’s reserves has fallen sharply.

Concerns grow over the country’s exposure to the US Dollar

Over the same period, the heavy losses the PBOC suffered on its reserves, particularly from 2002 through to the first half of 2008, due to the collapse of the foreign exchange value of the US Dollar against the Chinese Yuan, have led officials to consider diversifying part of the country’s reserves away from US Dollars. Although the Dollar rebounded strongly in the second half of last year, there has been an increasing concern in top political circles over the long-term viability of parking most of China’s reserves in US government bonds, particularly following the announcement made by the US Federal Reserve to purchase as much as US$ 300 billion of US government debt, which may eventually trigger a new run on the Dollar. Despite the obvious alternative for such a move being other major currencies, such as the Euro and the Japanese Yen, the government seems also to favor a marginal allocation into gold, energy and other commodity products.

Another important factor to support such a move into gold is undoubtedly the impressive performance of the precious metal’s price in both US Dollar and local currency terms over the last few years, especially its resilience during the financial crisis in 2008. Moreover, despite the significant increase in both gold prices and its published bullion reserves, the share of gold in China’s total reserves still remains extremely low at levels around 1.5%, whereas the average global figure is nearly 10%.

The public disclosure of an increase in the country’s reserves perhaps also reflected the government’s strategy to boost market confidence in its currency the Yuan or RMB, which China wants to raise eventually to the status of a global currency. Since the latter part of 2005, China has allowed the RMB to appreciate gradually in what may be (in part) preparation for potential RMB reserve status. In late March this year, the PBOC startled the world with a proposal to replace the US Dollar with a new international reserve currency. In light of this, it is worth noting that recently China has signed six bilateral currency swap agreements with other central banks totalling RMB 650 billion, in efforts to facilitate trade with these countries and expand the RMB’s role in international settlements.

How did China buy the gold?

According to the SAFE’s announcement, the 454-tons of gold was bought in the Chinese market from local sources, including domestically refined scrapped gold. While all the evidence available indicates that this gold was indeed neither from large-scale purchases in the open market nor through any new offmarket transactions with other central banks, GFMS is not entirely certain that all the gold bought was sourced from local mine production or scrap. This conclusion is based on a careful examination of supply/demand flows in the Chinese gold market.

As the graph below showing China’s gold market balance indicates very clearly, since 2006, the domestic market has shifted from a broadly balanced position to one of annual deficits, defined here as the difference between supply from mine production plus scrap and demand from fabrication plus local investment. This gap between local supply and demand has been filled by bullion imports into China, both official and unofficial ones.

On the supply side of the equation, for many years now, China’s gold mining industry has experienced remarkable progress, with output booming. Indeed, having overtaken South Africa to become the world’s largest gold producer in 2007, China extended its leadership in 2008, with annual gold output close to 300 tons. Nevertheless, the impressive growth in overall supply (from mine production and scrap) has not matched the even more rapid increase in demand in the form of gold fabrication (mainly jewellery) and investment, the latter very much reflecting China’s excellent economic performance over the period and high personal savings rate.

Given that the local market has been in a deficit for the last two years, it is hard to see how the SAFE could have sourced domestically all of the gold added to reserves over the same period. At present, we believe at least part of the gold added to reserves has come directly or indirectly from bullion imports via the Shanghai Gold Exchange. Indeed, it is presumably no coincidence that China’s bullion imports have soared in the last couple of years. In addition, there is also the possibility that internal accounting changes have played a part in the increase in officially declared reserves. For instance, it could be that some gold formerly held in a trading account has been shifted to the foreign reserves account.

China is likely to increase further its official gold reserves

Looking ahead, there is a good chance that the PBOC will increase further its gold reserves. The arguments that were put forward for purchases during the past few years remain applicable given the current state of China’s reserve assets. In addition, the massive financial commitments made by the US government and the Federal Reserve plus President Obama’s fiscal and monetary package may well undermine the US Dollar and, furthermore, risk igniting a major inflation in future. There are indications that such issues have been discussed at the very highest levels in China. A number of articles, for instance, have appeared in the official media arguing the case for China to reduce its exposure to the US Dollar and to seek diversification of its reserves through purchases of gold and other means.

Nevertheless, it should be pointed out that although GFMS expects to see continued official purchases by China, any large-scale buying by the country in the open market would seem unlikely over the medium term at least. One important reason for our caution is that the gold market is far too small to allow the country to make more than a very modest diversification of its foreign exchange reserves. To illustrate, at the current gold price, China would need to add an inconceivable 10,600 tons (some four times global mine production in 2008) to bring gold’s share up to the European Central Bank’s guideline of 15% of total reserves.

Furthermore, as the largest holder of US Dollar reserves, China would obviously face a serious problem if it dumped the American currency. In fact, any indication that the country was about to embark on large-scale reserve diversification would not only have a massive and immediate impact on the gold market but would also put the value of its US Dollar holdings under great pressure.

However, the “too big to sell” argument can also be exaggerated. In recent years China has sought to buy other currencies in an attempt to slow the growth in its exposure to the US Dollar. Moreover, if the country felt that a Dollar crisis were inevitable then it would be forced to take some risks in order to diversify its portfolio and thereby limit the losses it would eventually be forced to take on its Dollar reserves. Under such circumstances gold would offer another alternative. What is more, under extreme conditions, such as an outright run on the Dollar, gold prices might well be forced to very high levels, the yellow metal thus providing a particularly useful hedge during this kind of crisis.

When it comes to the gold market’s limited size, this constraint might also be circumvented through China making an off-market deal with other official institutions looking to offload gold. Such off-market transactions are not without precedent and could be repeated in the future. At the moment, given the high probability that the IMF’s plan to sell 403 tons of its gold reserves will be finally approved later this year plus the Fund’s desire for them to be executed in a way to avoid distorting the market, we can imagine that an off-market transfer could favor both China and the IMF. Likewise, it is quite possible that in the longer run we could see off-market transfers of gold reserves from countries ‘overweight’ in gold, such as some of the Europeans or even the United States, to an ‘underweight’ China. This is after all a pattern we have seen in the past, with the United States accumulating gold from highly indebted European countries that had balance of payments difficulties, this flow later reversing in the 1960s as the United States began to run unsustainable current account deficits. China is, of course, today’s burgeoning economic and financial powerhouse and with gold’s reserve role rehabilitated after its ‘lost decade’ in the 1990s, there is every reason to expect gold to flow to where the money now is.

China’s “pro-gold” stance could have important consequences for the price

As stated at the beginning of this article, China’s announcement of official bullion purchases can be seen as a defining moment for the gold market. There is little doubt in our mind that this represented both a statement of intent (to diversify further foreign reserves) and a clear message to the United States not to take Chinese support for the US Dollar for granted. Although China’s desire to reduce its exposure to the US Dollar and, indeed, move away from a US dollar-based international financial system will take many years to accomplish, the direction is clear. For gold prices the implications of this must be positive. Even if Chinese purchases, as seems very likely, turn out to be small in the context of the Asian giant’s overall foreign reserves, for the bullion market the quantities involved could turn out to be rather significant. For instance, if China were to set a target of say 3% of its foreign reserves to be in the form of gold (i.e. to double them), then this would imply adding another US$ 30 billion worth of gold to its holdings, equivalent at current prices to around 1,000 tons. Such an objective would seem to be perfectly feasible if purchases were to be spread over a number of years. For the gold market, buying on such a scale could be enough to offset greatly sales by other central banks over the same period. This result would represent an important change in terms of the official sector’s net impact on gold’s supply/demand balance. Over the last ten years net official sector sales have averaged no less than 488 tons per year. A shift from net sales on this scale to something close to ‘neutrality’ would be highly positive for gold prices, at the very least providing the market with a very solid floor and giving a major boost to sentiment and confidence in the yellow metal.

Philip Klapwijk has over 20 years experience analysing the gold, silver and PGMs markets, most of this time working for GFMS, which is the world’s leading specialist research consultancy on the precious metals markets. (GFMS, for example, is the prime source of statistics on gold and silver markets worldwide.) GFMS became independent of former owner Gold Fields of South Africa via a management buyout in August 1998 and Philip was the company’s first Managing Director. Since January 2004 he has been the Executive Chairman of GFMS. Philip is responsible for the strategic direction of GFMS and its market research on the official sector, investment and fabrication demand in the Americas and Europe. Philip has also helped to manage GFMS’ expansion in recent years into other areas, including base metals and steel research, mining exploration and consulting and mines’ costs analysis. (For more information see: www.gfms.co.uk.)

Philip is a frequent speaker at conferences on precious metals and commodities and the print and electronic media regularly quote his views on the gold, silver and PGMs markets. The most recent examples of the former include international investment conferences in late 2008 and early 2009 held in Kyoto, Shanghai, Toronto, Zurich, London and New York.