The End of the Super Cycle in Fiat Money

Well how about that! India pipped China at the post to walk away with 200 tonnes of IMF gold. Granted, India had to pay US$6.8 billion for the yellow metal. But with China steadily accumulating gold as a reserve asset (at the household AND central bank level), everyone thought China has this one in the bag. Not so!

Something more than meets the eye is going on here. The IMF sale was part of a plan to unload 403.3 tonnes of gold. It’s halfway there, and will use the proceeds to fund itself and loans to the developing world (or perhaps Britain and America when they go broke). But what else is going on?

In the past, large sales of gold – mostly by European central banks – swamped the gold price and kept it in check. Why did they sell?

The central bankers believed they had too much gold on their balance sheets doing too little work. In other words, these thoroughly modern bankers would explain, “Gold pays no interest.” So they thought it “prudent” to exchange their gold reserves for interest-bearing assets like Treasury bonds. So far, that’s been a horrible trade…and it is becoming an even more horrible trade as gold advances from record high to record high.

Nevertheless, the central bankers of the West continue to unload their gold reserves to the central bankers of the East….

India’s central bank is now the proud owner of 557 tonnes of gold. That gives it the tenth largest gold holdings among central banks. But it probably isn’t finished. Gold makes up just six percent of India’s foreign exchange reserves. There’s plenty of room for that to grow.

But don’t forget China. China has $2.3 trillion in foreign exchange reserves. But 70% of those – or $1.6 trillion – are in US dollars. It owns over just 1,000 tonnes of gold. That makes up less than 2% of China’s reserves and makes China the seventh largest holder of above ground gold. In fact the gold exchange traded fund (NYSE:GLD) owns more gold than China. France, Italy, the IMF, Germany and the United States round out the top five (from fifth to first).

What this tells you is that China could double (and then double again) its gold reserves and gold would still make up less than 10% of its total forex reserves. Compare that to 66% in Italy, 69% in Germany, 70% in France, and 77% in the US, according to official numbers. So what’s the big deal?

There will always be a threat that European Central Banks release gold supply on to the market. In fact, European central banks just renewed a five-year agreement (including the IMF) to sell down a maximum of 400 tonnes of gold per year from their holdings. They’ve agreed to this to disgorge their gold in an orderly fashion.

But it would not surprise us to see the Europeans fail to sell the gold they’re allowed to sell under the agreement. Our old desk mate in London, Adrian Ash (now with Bullion Vault) is at the London Bullion Market Association’s annual meeting in Edinburgh. Word from UBS analyst John Reade, also at the meeting, is that European Central Bank official Paul Mercier reckons that official holders of gold will, “no longer be net sellers of gold.”

As we predicted earlier this year, the European central banks would rather hoard their gold than sell it in a rising market. There may be a price at which they do sell it, in order to pay down sovereign debts. But psychologically, the fact that central banks want to own gold and not sell it is pretty important.

Also, it shows you how the balance of economic power in the world has shifted East. True, the European banks can still dump gold on to the market to drown the price. But between the ETFs, central bank buyers in India and China, and the average man on the street in Beijing, Mumbai, and elsewhere, there are more buyers of gold now than sellers.

And if we were right yesterday that the GFC is slowly morphing into a sovereign debt crisis, then the case for gold is that much stronger. This explains why gold futures were up by nearly 3% overnight and Old Yeller hit a new high at US$1,084.90.

The only worry? So many hedge fund managers and pundits are singing the same tune: long gold and short US Treasuries. These feel like “crowded trades.” So as a contrarian, you’ve got good reason to be a little worried about becoming a victim right about now.

Nevertheless, in the long term, the end of the Super Cycle in fiat money results in the re-monetisation of gold. That is what you’re seeing now. And it’s probably what you’ll see for a few more years. It also ought to benefit other precious metals, and of course, precious metals shares.