Why gold is central to China’s future trade settlement policy

“China’s challenge is the yuan as a purely fiat currency will take decades to replace the dollar, possibly never. And that assumes that China follows more stable monetary policies than the US. This has not been the case since the Lehman crisis, with China’s M2 broad money quantity expanding rapidly, accounting for much of the world’s monetary growth in recent years. The rate of monetary expansion is criticised as a dangerous credit bubble by western analysts, who are quick to condone monetary expansion in their own developed nations, but turn into hard-core monetarist critics over China. No, China will never replace the dollar with her own currency without a golden guarantee.

“Therefore, China needs to deploy gold to displace the dollar. This might be done in one of two ways, one encouraging markets to evolve away from dollars towards gold, or alternatively by the state forcing the pace.

“China provides the facility to convert yuan into physical gold in the Shanghai market through the Shanghai Futures Exchange. This gives an exporter of raw materials to China a sound-money option instead of being paid only in yuan or dollars. It does not require China to use state-owned gold, the physical gold being sourced through the market. In time, liquidity in the yuan futures contracts should improve, and Shanghai is already the largest physical gold market. Note that only last month it was announced that Russia’s central bank has opened an office in Beijing, and is tasked with resolving the technical aspects of gold deliveries from Russia into China. The importance of the Shanghai Gold Exchange will increase further through this link to Moscow. Using the Chinese market for physical gold delivery over time should impart some stability to the yuan relative to the dollar, particularly if American banks trading on Comex continue to discourage taking delivery of physical bullion.

“That might take for ever. Alternatively, China could announce plans to make her currency convertible into gold at a fixed rate, but it would have to be at a far higher exchange rate than the current CNY8,700 to the ounce. If this course is followed, US Treasuries are bound to be displaced as the zero-risk bond standard, potentially creating chaos in western financial markets. China would also need to reveal her true holdings of gold bullion, transferring them into the currency reserves account, to give the foreign exchanges confidence over the scale of gold backing for the yuan.

“So far, China’s policy has been to pursue the least disruptive route, preferring not to dislocate global trade, partly because she needs to co-exist with the rest of the world politically, and partly because it would affect her own trade adversely. It has also been very convenient to be able to direct the Chinese economy through the expansion of bank credit. The least disruptive route is still the default assumption.

“China will also want to reduce her reserve exposure to the dollar and US Treasuries in an orderly fashion. The pace of selling, the degree to which dollar reserves are to be reduced, and the rate of accumulation of industrial materials and energy all determine the length of time to complete a currency reset. This course has been expected by informed observers to lead to a gradual decline in the use of the dollar as its role in global trade diminishes. The alternative, with China announcing its true gold reserves and a rate of exchange with its own currency was always viewed as an extreme option, only to be resorted to upon severe provocation.

“North Korea might become the trigger for that event, but so would a domestic financial crisis in America, insofar as it might be expected to affect America’s foreign policy. Remember that the Chinese believe America periodically engineers a foreign crisis to fund its own economy, by encouraging dollars to buy US Treasuries, in preference to more risky employment. For this reason, China will be watching the US economy closely for signs that might impact on the dollar’s value.

“After a long period of subdued growth, there are now signs that the US economy is suffering from overall debt fatigue. Bank lending is stalling, as the chart below of US M2 minus M1 money supply shows.

The yield on the long bond has fallen from 3.2% to as low as 2.9%, indicating a possible recession is on the cards, and the Atlanta Fed has also revised its expectations for economic growth sharply downwards.

Shortly, unless some miracle occurs, the US Government begins to shut down, the debt limit having been reached with no sign of an agreement to increase it. At the same time, America is escalating tensions over North Korea. Beijing is convinced that America’s belligerency is driven by financial factors, and it is possible that Trump is stoking up American patriotism to force Congress to increase the debt limit. In short, China probably believes America has become desperate.

Imagine how China feels about this. Will China bring forward an attack on the dollar’s status as a defensive warning shot? Will it be forced to abandon its softly-softly approach to easing the world away from dollar-dependency? Is it prepared to escalate the financial war with America, to the point of America’s financial immolation?

The answers to these questions are likely to be revealed in the coming months, possibly in only a matter of weeks, if North Korea hots up. But if China decides to revalue gold, western capital markets will be wholly unprepared for the fall-out. China itself will be affected, as will all other nations that trade with the US or trade with countries that trade with the US. The advanced welfare-driven nations dependant on capital markets are at risk. The great financial crisis of nine years ago will be a light rehearsal compared with what could follow.

The irony is that the countries isolated from the dollar, especially Russia and Iran, will come out best. Iran will be significantly stronger relative to Saudi Arabia, with important consequences for the power-play in the Middle East. Russia will also have an interest in pushing China for this action, partly because it should tip the balance in Syria in Russia’s favour, and partly because the destruction of US hegemony will free Western Europe from being tied to America’s apron strings.

This is the final prize for the two leading nations of the Shanghai Cooperation Organisation: a free trade area which will eventually include the whole Eurasian Continent, with the rest of the world acting as its feedstock. It has always been the ultimate logic behind the Russian-Chinese partnership. Despite all its military power, America will be isolated, unless, like Britain ditching her colonies in the 1960s, America accepts she no longer controls global commerce.

That is hard to imagine. Meanwhile, uppermost in Russia’s mind will be the continuing problem of oil prices tied to the dollar. There is some circumstantial evidence that America used the oil weapon to attack Russia by encouraging the collapse in oil prices in 2014. True or not, Russia will not want to be exposed to the continuing risks of her major export commodity being priced in dollars. She will almost certainly prefer to see oil priced in gold, or a currency linked with gold. Our next chart, which compares oil priced in dollars with oil priced in gold, illustrates the financial stability this can be expected to give Russia and the other Asian oil exporters as well, relative to the historic price volatility in dollars.

Before the failure of the gold pool in the late sixties, and the subsequent abandonment of the dollar-gold standard in 1971, oil, in common with all other commodities, was effectively priced in gold, the dollar being merely the settlement medium. Since 1971, the oil price measured in gold has varied in a 350% range, while in dollars the range has been many magnitudes greater. If the dollar is to be undermined, the dollar-oil price may rise, but the dollar’s purchasing power eliminates any benefit. Russia will almost certainly want to revert to the pre-1971 regime, of oil priced in gold, allowing her to accumulate monetary reserves that retain their value.

So, we can begin to understand the importance of Sergey Glazyev sharing China’s geostrategic view. It confirms, that sufficiently provoked, the Shanghai Cooperation Organisation’s plan to operate without the US dollar, might have to be brought forward. The SCO’s economic stability cannot be guaranteed by replacing one fiat currency in its death throes with another. Some form of gold convertibility will be essential, so those plans will be brought forward as well.

Perhaps China and Russia no longer have the luxury of time. America’s increased military belligerence in Trump’s first hundred days might force their hand. Perhaps America, knowing her demise is becoming increasingly inevitable, has some dramatic plan under wraps to seize the financial initiative, as dramatic perhaps as the Nixon shock, when America abandoned the post-war gold standard. The instability brought into the geopolitical equation by the Trump presidency, and the early signs the US economy is grinding to a halt under the sheer weight of consumer and government debt, are increasingly likely to prompt China and Russia into firm financial action, if only to protect themselves in an unstable financial and monetary environment.

About Jay Taylor

Jay Taylor is editor of J Taylor's Gold, Energy & Tech Stocks newsletter. His interest in the role gold has played in U.S. monetary history led him to research gold and into analyzing and investing in junior gold shares. Currently he also hosts his own one-hour weekly radio show Turning Hard Times Into Good Times,” which features high profile guests who discuss leading economic issues of our day. The show also discusses investment opportunities primarily in the precious metals mining sector. He has been a guest on CNBC, Fox, Bloomberg and BNN and many mining conferences.