By Lee Quaintance & Paul Brodsky, QB Asset Management
The following is the third in a series of posts by QB Partners. The second post is available for review here.
The Heir Apparent
Is there a viable currency to replace the US dollar when over-leverage, economic imbalances and consequent money printing ultimately lead to an overwhelming decline in confidence in the dollar as a store of value? Special Drawing Rights (SDRs) are thought to be the economic illuminati’s ace in the hole – the "nuclear option" if and when popular confidence in the existing regime evaporates.
SDRs are an active currency but they have not been widely distributed and so they are not used as media of exchange. They are issued by the International Monetary Fund (IMF) to its membership, which is comprised of 187 sovereign nations. For all the world’s economies to adopt SDR’s as media of exchange, global politicians, commercial participants and wealth holders would have to accept the IMF as the sponsor of the means of storing and exchanging wealth. Is this possible?
Let us review the organization as a potential independent sponsor. According to the IMF’s website: ‘"The IMF was conceived in July 1944 when representatives of 45 countries meeting in the town of Bretton Woods, New Hampshire…agreed on a framework for international economic cooperation. They believed that such a framework was necessary to avoid a repetition of the disastrous economic policies that had contributed to the Great Depression." The IMF mission was to "ensure exchange rate stability and encourage its member countries to eliminate exchange restrictions that hindered trade.""(International Monetary Fund; https://www.imf.org/external/index.htm.)
Fair enough. Let’s look further. The IMF’s Articles of Agreement suggests requisite sovereignty. For example:
• "Article VIII, Section 7. General Obligations of Members: "Each member undertakes to collaborate with the Fund and with other members in order to ensure that the policies of the member with respect to reserve assets shall be consistent with the objectives of promoting better international surveillance of international liquidity and making the special drawing right the principal reserve asset in the international monetary system." (Ed. Emphasis added)
• "Article IX, Section 3. Immunity from judicial process: The Fund, its property and its assets, wherever located and by whomsoever held, shall enjoy immunity from every form of judicial process except to the extent that it expressly waives its immunity for the purpose of any proceedings or by the terms of any contract."
• "Article IX, Section 4. Immunity from other action: Property and assets of the Fund, wherever located and by whomsoever held, shall be immune from search, requisition, confiscation, expropriation, or any other form of seizure by executive or legislative action."[1]
We could continue on, describing the granting of complete immunity from judicial process to the IMF’s officers and the Fund’s immunity from taxation within all member jurisdictions, but we think you get the picture. The IMF seems at face value to be an independent, sovereign organization with the ability to objectively issue and oversee the world’s money and capable of doing what it pleases without review or consequence.
The observable function of the IMF since the demise of Bretton Woods in the early 1970s has been as financial intermediary between have and have-not countries, effectively serving as a mechanism to redistribute money when currencies or economies of third-world or developing nations falter. Most recently, the IMF has been selling a portion of its gold hoard to small and bourgeoning central banks. Thus, the IMF seems to have shown that it takes seriously the interests of all its members.
Looking Deeper
Is the IMF really a super-sovereign entity credible enough to issue and oversee the global reserve currency? Further consideration creates doubts. For example, the IMF’s most recent public activity has been selling its gold hoard at market prices "to generate profits to fund an endowment that would diversify the Fund’s income sources away from lending income"[1]. Yet the nature of these gold sales does not engender confidence, from the market nor do we imagine among many of its members.
Consistent with an agreement signed by Euro zone central banks in August 2009[2], the IMF sold the first tranche of what will eventually be a total of 2,000 tonnes (metric tons) of gold over a five-year period. The gold is being privately placed at prevailing market pricing at the time of each sale. From October 2009 to December 2010, the IMF claims to have sold about 403.3 tonnes (almost 13 million ounces), which generated "windfall profits" of about SDR 1.75 billion (about $2.75 billion).
The first half of this first tranche, about 212 tonnes, was sold to the Reserve Bank of India, the Bank of Mauritius, the Central Bank of Sri Lanka and the Bangladesh Bank. A private investor, the Sprott Physical Gold Trust, then made an offer to purchase the remaining 191.3 tonnes. The IMF did not consider this offer. While the IMF may sell its gold privately to whomever it wishes at whatever exchange value each party agrees, the rejection of a public tender offer from a bonafide investor serving the public raises serious questions. Do these gold sales imply an agenda beyond IMF income diversification? Are the gold sales a means of transferring gold among its members, and if so, for what reason? And why are central banks interested in gold?
An IMF press release in December 2010 reported only that the balance of the first tranche was sold but it did not provide the buyer(s)[3]. We presume the lucky buyer(s) passed scrutiny not only from the IMF board but also the Euro zone sellers. We also presume that there were terms established that surrounded the transaction. As it does not release audited financial statements to the public, it is impossible to confirm whether the IMF actually owns and custodies the gold it claims to have and has sold or whether it acts as intermediary among its members. We may presume that IMF members (or some members) are aware of specific assets, their derivation and the terms of operations while others are not.
[1] https://www.imf.org/external/np/pp/eng/2011/031611.pdf
[2] https://www.ecb.int/press/pr/date/2009/html/pr090807.en.html
[3] https://www.imf.org/external/np/sec/pr/201Q/prlQ509.htm
And so the shadowy fashion in which the IMF operates raises suspicions among public market participants and must raise suspicions among members as to its priorities. Is the IMF a tool of other sovereigns? Are these transactions a means of equilibrating official gold holdings among economies? If so, why?
Special Drawing Rights
According to the IMF’s website, "the SDR is an international reserve asset created by the IMF in 1969 and serves as its unit of account. The currency value of the SDR is determined by summing the values in U.S. dollars of a basket of major currencies." The SDR basket includes US Dollars, Japanese Yen, British Sterling and Euros, and the proportion of each is changed once every five years. The IMF quoted a value of almost 230 billion SDRs as of March 25, 2011 and as of February 28, the SDR exchange rate was .6357. We presume the US dollar value of SDRs approximates $360 billion, give or take.
The United States holds 18.3% of all SDRs and enjoys 17.34% of IMF voting rights, far and away the largest share. China, the world’s second largest economy in terms of nominal GDP, holds 4.14% of all SDRS and controls 3.94% of voting rights. The table below lists the top 10 members of the IMF as of March 25, 2011:
All 187 current members of the IMF hold SDRs and have voting rights; however, there does not appear to be a rigid formula for determining proportional weightings for SDR holdings or voting rights. Obviously, China’s share does not seem to represent the comparative size of its economy or its economic momentum and there are other obvious quirks that seem to imply IMF rights are inequitable (e.g. Belgium holds 2.00% of outstanding SDRs while India holds 1.81% and Brazil holds 1.32%). So we ask again: is the IMF credible enough among its member economies to oversee SDRs as the super-sovereign global currency?
IMF = Inviting More Finance
Judging from its policies, the IMF remains biased towards accommodating certain economies over others. One does not have to look far to substantiate this claim. According to the first page of the overview in the 2010 IMF annual report:
"During the year, the IMF remained at the center of the international community’s efforts to return the global economy to a sustainable growth path. Efforts focused on providing policy advice to members to support recovery, reinforcing the global financial safety net, and fortifying the international financial system."
We are compelled here to point out a subtle but very major "tell" that likely gives pause to many IMF members to adopt SDRs as the world’s reserve currency. "Reinforcing the global safety net" and "fortifying the international financial system" are the first priorities of financiers, not the first priority of capital producers with growing domestic production. The IMF board seems to see sustainable global growth as being a discrete function of a healthy financial system. This is a very Western (and very contemporary) idea. A healthy financial system disproportionately benefits importers and weak capital producers and penalizes exporters and strong capital producers that are less in need of financing their commercial activity.
If the IMF were to argue against this accusation by asserting all nations would benefit by saving the current global financial system because the level of global trade would be maintained; then we would counter that although the exports of capital producers like China, India, Brazil and Russia (and even Germany) would be stabilized, deeply indebted economies like the US and much of the EU would benefit far more. Yes, global trade would decline and exporting capital producers would suffer without financial help, but the fate of indebted importers would be far worse because they would be forced to reconcile their over-leveraged balance sheets. Consistent with our criticisms of the Fed in Section 1, the IMF’s actions disproportionately benefit certain constituencies.
SDRs = Surplus Dollar Receptacles
Let us suppose that by some Herculean show of collective foresight and statesmanship, global leaders preemptively press the monetary reset button and proclaim to the world that as of, say, January 31, 2020, the world will use SDRs as its media of exchange. Should we celebrate?
No, the structural flaws that trouble the current monetary system would be magnified many times by adopting SDRs or something similar as a common currency. First, the SDR is a derivative on derivatives – a baseless currency that rests atop other baseless currencies. It would unlikely gain respect among the world’s wealth holders, commercial counterparties and savers. Second, consider that the fundamental problem being experienced with the Euro today would be exaggerated by a multiple of 11 times (187 IMF global countries divided by 17 Euro zone countries). There would be 187 different growth rates and fiscal policies and only one monetary policy to deal with
There is another practical issue to be considered. The only instance where SDRs would logically be called into action would be at a time of distress in the current system. At such a time why would other economies agree to give the US dollar an 18% weighting in SDRs? Further, why would the United States accept a meaningfully diminished weighting when it could simply create a new currency it could then control unilaterally? It would be easier to pass a camel through the eye of a needle than to find an equitable conversion rate for 10 existing major currencies used by 187 nations at a time of US dollar distress. (If you think the G20 is dysfunctional now…) The economic volatility, inequality and currency cheating (leveraging) that would occur are too great to fathom. It would seem the SDR regime would end almost as soon as it begins.
What About A Semi-Hard Currency?
There have been rumblings recently that the SDR should include gold as a portion of its underlying currency basket (as hinted by Robert Zoellick). Gold bugs love such talk but we would advise more tempered expectations. Gold cannot be included in the SDR basket for the same reason there cannot be a multiple reserve currency system. Gold would implicitly be the. sovereign currency within the SDR basket, which would then destroy the entire concept of the broader SDR as the reserve currency. It would be dysfunctional in the practical sense.
Let us assume tomorrow the world’s elders proclaimed SDRs were the global reserve currency and that its basket would be comprised of some weighting of Dollars, Renminbi, Euros, Yen, Sterling and gold. Say gold was given a 15% weighting in the basket. Foreign exchange traders would quickly arbitrage all inefficiencies so that SDRs and its six components would more or less trade in equilibrium to them. So far, so good, but this theory does not hold up when we go through practical iterations necessary when and if confidence in SDRs wanes.
As we wrote last November ("Towards Capitalus"), partially backing a currency with gold is functionally impossible. Say we have SDR 100 and we decide that we would prefer to hold gold. If SDRs are "15% backed" by gold, we would exchange our SDR 100 and receive SDR 15 of gold and SDR 85 of the other currencies. If we wanted more gold for our SDRs we would then have to get back in line and exchange our SDR 85 for SDR 12.75 of gold (SDR 85 x 15%) plus the other currencies. We could do this forever but never fully redeem our SDRs for gold, or for any one of its components for that matter. "Partial backing" is a concept lacking any foundation in logic or practicality. A precondition of any currency must be redeemability. Anything less than 100% redeemability is easily gamed.
When push comes to shove, the notion that the IMF is an objective intermediary and credible issuer of a widely adopted media of exchange seems irreparably compromised and the idea that the SDR can be broadly welcomed as the world’s reserve currency does not hold water. Functionally speaking, the IMF is an agent of Western policy makers and it would only be able to maintain credibility if the US and its friends continue to see it as useful, which is precisely why it cannot accommodate a wider world. Thus, we fail to see how SDRs could become the world’s reserve currency (regardless of how many Western Economic Nobel Laureates suggest it).
Geopolitical Rhetoric
So if we are right that the idea of the SDR as the global reserve currency is Dead on Arrival, then why is there continued discussion about them? Perhaps because leaders in centrally-planned economies are as adept as those in more open ones at geopolitical grandstanding?
Zhou Xiaochuan, Governor of the Peoples Bank of China (PBOC) has repeatedly called for an overhaul of the global system, suggesting just last month that the US dollar be replaced by SDRs and monitored by the IMF. This prompted US Treasury Secretary Timothy Geithner to respond that Washington is "quite open" to Chinese proposals for the gradual development of a global reserve currency run by the IMF. Gradual indeed. Time is the one element in which each side shares an interest. The SDR is a red herring, everyone knows it, yet it is in global policy makers’ current best interests to continue "hinting" about its future role.
How About a Basket of Hard Currencies?
The question among many that see pending doom in debt currencies and value in tangible assets is whether there might be a global currency backed by a basket of commodities. The thinking is that such a basket would back the new currency with assets having more transparent value. We do not think such a currency would work, conceptually or practically.
First, a medium of exchange cannot be an asset unto itself because there must be separation between the ability to save (in currency) and the process of investing (in assets). An honest wage demands good currency that may be saved without risk. Deploying excess purchasing power demands assets in which investors may take risk. For a fair and sustainable currency, there must be a conscious decision among all economic participants, including wage earners at every level, of whether to save or invest. A commodity-backed currency would not provide this.
When we apply the concept above to the real world we can easily see the second, more practical reason a currency cannot be backed by commodities. Commodities are generally depleting resources. Their values are also subject to preference and innovation. Changes from year to year in their above ground supplies are uneven, subject to changing demand, weather and innumerable other factors. Were the world to adopt a commodity- backed currency as its store of value, resource-rich territories would gain immediate wealth while others would lose it. Governments of resource-rich nations that would benefit most from such an arrangement, with the possible exception of Russia, do not have military strength sufficient to enforce compliance.
Further, incentives would surely lead to a race to extract commodities regardless of current demand or collateral damage to workers and the environment. This explicit incentive structure would in turn surely lead to provincial and possibly even global military conflict. Even narrow-minded politicians laboring under the tyranny of the short- term would see that the consequences of such an arrangement would make adopting it foolish. We think any motion for a commodity-based currency would also be dead-on-arrival.
Suspension of Disbelief
There certainly does not seem to be much conviction or foresight behind geopolitical rhetoric surrounding the current monetary system, whether it is suitable for the global economy and, if not, a monetary system that could replace it. Most have been tangential afterthoughts. Following the bursting of the credit bubble in 2008, French President Nicolas Sarkozy proposed a new global monetary order before deciding later to scale back his ambitions. A list of "indicators" to assess economic imbalances now seems best to Monsieur. Tres pragmatique.
We have come to understand that politicians executing the most critical policies are making it up as they go – that there really is no there, there. This is a frightening proposition for most people because it is most comfortable to be told tomorrow will greatly resemble today, even if that may not be true. We want to be lied to. We want someone else to fix the fundamental problems we know intuitively cannot go away without hardship. (To be frank, we’re not sure this is such a bad thing, all in. A big screen TV, food on the table and a modicum of dignity and what more can we ask for?)
Our leaders have a tough job. Our social contract with them is that we will let them boost their egos and exert their power in return for allowing us not to sweat the small stuff. We have come to see elections as sporting events. Even if the other team wins we know there will be another game or season. We watch as spectators, trying to recruit others to our team. Understanding policy is a secondary issue, for us and therefore for our elected officials. To generalize unfairly, being a politician in a republic today is no different from anytime in the past – it is a job given to overachieving egomaniacs with intellects that reflect their constituents’.
But politicians appoint policy makers who, with career government operatives with true expertise and genuine interest in the greater good, have no excuse. We presume these bright men and women suffer from one or more of the following conditions: 1) their personal neediness to be accepted trumps their ability to express what they may know to be true; 2) if it has not happened before then they are wired to believe it must not exist; 3) they ascended to their positions precisely because they suffer from one or both of the first two conditions.
As investors we are unconcerned with what politicians and policy makers say or intend to do. Our professional interest is not to try to like them or hope they succeed. It is whether the decisions they make will affect incentives, and if so, how? This leads us to two closing conclusions:
- politicians and policy makers following their own natural incentives to kick the can down the road will succeed up to the time when their own cans are kicked down the road, and
- independent postulations that seek to include the incentives of all concerned should be more accurate than the best intentions of bright, articulate, earnest men and women from around the world genuinely seeking to do good for their constituents (or on behalf of special-interests trying to do well).
No matter what the titles or job descriptions are, individuals trying to exert power by relying on their legal authority will find they have far less power than they (and most of us) believe because they must operate through large institutions with disparate legal and practical agendas. It would seem that true power to shift incentives and priorities could only be found in sensible ideas and the will of the majority to make them happen.
We think the will and power of politicians and policymakers are vastly inferior to natural market incentives, which is where the real power lies. The dollar will remain supreme until it and the entire global monetary system fails, and there is nothing Ben Bernanke or anyone else can do about it.
This is the end of part three. In the next part, a solution will be discussed along with responses to common criticisms.