Fenil's Library

Or, like the greenback, the yellow metal, too, would have lost much of its value by now

Devendra Nevgi

We often walk into a restaurant to have lunch or dinner and pay with the local currency, since we are confident that it would be accepted by the restaurant as a medium of exchange.

But what if the restaurant refuses to accept the currency notes offered by us? What if the restaurant manager says he wants something real, something that would not lose value?

It would give us the shock of our lives, used as we are to exchanging currency notes for goods and services.

Could this happen for real?

The global financial crisis that we are witnessing is unprecedented and we are not out of the woods as yet. Many of the developed economies are on the brink of recession, led by the US. Central banks are pumping in tonnes of money, to help stimulate the beleaguered economies and bail out bankrupt institutions. The US leads the pack in terms of monetary injections to help the economy to stand firm on the face of troubles that include plunging home prices, severe job losses, rising default risks, growing deficits, massive portfolio losses, a deflation scare etc.

The US Federal Reserve would probably continue pumping in the so-called “liquidity” into the financial system by merely printing more and more dollars, which are not backed by real assets such as gold as much as by ‘faith in the government’. Technically, there is no limit to this printing, i.e. no supply restriction on paper currencies. This leads to what economists call a “debasement of the currency.”

Such actions of central banks may lead to a lack of confidence in the paper currency.

Zimbabwe offers a classic example of currency debasement. The Zimbabwe dollar is available in denominations of as high as one billion dollars, and one has to carry currency notes in large sacks to buy even grocery.

In such a situation, a proxy currency such as gold has intrinsic value, since its supply is limited and it is not in the control of any central bank. Gold has a unique characteristic of ‘store of value’ vis-à-vis paper currencies, which tend to lose value over a period of time due to inflation (loss of purchasing power) caused by oversupply.

We tried to compare the currency in circulation issued and the underlying gold held by concerned central banks in developed countries such as the US and the UK. We divided the gold reserves (in tonnes) held by central banks with the currency in circulation (in billion dollars) of the respective country. The result was not surprising. Gold held by such central banks relative to the paper currencies issued by them has fallen dramatically over the last few decades, especially in the US.

In 1973, gold held by the US central bank was 8,584 tonnes and the currency in circulation was $61 billion. Dividing the gold held by the currency in circulation, we get a ratio of 141.2 for that year, i.e. 141.2 tonnes of gold was held per 1 billion of currency in circulation.

In 2007, the US central bank held 8,133 tonnes of gold and the money in circulation was $759 billion. The ratio has now become 10.7, i.e. only 10.7 tonnes of gold held per billion dollars in circulation.

If the US were to get back to the 1973 ratio of gold held per billion dollars in circulation, it would have to increase its gold reserves to a whopping 1,07,153 tonnes from the the current 8,133 tonnes, an increase of more than 13 times in potential demand.

The falling trend, as seen in the graph, indicates that more and more paper currency in circulation is backed by less and less gold held by central banks. The backing comes only in the form of faith in the government, which is fast dwindling due to the financial crisis and the massive bailouts, especially in the US.

With the financial crisis not over yet and recession looming large, central banks would continue to inject more and more money into the financial system. Thus, the debasement of currencies will continue, making gold more and more attractive as a hedge against the dwindling purchasing power and the loss of faith and confidence in paper currencies.

Thank God, the US doesn’t have a printing press for gold. The yellow metal, which has historically had an inverse relationship with the US dollar, may be the only saviour of wealth over the long term. That sure makes a case for buying gold. And to those uncomfortable with the idea of buying and storing physical gold, and easier, safer and more cost-effective way to increase exposure is through buying a gold exchange traded fund listed on the National Stock Exchange.

The writer is CEO & CIO, Quantum Asset Management Co Pvt Ltd and can be reached at devendra@quantumamc.com. Views are personal.