Currency implication of gold’s bull run

By the OFX team | 14 May 2024 | 5 minute read

A record-setting run for the gold price is prompting questions about how the international currency system works.

There’s gold in them thar vaults.

Mark Twain, known for a plethora of quotes, notably penned the famous line, “There’s gold in them thar hills” in his 1892 novel The American Claimant, referencing the euphoria of the 1849 California gold rush when 300,000 hopefuls sought fortune in the West.

The discovery of vast amounts of gold in California and elsewhere led to the creation of the gold standard, where major currencies tied their value to physical holdings of gold.

Even though the gold standard was abandoned by the US in 1971, and eventually most other countries, many central banks – including the US Federal Reserve – continue to hold gold as an asset, seeing it as an important stabilising hedge against volatility.

Gold found its way into the headlines last month when Zimbabwe – no stranger to economic instability – declared it would create a new gold-backed currency called ZiG, designed to reduce the hyperinflation that at one point saw a loaf of bread cost more than 500 million Zimbabwe dollars. (So far Zimbabweans haven’t been convinced to switch to the ZiG. According to reports, black market US dollars continue to remain the favoured unit of exchange)¹.

The new currency’s launch came amid a record-setting run for the precious metal, which had investors scrambling to find out who was buying.

Gold in a time of uncertainty

Gold’s lustre as an investment baffles many. It generates no income, unlike stocks or bonds, and its price is just as likely to fluctuate as any other commodity. However, it is considered a safe haven for both consumers and countries in times of high inflation and low interest rates.

Why the gold price has hit a record in April is the subject of some conjecture.

Some say that investors, including many small ones, are looking for a safe haven asset in the event that the significant debt accumulated by major governments causes another financial crisis (Bitcoin’s price rise is also attributed to this thesis)².

Retail investors in China have also been buying up gold as they see weakness in the Chinese economy and the struggling real estate sector.

What has observers sitting up straight, is the amount of gold the Chinese central bank has been buying.

According to a Citibank investment note, the People’s Bank of China (PBOC) bought more than 311 tonnes of gold in the last few years. As a country, China’s imports of gold were up 34% year on year and at 566 tonnes in the first quarter of 2024 alone, accounted for 60% of the global consumption. This is on top of the gold that is produced domestically, which is the largest in the world³.

Globalisation and its discontents: de-dollarization edition

China is one of the core members of the BRICS coalition – others include Brazil, Russia, India and South Africa – whose aim is to reduce the global power of the US dollar.

BRICS Coalition: Brazil, Russia, India, China and South Africa have joined together to challenge the political and economic power of North America and Western Europe.

Because of its stability and liquidity, the US dollar is the primary unit for foreign exchange – a reserve currency – with dozens of countries worldwide pegging their currencies to it⁴. As mentioned in the Zimbabwe example, it is also an alternative currency amid domestic instability.

The reserve currency status of the US dollar keeps it strong and means that any policy action that affects the USD, like a rise in US interest rates, has consequences far beyond its borders.

BRICS countries would like that to change and have proposed that the “R5” – the renminbi, ruble, rupee, real, and rand – should become the standard to underpin global trade instead. That worries US officials, who can leverage the dollar’s status to impose financial sanctions on terrorist networks, rogue states and criminal networks⁵.

Gold watchers have suggested that China, having seen the 16,000 sanctions placed on Russia⁶, have accelerated buying up gold on the path to de-dollarization. By holding gold, the speculation goes, that will ensure stability amid the turbulence that would accompany a shift away from the US dollar as reserve currency⁷.

What does it mean for currencies?

It may not happen anytime soon but if a BRICS currency were to gain ascendancy it would put enormous downward pressure on the US dollar. BRICS countries account for 31% of global GDP based on purchasing power parity and the addition of six new members, Argentina, Ethiopia, Egypt, Iran, Saudi Arabia, and the United Arab Emirates, will further strengthen the economic power of the bloc.

Central banks in the developing world could dump their dollar reserves as they switch to the new currency⁸. That would have enormous implications for the US, which relies on its reserve status currency to run large federal deficits at relatively low interest rates. A consequence would be hyperinflation in the US as foreign goods become more expensive, forcing the Federal Reserve to ratchet up interest rates which would drastically slow down the US economy⁹.

In short, it would upend the financial system as we know it.

In the short term, the greenback’s strength is a challenge in Asia

In the here and now, where the US dollar’s sway is near absolute, Asian countries are desperately looking for ways to keep their currencies stable in the face of US dollar strength.

The governments of South Korea and Japan issued a statement last month that they had “serious concerns” over their currencies testing multi-decade lows against the greenback.

The yuan, subject to PBOC market intervention, has approached its government-imposed lower limit.

Some analysts speculate that the PBOC may devalue the yuan to stimulate China’s economy, potentially igniting a currency war in the region as other Asian exporters seek to maintain competitiveness¹⁰.

Perhaps all this uncertainty is a good reason to stockpile gold – for players big and small.

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