Returning to gold standard a disaster to humble even Great Depression – snr. economist
The global economy has lurched from boom to bust and back again in the last few years, but beneath the turmoil the balance is shifting. With an emerging Chinese economic giant, will be dollar as strong as it is now? Could the yuan become a viable alternative? Or is it perhaps time for the financial world to return to some old habits? We ask these questions to the former director of the London School of Economics, Sir Howard Davis, on Sophie&Co today.
Sophie Shevarnadze:Sir Howard Davis, leading economist, former director of the London School of Economics, welcome to the show, it’s great to have you with us. Now, direct exchanges between the Yuan and the Pound started earlier this year. Why is the UK so eager to take on the Yuan?
Sir Howard Davis: The businesses in London and the British government and the authorities, the Bank of England, etc., believe that the internationalization of the renminbi, Yuan, is going to be one of the big financial developments of the next decade. They are very keen to position London as a city in which that activity takes place more there than elsewhere in Europe. So, they have been very keen to try to organize a regulatory framework and other things to attract Yuan business to the city of London. It is quite important strategic priority for our government.
SS: But it’s true that the Yuan is increasingly being used for global transactions. Will we see a time when the Yuan is used for as many deals as, let’s say, dollar, or the euro?
HD: The story of the last few years is one of some disappointment in relation to the euro. When the euro was introduced, is was widely thought that it would become a more used reserve currency than the previous Deutschmark, Franc, Lira, etc., had been, and that other central banks and sovereign wealth funds would have a larger proportion of euros on their balance sheets as their national reserves. What we’ve seen is, only a very modest increase in the proportion of euros held in reserves, in little more, actually, than if you simply add it up the portion that was held in the legacy currencies. So, we haven’t moved very far towards a multipolar currency world. Many people think it would be better – and I would share this view – if the dollar was somewhat less dominant in the global financial system. So, the next candidate to be a rival pole to the dollar is the Yuan. The Chinese would seem to want that now – they’ve been rather hesitant about it for a period. So, I think the betting is that the Yuan will probably become a more significant reserve currency over the next few years, and the euro still hasn’t really fully established itself on the global markets.
SS: Okay. So, you are saying that we haven’t yet got a world with multipolar currencies, but we still see countries trading more and more in their national currencies, going away from dollar, why is that?
HD: Well, I think that there have been attempts to trade more in national currencies, but the problem is that you need – if you are trading extensively in a national currency – there needs to be a market in interest rate swaps, in foreign exchange futures and forwards and the capital markets need to be open, because otherwise you may find yourself with a currency where you can’t convert it easily into the other currencies that you need to pay for suppliers or pay your workforce, etc. And, really, the dollar has had a particular advantage, because it has been extremely liquid. You can always sell dollars. The dollar may go up and down, of course, but you can always sell dollars and you can buy a whole range of derivative transactions around dollars. What has so far not yet happened is the depth and richness of instruments surrounding any other currency. So, you can trade in the renminbi, you can trade, of course, in rouble, but it’s difficult to offset your risk, to hedge your risks, because the instruments simply are not available in the quantity and the depth of market that you need.
SS: Let’s talk a little bit about politics. Can China’s neutral position in the confrontation between the West and Russia spark more demand for its currency? Will using it be seen as a way to sidestep potential political risks, for example?
HD: I don’t think that Chinese see this as a geopolitical game rather than an economic game. I think that they believe that given their weight in global economy, that it makes sense for their currency to be traded more internationally, because that will assist them in hedging their own risks, and assist them in developing their trade. I, when I’ve been in Beijing – and I was there a couple of weeks ago with the Chinese regulators – I don’t’ think that this should be seen as a kind of political, strategic move, you know, that they are going to use the renminbi to enforce their will around the world. I don’t think that’s the way they see it. I think they see it as an economic issue rather than a political and strategic one.
SS: Okay, but I’m wondering, why hasn’t the Yuan already become freely convertible currency? What will change if that happens?
HD: I think the reason why they have not yet taken the step of making it fully convertible is because they have been very anxious about what the level of that currency would be if they allowed free movement of capital. I think they fear that at a number of times in the last few years, the Yuan would have attracted a lot of hot money, and would have been bid up significantly. I think they believe that the Yuan would, particularly in the years immediately after financial crisis, have risen quite high – and that would have had a big impact on their exports. China, of course, although it is transition, is still a large manufacturing exporter. Manufacturing companies have been extremely influential in policy-making in China, arguing with the authorities in favor of a competitive rate for the Yuan, which improves the competiveness of their exports. That is starting to change, and the mood is begging to alter in Beijing, and they are saying: “Well, do we really want to have a whole economic policy biased towards manufacturing exports, when in fact our economy is shifting, more domestic consumption, more services, more financial services, and they are held back by the lack of convertibility.” So, at the moment, they haven’t made that decision, but I expect them to move towards convertibility of the renminbi in the next couple of years.
SS: Is that the same reason why the Yuan’s exchange rate with the dollar is said by the officials instead of the market? Why can’t China have foreign currency exchange? Is it a same reason, basically?
HD: Yes, they have attempted to manage their exchange rate. Now, some people in Washington say this makes China a foreign currency manipulator, which is rather loaded word to use. The Chinese say: “Look, we don’t want a very volatile exchange rate”. Now, they have, in fact, allowed the renminbi to rise gently over the last few years. In fact, it has been tailing off a little bit recently as the economy has softened, they have responded to market pressures to some degree; but they haven’t yet been prepared to take their hands off the currency and allow it to find its own level in market. That’s a big step for them to take, and they so far haven’t been prepared to take it.
SS: The Chinese economy is strong and its flexible – could a fully convertible Yuan become the world’s reserve currency in case of another crisis and another drastic fall of the dollar? Does China even want that to happen?
C)I don’t think that Chinese have in their minds to replace the dollar as the Number One reserve currency. I do think they believe that the Americans have had a great advantage for a long time in having the reserve currency which has been so dominant. This is often referred to as the “U.S. exorbitant privilege.” The United States is able, always, to borrow in dollars, to fund its deficit, it’s sometimes said “the dollar is the U.S. currency and other people’s problem”. The Americans, by having this dominant position, mean that their borrowings are cheaper, they can borrow only in their own currency, they don’t have to worry about foreign exchange risk, and I think that Chinese would like to get into position which is roughly in parallel with the U.S. – not to replace the U.S. dollar, I don’t think that they have that in mind, and indeed, there are some disadvantages in having a world’s reserve currency: you can’t so easily, actually, control your domestic financial conditions. But, I do think that they believe that they shouldn’t in future be so reliant on U.S. dollar investments, and they should be able to see the yuan take an appropriate place in the world’s financial system; appropriate in terms of the share of Chinese economy in the global world economy. At the moment, the China is bigger in the relation to the world’s economy than the renminbi is in relation to the world’s financial system.
SS: Now, China is the largest holder of the U.S. debts. Doesn’t this mean – I mean, they still believe in the strength, in the American economy, despite its low level of growth?
HD: I think, bluntly, that’s the reason the Chinese hold so many U.S. treasury bills and treasury bonds. There are, really, two reasons. One, because they didn’t want to see the dollar weaken against the renminbi which would have made their exports more costly in the U.S., which, after all, is their single biggest market. So, by offsetting their trade surpluses, by buying U.S. dollars as investments, they help to prop up the dollar, which further helps their exports. So, that’s one reason. The second reason is a rather simple one: if you are generating surpluses on the scale the China is, there aren’t that many choices as to where you can invest your money. They have been diversifying their investments through a new sovereign wealth fund, which has been taking direct participations and buying more equities and buying property in other countries. But, if you’ve got 3 or 4 trillion dollars to invest, which is what their Central Bank reserves are – there are not that many place where you can put that amount of money, because, obviously, some countries are relatively closed, or there is political risk – and so, really, they were obliged to hold U.S. dollar assets.
SS: Now, could China decide to dump the American debt it holds? And, if it does, what will happen to the U.S.?
HD: I don’t think it’s very easy for China to dump its U.S. debt, because what else it would do with the money? It has been trying to diversify its investments, and that’s been involving activities like investing heavily in natural resources in Africa, the sovereign wealth fund has been buying a lot of stakes in other investments. I mean, the Chinese sovereign wealth fund owns quite a proportion of Heathrow airport in London, for example. It has been diversifying into other assets, but it’s not easy, frankly, to find a way of investing 3-4 trillion dollars in non-dollar assets. There just aren’t those assets available. So, I think that they would like further to diversify, but I don’t think that they will be engaged in a wholesale sell-off of the U.S. assets.
SS: We’re hearing all kinds of forecasts about China’s growth and how it will soon become the world’s leading economy. What are your expectations?
HD: Whether it will be the world’s leading economy in the next few years depends a little bit on your calculations. Of course, there are different ways of measuring relative size of economies – on purchasing power parity. Some of those measures would say that China’s economy might become the largest in the world in the next 3 or 4 years, but I think, expressed in the internationally-traded currency, they won’t become the largest economy for a little while, but it wouldn’t be at all surprising if they did – I mean, after all, their population is four times the U.S. population, and they are industrious, hard-working, intelligent people. So, there’s no reason why they should have GDP per head of less than a quarter of the U.S. That’s the tipping point, if you like. Once their GDP per head is quarter of the U.S., then they become the world’s largest economy. So, I would expect that to happen, but probably by about 2030.
SS: Here’s a little statistic – a million millionaires for a country of over 1.4 billion people – is that a lot?
HD: it’s in itself, I don’t think it’s particularly meaningful as statistic. I think what is more significant in China is that income inequality generally is on the rise, and for an ex-communist country that’s a rather strange phenomenon, if you like. You wonder whether that would create significant social strains at some point, because the rewards of Chinese growth are being distributed rather unevenly. Quite a lot of very wealthy people at the top, some of them have got there by corrupt means rather than honest means, and, also, a well-off population in the coastal cities, but still, an awful lot of people being completely left behind by this growth. I think that could be a significant political factor in the future. If China doesn’t find a way of spreading benefits of growth more widely across the economy, then there’s a risk of political instability in due course.
SS: What about us? If the globe’s economic weight is moving to Asia, should we be handling our savings in Yuan rather that dollars?
HD: Yes, at least some of them. At the moment, of course, perhaps, not in roubles given what has been happening to the rouble temporarily, but… yeah, I think that anyone would do well to consider some diversification. Of course it’s not been that easy to do that, and, in fact, if you had been investing in Chinese stock market, you would not have done terribly well – I mean, Shanghai stock market, in spite of China’s very rapid growth, has gone absolutely nowhere in the last decade, because there has been so many restrictions on who can invest in it. Certainly, if I were advising anybody to think about their long-term investments for their pension, which is closer for me than for you, Sophie, I would say…, you should be looking to have part of your assets invested in the fast-growing areas of the world. So far, from the UK it has been easier to do that trough Hong Kong or through Singapore than directly into China, but certainly, a proportion of your assets should really go to some of kind of emerging markets fund.
SS: Now, the Chinese government is also buying up a lot of gold, but we don’t really know how much. Why is it buying so much, first of all, and why so much secrecy around it?
HD: The Chinese are keen to diversify risk. As I said when you asked me about the deployment of their assets and whether they would sell their dollar assets – they have been thinking about diversification. Now, for a while, their reserves were heavily dominated by short-term U.S. treasuries, on which they were earning very-very little indeed. I think that they have felt “well, that is not necessarily the only thing we can invest in”, but there are constraints, because of the sheer size of the money that they have at their disposal, so they have decided that a proportion of their assets should be held in gold reserves. Most Central Banks do that. We in the UK do rather less of it; the French traditionally have a lot of their reserves in gold, and continue to do so. So, I don’t think that this should be seen as more than a diversification move; a sensible, prudent diversification move. But of course, gold recently has been a reasonably good asset to hold. The one problem with gold of course is that it costs you slightly to hold it, because you have to pay somebody to keep it safe for you, and you don’t get an interest rate – but, of course, in the recent period, you don’t have much of an interest rate on treasury bills or treasury bonds either, so the opportunity cost of holding gold has been lower, and therefore people, on the whole, held more of it, and the price has gone up.
SS: We’re going to talk about holding gold and getting your gold back in just a second, but before we get to that, I want to talk a bit of a speculation here. There are rumors that China wants to raise gold prices: while the country doesn’t have the currency exchange, like we say, it does have a Shanghai gold exchange – could it be setting gold price for gold in the future.
HD: They are looking very hard at developing that commodity exchanges in China. I was talking to Chinese security regulator about that, just two weeks ago in Beijing. They are working with the Chicago currency exchanges and commodity exchanges, and I think you will see a gold exchange developing in China on a significant scale in the future. But that’s partly because Chinese like to hold gold, individuals, as well as authorities – they hold a lot more gold as a share of their assets - as Chinese individuals – than British people typically would. So it makes sense for them to try to internalize that trading and to have it in China. But I honestly don’t think that that is the same thing as trying to manipulate the gold price for some particular strategic purpose – I don’t detect that that is what they are trying to do.
SS: Let’s talk a bit about holding your gold and getting it back. Germany and the Netherlands are bringing home the gold they got stored in foreign vaults – is this trend? What does it signal?
HD: It may be… I don’t honestly think that it’s hugely significant. When I was deputy governor of the bank of England, I was responsible for the Bank of England’s gold holdings and every now and again I used to go down to the basement and have a look at it – and typically, there was trading of gold and sometimes the Bundesbank would sell gold and the Bank of Italia would buy it, and you simply went down into the basement and took one bar of gold and changed the label on it. It didn’t really move. There’s not much actual mobility of gold, because it’s costly to move, it’s difficult from a security point of view. So, most gold actually sits in the vaults of certain Central Banks which specialize in this kind of thing, like the Bank of England, and it does not, on the whole, move. Now, it may be that some people think that it would be prudent to have some of their gold back in their homes – I can’t personally get terribly excited about it, actually, I doubt it is really significant strategic move, I don’t think that the Bundesbank is really worried about some kind of coup-d’état in the UK, so I think this is perhaps just a matter of sort of prudent housekeeping.
SS: Okay, but what if you do want to get your gold back? You’re entitled to it, right, and you can’t get it back – because when Germany asked for its gold back from the U.S., it didn’t receive this 680 tonnes it was owed. America just didn’t have the total to give back. So, does the gold that exists on paper even exist in the reality?
HD: It certainly does if you have it at the Bank of England, because I have seen it. It is clearly there, and it is clearly described and the ownership is clearly established. It does trade, but it trades without moving. There are accounts in the Bank of England which would be debited by someone selling and credited by someone buying. So, there is this physical gold and I think that people who think that this is all made up – I fear that’s a conspiracy theory, which I couldn’t support.
SS: And we have last question and very little time left till the end of the program: the gold standard tied money to a resource and answered the questions about its value. But now, currencies are basically not backed by anything of value – when we buy something, are we just using paper?
HD: No, they are backed by something of value. They are backed by the value added by the economy which trades them. You don’t need to be backed by physical asset. I would on the whole rather be backed by industrious people in Germany or Singapore or China than just by some piece of silver or gold metal. So, they are backed, they are backed by real economic activity and real value added by people producing goods that other people want to sell. That’s the reality of a currency backing. I think, the idea of returning to a gold standard is an absolutely terrible idea, because you would create a massive contraction of credit in the world economy. If you had to go back and say “we’re going to back every currency with gold”, this would radically reduce the amount of credit and would credit a world-wide depression which would make the 1920s look like a holiday. So, I think that the people who argue for retreating to a gold standard really do not know what they are talking about. I think it would be absolutely catastrophic from the world’s point of view. Of course, what you can say is, maybe, at times, given the paper money basis of our economy, maybe at times we allow credit to expand too rapidly, and essentially the story of the last financial crisis was that. We allowed credit to grow too quickly – but there are ways of dealing with that, through interest rates, through bank capital ratios etc., which can constrain credit growth and you don’t need the really-really freezing shower of a gold standard to do that, which would destroy much of the world’s economy.
SS: Okay. Thank you a lot for this interesting insight. We were talking to Sir Howard Davis, leading economist, former deputy governor of the Bank of England, ex-director of the London School of Economics, talking about the growing role of Yuan in the world, and also what could going back to gold standard mean for world’s economy. That’s it for this edition of Sophie&Co, I will see you next time.