The Weight on Gold

On November 8th, while the world was busy focusing on the US presidential race, India’s Prime Minister Modi decreed that the two highest denomination bank notes circulating in his country, worth the equivalent of US $7 and US $15 each, would be demonetized within 50 days in an effort to fight corruption, tax evasion, counterfeiting, and terrorist financing.  86% of India’s currency, equivalent to US $219B, in an economy that uses cash for 98% of consumer transactions, was voided by his executive decree.  Those seeking to exchange, what up to then had been legal tender, must provide proof of tax payment on amounts of 250,000 rupees or greater (equivalent to US $3,650) or be subjected to 50% confiscation and legal prosecution.

The policy has caused economic paralysis in India, ignited a booming money-laundering industry, and resulted in currency shortages throughout the nation as the supply of new bank notes relative to old ones has been intentionally restricted to force out parts of the underground economy into the banking system.  The currency shortage is having a profoundly negative impact on this year’s wedding season, a period that traditionally accounts for more than half of India’s annual demand for gold.  Since November’s announcement, the country’s demand for the metal has collapsed by 70% and domestic gold prices have moved to a discount.

Meanwhile in China, the population is trying to stay one step ahead of its own government by steadily moving its money out of the country.  The Chinese government has reacted to these flows by increasing capital controls over the year.  One of those controls is a restriction on the amount of gold imports into the mainland.  Domestic gold premiums in China are at a 3 yr high, 2% over prevailing international prices. Together, China and India usually account for more than half of the total worldwide annual gold demand but neither country is a significant buyer at this time due to the weight of government intervention.

Europe has seen its share of capital controls over the past 8 years, in Iceland, Cyprus, and Greece.  Policies designed to trap money in a country and prevent depositors from accessing their own money.  3 years ago, every bank account in Cyprus was frozen; 47% of all funds over 100,000 EUR per account were confiscated by the government and used to bail-in the failing banking system without the consent of the depositor.  Italy is currently trying to avoid a repeat of the same episode and save it’s own under-capitalized system.  A EU directive that came into effect this year requires investors absorb the first losses before a failing bank is permitted to receive state aid.  The problem for Italy is that its small domestic depositors own $250 billion worth of soured Italian bank bonds and they would be the ones first in line to absorb the losses according to the new rule.

While we in the west have not experienced a cash ban like the one seen in India today, western academics and central banks are gradually moving towards that direction.  Ken Rogoff professor of economics at Harvard University and former chief economist at the IMF advocates phasing out all US banknotes above $10 in his new book “The Curse Of Cash”. The European Central Bank will discontinue production of its highest denomination 500 EUR notes. Singapore will stop printing its highest denomination 10,000 SGD bank note, leaving Switzerland with the highest value note in the world, the 1,000 CHF bank note.

In an environment restricting the use of bank notes, holding physical gold outside of the banking system may soon be the only liquid option.


by Eric Schreiber | EMS Capital

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