2012-12-02

More thoughts on dematerialized gold, or paper gold

Last week I wrote in Dematerialized gold in India—it's about the rupee, not gold
Many gold bugs are pointing to this story as evidence of a lack of physical gold. The reality is much simpler: India is trying to defend its currency and cut imports. The aim is to redirect speculative and financial demand into a paper market, with the goal of reducing imports. There's not really a conspiracy here, at least not the one the gold bugs are looking for. If there's a "real" reason behind the move, it is to protect the value of the rupee.
The gold bugs are transferring their belief about paper gold onto the Indian government's attempts to spread the gold demand into financial products. One of the constant arguments made by gold bugs is that many people who buy paper gold think they are getting physical.

I do not believe this is the case. There are derivative products for everything, including single-stock futures, for those who wish to engage in speculation. In the grand scheme of things we could argue about the growth of simulacra, but at the micro level, there are people who simply wish to speculate and who prefer the virtual nature of the transaction.

That said, the move to paper gold does reflect a great truth in the gold bugs' argument. Without the existence of gold futures, gold ETFs and gold derivatives, physical gold prices would be higher. India wouldn't care about gold imports if the rupee were stronger; it cares because gold is becoming a drag on the rupee and could result in a self-reinforcing cycle that wrecks the currency. Gold bugs will say that will happen to all fiat paper eventually (and I agree), but the reality is that if India had a domestic supply of gold, the Indian government would not be pushing paper gold today.

The issue with gold is that it is money. Some countries lack food, others energy, others consumer goods. If their citizens run a large trade deficit, this will put pressure on the currency, pushing its exchange value lower (in the long-term). In the case of gold, however, it is also a signal of the health of a currency.

In the end, India's problem is not really gold. It is about weakness in the political-economy. They are dealing with a symptom, rather than a cause. The greatest proof of this is China. Why has Chinese gold demand surpassed that of Indians? China is India's mirror case: the government promotes physical ownership of gold. Physical gold products are on sale at state-owned banks, alongside brochures for precious metals accounts.

China has a politically dangerous trade imbalance and the concurrent problem of massive fiat currency reserves piling up on the central bank's balance sheet. Gold importation is a perfect solution: it reverses the trade balance and slows the flow of foreign currency. It also has the effect of being non-competitive with Chinese firms: instead of importing consumer goods, Chinese are saving. They may use those savings to consumer foreign goods in the future, or not. Buying gold today is the ultimate currency "sterilization" for the Chinese central bank. Instead of the PBOC issuing renminbi to buy U.S. dollars from Chinese importers, Chinese are using the dollars to import gold. They achieve all of their policy goals without the cost of rapidly rising forex reserves.

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