Separated at birth: Russian gold reserves and Switzerland's 5000 franc bill

I recently read (WSJ, 2/23/16, C2) that demand for the CHF 1000 note, currently Switzerland's largest denomination, has been increasing as Swiss central bank rates have turned negative. This raises the fear that local depositors will soon be charged for storing their money in banks. There are now CHF 45.2 bn (US$45.7 bn) in circulation, a 17% increase in the last twelve months.

Two gnome-like parliamentarians from Zug, near Zurich zeroed in on this and proposed that the SNB also Issue CHF 5000 notes, arguing that "an individual's ability to keep wealth stockpiled in cash, and out of the reach of banks, digital payment systems or the government, is a fundamental right." (WSJ's paraphrase)

Meanwhile back in the Kremlin, Bank of Russia President Elvira Nabuillina, a Tartar and worthy scion of the Golden Horde, whom Euromoney has named Central Banker of the Year in 2015, is buying all the gold she can get her hands on. (Well, almost all) In the fourth quarter, the Bank was reportedly the world's largest single buyer of gold, and in January alone it added another 700,000 ounces ($840 mn). Russia's concern is that by holding dollars in reserve it risks having them effectively cancelled by denial of access to the international transfer system, which is the only way these ones and zeroes in the their computer have any value. It is interesting that the Zug solons also expressed concern for digital payment systems in arguing for the CHF 5000 bill. (By the way, one of the ideas discussed last year by the US authorities was to close the payment system to Russia to force them to default on their external debts, which are mainly corporate, thus strewing chaos; international creditors did not like this idea, however.)

Money is a means of exchange and a store of value. In the dollar world, both of these functions are available at the pleasure, and only at the pleasure of the Fed and the US Treasury. That is why politics worry some and "unconventional policies" worry others.

What China yuans, China gets; my humble and beneficent exchange rate forecast

Mr. Kyle Bass of Hayman Capital Management has, according to the Wall Street Journal, a multibillion-dollar bet against the Chinese yuan (money), the renminbi. In an eleven-page letter to investors that was cited in the Journal, Bass reported that his fund had sold off the bulk of its other investments to concentrate on shorting Asian currencies. What caught my attention, and the attention of many other investors, was the following quote from Mr. Bass: “The view that China has years of reserves to burn through is misinformed. China’s back is completely up against the wall today. . .” Bass justified his view with the fact that China’s liquid reserves were “only” $2.2 trillion at the end of January compared to its total reserves of $3.23 trillion.

The use of the words “only $2.2 trillion” is interesting in light of the facts that the total reserves including gold of the UK are only $107 billion, of the US only $434 billion (almost all illiquid gold), of Germany only $193 billion, and so on. (This is from the latest World Bank data at http://data.worldbank.org/indicator/FI.RES.TOTL.CD .) China’s liquid reserves of “only” $2.2 trillion are huge in comparison. Of course, Bass can be excused for a bit of hyperbole since it reflects his investment position and thus may be of near term benefit to his investors.

Bass will probably make a lot of money on his short because his investment strategy is not at odds with the policy of the People’s Bank of China (PBOC). Between the Asia crisis of the 1990s, when the renminbi was devalued, and 2005, China tied the renminbi to the US dollar, much to its benefit. Then, until 2005, it followed a policy of gradually increasing the value of its currency relative to the dollar. This policy has had bad consequences for China because the US dollar has been strengthening, dragging the renminbi up with it to a very overvalued position. The negative consequences were aggravated by the large devaluations of the currencies of China’s main trading partners other than the US, which has left China with an even greater overvaluation than the US.

So in December 2015 China announced it would no longer track only the dollar but rather a trade-weighted basket. China can be expected to adjust gradually its currency valuation again this basket to bring the renminbi back in line with other currencies.

The BIS has created trade-weighted indices of many currencies based on each country’s individual trade relationships. The graph of the US dollar, the renminbi, the euro (based on Germany’s trade), and the yen shows that the renminbi has risen considerably against all them since 2010. (About twice as much against its basket as the US dollar against its.) (This is not to say whether or not the renminbi is overvalued in some absolute sense, but only relative to where it was five years ago.)

Were it to regress to the mean, the renminbi would depreciate about 30% on a trade-weighted basis. So here is a crude forecast: Both the US dollar and the renminbi will likely depreciate on a trade-weighted basis, China by 30% and the US by 15%, so China will depreciate 15% in dollar terms. The renminbi/dollar is now 6.53 yuan/dollar; in this scenario our guess is that that rate will be about 7.50 at some point. This is a big move, but I am guessing that this is in the ballpark of what the PBOC is targeting. They will, of course, proceed by baby-steps, like the mincing gait of the women with bound feet in the old imperial court. But proceed they will. In the words of Lao Tzu, “The journey of a thousand miles begins with a single step.”