This week, Premier Wen Jiabao’s angry reaction to EU’s unusually public pressure to elicit a modicum of Renminbi revaluation may have been surprising in its tone, if not really in its content. China’s Prime Minister used the occasion to lash out at Europe’s “protectionist” measures, thus inadvertently admitting to the link between the two aspects of international exchanges: trade imbalances and currency misalignments. And both are relevant to understand how gold prices respond to the increasingly dysfunctional shifts global foreign exchange markets.

Almost a decade has elapsed since the last internationally coordinated intervention in the currency markets. In 2000, the fledgling Euro’s teething problems were averted by a multilateral support effort. As on several other occasions over the preceding 15 years, the leading governments and central banks of US, Europe and Japan decided to cooperate to smooth out currency adjustments, reflecting a fairly harmonious image of international economic coordination. Notably, during the 15 years separating the $10bn intervention in September 1985 (an event commonly referred to as ‘Plaza Accord’) from the $2bn worth of Euro purchase in September 2000, gold had lost 17% of its value in nominal dollars. Within two quarters following the Euro support, gold hit a long-term low of $256/oz.

But in 2000, these three, periodically cooperative economic centers represented almost 75% of the global GDP. In five years from now, they will barely constitute 50% of the global GDP (calculated at PPP). In many ways, the year 2001 was a game changer, and not only because global perception of (terrorist) risk changed forever. China’s entry into WTO sent shockwaves through the global trade system with positive – mostly disinflationary – externalities for the developed economies. The Western nations and Japan could now afford maintaining relatively low interest rates. After a three year pause, Yen carry trades resumed. The dollar began its lengthy descent. The low interest rate environment also helped feed appetite for commodities, which, in response to increased investment demand in Asia, were awakening from a multi-decade slumber. The lower interest rates also put a floor under gold, where the investment demand was at that point of no relevance.

Ten years later, China is sitting on nearly 2,400,000,000,000 dollars worth of reserves. The pace of the accumulation accelerated as the country became the pivot of the global trade. Recent experiments in international swap arrangements and bond offerings notwithstanding, China’s capital account has remained closed and the dollars earned by importers had to be sterilized locally. Current account inflows generated a surplus of dollars because so much of the global trade is denominated in this currency. In fact, the role of the dollar as a form of payment in international trade (around 70%) outstrips its role as a reserve currency. Importantly, China’s entry into WTO coincided with the slow, yet gradual loss of dollar’s importance as a reserve currency (from 72% in 2001 to 65% now). The high correlation between current account surplus-driven accumulation of dollars by China and the fluctuation of euro-dollar exchange rate could indicate that some of the sterilized dollar inflows are sold in the market and exchanged into structurally overvalued currencies of Europe and Japan. Not surprisingly, the sudden, petrifying collapse in China’s trade in the fourth quarter of 2008 coincided with a bout of dollar appreciation. This remarkable jump in the dollar, commonly associated with increased risk aversion, was also reflected in the fall of the gold price, a “currency” with long-term negative 60% correlation to trade-weighted dollar.

Yet gold is largely a passive bystander in the current bras de fer between China and its trading partners. And although Beijing’s nervous verbal reaction to external pressure does not rule out a minor adjustment of Renminbi exchange rate as heralded by the non-deliverable Renminbi forward market, it does not bode well for further international economic cooperation. China has not been known for altruistic gestures similar to Japan’s voluntary export restrictions or the bubble-inducing strengthening of the Yen in the late 1980s. Gold remains a refuge among the increasingly feisty rhetoric, creeping moves towards capital account controls (Brazil, Taiwan, India) and competitive devaluations (Vietnam). Trade protectionism could yet become a natural (if politicized) response to this crumbling confidence in multilateral cooperation. Should this happen, the global growth will suffer and the interest rates will have to be kept at historic lows for much longer than initially expected. There is very little economic upside from such a scenario, but when interest rates are at basement levels, holding non-yielding assets – including gold – could be more attractive than usual.

But this is not necessarily a reason to cheer. Last time the global economy endured widespread devaluations and trade protectionism, the world fared a lot worse than simply suffering a recession. It was in the 1930s.

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Tags: currencies, gold, international cooperation, reserves, trade