Sep 102015

Would you lend money to someone in another country who told you they were doing it because interest rates in your currency were cheaper than their currency and not to worry about them paying you back if the size of the loan amount in their currency increased due any weakening in their exchange rate as they would set aside the money they saved in interest to cover that risk? I hope you answered NO!

Such foreign currency denominated loans are attractive to borrowers facing high interest rates who are willing to overlook the exchange rate risk (or be sold them by a bank underplaying that risk). Polish Swiss franc mortgages, which blew up when Switzerland dropped its currency peg, are the latest in a long line of such exploitation of unsophisticated or desperate borrowers. My Australian readers of mature age are no doubt familiar with the 1980s foreign currency loan scandal that “involved significant financial losses and personal suffering for many borrowers”.

So who is the latest desperate borrower to ask investors to lend them their foreign currency at cheap interest rates? Well if you only read mainstream media who just report press releases without any analysis, you’d have missed that it was the Government of India (GoI) asking average Indians to lend them their gold. Although in this case I think it is the lender than is going to lose, not the borrower.

Lest you think I am exaggerating, here it is clearly stated in this official press release on the Indian Sovereign Gold Bonds Scheme:

“The amount received from the bonds will be used by GoI in lieu of government borrowing and the notional interest saved on this amount would be credited in an account “Gold Reserve Fund” which will … take care of the risk of increase in gold price that will be borne by the government.”

What could go wrong with that? Certainly the Government doesn’t think there is much risk as the borrowing “will not be hedged and all risks associated with gold price and currency will be borne by GoI”. But don’t worry, “the Gold Reserve Fund will be continuously monitored for sustainability”, with sustainability being lovely bureaucratic speak for “are we losing money”.

The Government only seems concerned about the risks to the lenders, noting that “investors will need to be aware of the volatility in gold prices” and that the bond tenor “could be for a minimum of 5 to 7 years, so that it would protect investors from medium term volatility in gold prices” and giving investors the option to roll over the bond if the gold price falls. But don’t those same risks equally apply to person on the other side of the loan?

Why is the Government so confident that the Rupee price of gold will fall? Possibly they think that by “reducing the demand for physical gold by shifting a part of the estimated 300 tons of physical bars and coins purchased every year for Investment into gold bonds” the global gold market will be weakened?

I should note that this Sovereign Gold “Bond” is another example of government doublespeak as one does not initially lend gold but instead pays Rupees and is given a loan denominated in grams of gold, receiving Rupees back at the end (based on gold prices at maturity). There is a Gold Monetization scheme where you can deposit actual gold but there is little difference to the Gold “Bond” as the medium and long-term deposits are redeemable “only in cash, in equivalent rupees of the weight of the deposited gold at the prices prevailing at the time of redemption”.

I will at least give the Government credit for being explicit about what they are doing as they say “the deposited gold will be utilised in the following ways …

  • Auctioning
  • Replenishment of RBIs Gold Reserves
  • Coins
  • Lending to jewellers”

The first and the third point are basically the Government selling the gold and taking a (vaguely Gold Reserve Fund hedged) short position against the depositor. The last one is the only legitimate and minimal risk use of gold (but as I explained here, it has limited use in throttling Indian gold imports). The second is the Government effectively buying the depositor’s gold on the cheap, as long as interest savings outweigh Rupee price changes.

The key question of course is what will happen to Rupee gold prices. Yes, Rupee prices have been stable the past few years, but note the general downward trend in the INR/USD rate.


What would happen if the Gold Reserve Fund became “unsustainable”? Would the Government just give up all its interest saving gains and incur the cost of hedging its position, or decide that it might need to roll over the bond to protect itself “from medium term volatility in gold prices”. What me worry indeed.

May 192015

The “war on cash” story is getting a good run on the usual websites (try here, here and here for a sample) and no surprise to see some hype involved like this from Martin Armstrong (debunked by Bullion Baron here). Generally commentators are seeing this as positive for gold, but I’m not so sure it is good for gold in the long run.

The idea is that to get around the “zero bound problem” – where central banks cannot reduce interests rates too far below zero because people will withdraw cash to avoid negative interest rates (see JP Koning for more on this issue) – central banks will ban or punitively tax cash. To avoid this, people will buy gold instead of holding bank deposits, and/or use gold transactionally, which will increase demand for gold and its price.

I think that is a viable scenario with potential to go mass market depending on how aggressive the government gets. However, consider this selection of quotes on the “cash problem”, which are fairly representative of mainstream economic thinking:

  • Frances Coppola: “it is only those who seek to evade monetary policy who find convertibility suspended”
  • Jim Leaviss: “the authorities will be able to encourage us to spend more when the economy slows or spend less when it is overheating”
  • Peter Bofinger: “it would make it easier for the central bank to enforce its monetary policy”
  • Kenneth Rogoff: “given the persistent and perhaps recurring problem of the zero bound”

Note the use of “evade” and “enforce” (lets ignore for the moment that they are talking about policy, not law) – the attitude is that a central bank cannot be restricted in its need to “fight a large deflationary shock”, it must be able to reduce interest rates as far as possible until people do what it wants. There is no consideration of whether the existing policy is working or is counterproductive, more of the same medicine must be allowed to be administered.

This attitude means that if people find another way of evading the “policy” to force spending over savings, we can be sure that the thinkers will call for that method to be banned as well. They are already there, as Rogoff notes in his paper:

“It is unclear how easily these activities [use of anonymous cash] could substitute into other transactions media, but presumably this could be made difficult by restricting other potential anonymous transactions vehicles.”

It doesn’t get any clearer than that. I like the euphemistic “anonymous transaction vehicles” – gold and silver surely are the only globally recognised and easily used substitutes for physical cash (sorry, bitcoin is not easily used or understood by the mass market).

In the past I haven’t see gold confiscation as a likely scenario, but that was pre negative interest rates. If central banks continue down this path and can get governments to agree that they must be allowed to force people to spend, then it does change the risk assessment of confiscation.

However, I do not want to get all hype-ish myself. Policy and politics wise it is not a universally held view that cash should be banned, and we are speculating that people will just take a cash ban without any resistance. To be fair, Kenneth Rogoff did raise a number of costs to banning cash, which would cause policy makers to move cautiously. Also consider these thoughts from Carl-Ludwig Thiele from the German Bundesbank:

“we believe that there should be a mix of different payment instruments and government agencies do not have the right to tell the citizens how they should pay”

Then again, Germany is repatriating a fair bit of gold from the US, even if slowly.