The Death of Money

by James Rickards

  ■ The Shanghai Cooperation Organization

  Wall Street analysts are not alone in identifying commonalities in emerging market economies, as other regional groups have come to the fore in recent years. These linkages, based upon regional proximity or community of interest, are beginning to challenge the postwar arrangements of the leading Western economies. They include the Shanghai Cooperation Organization (SCO) and the Gulf Cooperation Council (GCC). Once again, these groupings share an inclination to reduce the U.S. dollar’s role as the leading reserve currency. Their agendas go beyond the free-trade areas and common markets found throughout the world and include strategic, military, natural resource, and international monetary initiatives. Depending on how well these groups pursue their agendas and overcome internal rivalries, they stand to play a significant role in any reformation or evolution of the international monetary system from its current configuration.

  The Shanghai Cooperation Organization was formed in June 2001 as the continuation of a predecessor organization, the Shanghai Five. The SCO members are the original Shanghai Five members—Russia, China, Kazakhstan, Kyrgyzstan, and Tajikistan—plus new member Uzbekistan. However, the SCO includes India, Iran, and Pakistan among its observer states and regularly invites the former Soviet republics and members of the Association of South-East Asian Nations (ASEAN) to their meetings.

  The SCO had its origins in security issues indigenous to its member states, including suppression of secessionist tendencies in the Caucasus, Tibet, and Taiwan. The members also had a shared interest in defeating Al Qaeda and other terrorist groups in Chechnya and western China. But the SCO quickly evolved into an Asian counterweight to NATO. Russia gained China’s support in its confrontation with NATO in eastern Europe, and China gained the support of the Russians in its confrontation with the United States in East Asia. In this context, the SCO’s rejection of a U.S. application for observer status in 2005 was unsurprising.

  In addition to conducting joint military exercises and cooperating in dozens of large-scale infrastructure projects related to energy, telecommunications, and water, the SCO has also launched initiatives in banking and multilateral finance, which are pertinent to the international monetary system’s future. The Prime Ministers Council of the SCO signed an agreement at its Moscow summit on October 26, 2005, creating the SCO Interbank Consortium, designed to facilitate economic cooperation among its central banks, joint infrastructure financing, and formation of specialized development lenders to its members.

  At the SCO Prime Ministers Summit in Astana, Kazakhstan, in October, 2008, Chinese premier Wen Jiabao and Russian prime minister Vladimir Putin endorsed Iran’s application to become a full member of the SCO. At that summit, Iranian vice president Parviz Davoudi remarked that “the Shanghai Cooperation Organisation is a good venue for designing a new banking system which is independent from international banking systems.” The SCO summit in June 2009 was conducted side by side with the BRICS summit in Yekaterinburg, Russia. Chinese president Hu Jintao and Russian president Dmitry Medvedev used the occasion of the SCO and BRICS summits to sign a joint Sino-Russian declaration calling for reform of the global financial system and international financial institutions and greater developing economy representation in the IMF.

  Newly elected Iranian president Hassan Rouhani had a kind of international coming-out party at the SCO summit in Kyrgyzstan’s capital, Bishkek, on September 13, 2013. At the summit, Iran received strong support from Russia, China, and the rest of the SCO for noninterference in Iran’s uranium-enrichment efforts.

  As geopolitics are increasingly played out in the realm of international economics rather than purely military-diplomatic spheres, the SCO’s evolution from a security alliance to a potential monetary zone should be expected. This has already happened covertly through Russian and Chinese banks’ role in facilitating Iranian hard-currency transactions, despite sanctions on Iranian money transfers imposed by the United States and the EU.

  The convergence of the BRICS’ and SCO’s agendas on international monetary matters should be most worrying for traditional Western elites. The drivers are Russia and China, the two most powerful members of both organizations. The BRICS and the SCO may have separate agendas in military and strategic affairs, but they are like-minded on the subjects of IMF voting rights, and they share an emerging antipathy to the dollar’s dominant role.

  ■ The Gulf

  Another strategic and geographically contiguous alliance, the Gulf Cooperation Council (GCC), genuinely has the potential to form a single-currency area that would diminish the U.S. dollar’s role.

  The GCC was founded on May 25, 1981, when Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates signed a pact in Riyadh, Saudi Arabia. There have been no additions to this original group, although Morocco and Jordan are currently under consideration for membership.

  The GCC does not have links to Iraq or Iran, despite the fact that both of those nations border the Persian Gulf along with all the GCC members. The reasons are obvious. Iraq ruined its GCC relations with the invasion of member Kuwait in 1990. Iran is not a candidate for membership because it is ethnically and religiously distinct from the Arab states with which it shares the Persian Gulf and because it is Saudi Arabia’s bitter enemy. But the possible additions of Jordan and Morocco make sense. The existing GCC members are all Arab monarchies. Jordan is an Arab monarchy, and Morocco is an Arabic-speaking monarchy and Arab League member. While the GCC pursues relatively liberal economic and trade policies, it is still a de facto club for the remaining kings of Arabia.

  The GCC has pursued a path not unlike the EU in that it successfully launched a common market in 2008 and is now moving toward a single currency. The GCC’s significance for the international monetary system lies more in its single-currency initiative than in other facets of strategic and economic cooperation, which are of mostly regional rather than international importance. As was the case with the euro, implementation of a single currency in the GCC will take a decade or more to complete. Key issues that need to be resolved include convergence criteria for members’ fiscal and monetary policies and the powers of the new central bank. Most vexing in the short run are the inevitable politics that swirl around issues such as the physical location of the central bank’s headquarters and the membership and governance of its board.

  The GCC members are already in a quasi-currency union because their individual currencies are pegged to the U.S. dollar and therefore to one another using fixed exchange rates. However, each GCC member retains an independent central bank. This arrangement resembles the European Rate Mechanism (ERM), which lasted from 1979 to 1999 and was a predecessor to the euro, although the GCC has had more success than the ERM, which witnessed numerous breaks with designated exchange-rate parities by its members.

  The conversion from the current GCC arrangement to a single currency would appear to be a straightforward process. But recent stresses in the Eurozone have given pause to the GCC members and impeded the monetary integration process. The most prominent impediment is running a single monetary policy with divergent fiscal policies. This problem was one of the principal contributors to the European sovereign debt crisis. Countries such as Greece and Spain engaged in nonsustainable fiscal policies financed with debt issued in a strong currency, the euro, to investors who inferred incorrectly that Euro-denominated sovereign debt had the implicit support of all the Eurozone members. The core problem for any proposed currency union (such as the GCC) is how to enforce fiscal discipline among members when there is a single central bank and a single monetary policy. The need is to prevent a recurrence of Greek-style free-riding on the stronger members’ fiscal discipline.

  The GCC has already witnessed this free-riding problem in the 2009 Dubai World collapse. Dubai is part of the United Arab Emirates along with six other principalities, most prominently Abu Dhabi. The emirates share a single currency, the dirh
am, issued by a central bank located in Abu Dhabi.

  Dubai World, an investment holding company, was created in 2006 by Dubai’s ruler, Sheikh Mohammed bin Rashid Al Maktoum. Although Dubai World insisted its debts were not government guaranteed, its debt appeared to investors as tantamount to a UAE member’s sovereign debt. Between 2006 and 2009, Dubai World borrowed approximately $60 billion to finance infrastructure projects, including office buildings, apartments, and transportation systems, many of which remain empty or underused to this day.

  On November 27, 2009, Dubai World unexpectedly announced it was requesting a “standstill” among creditors and called for debt-maturity extensions across the board. This default, rather than any specific event in Europe, was the catalyst for the sovereign debt crisis that quickly engulfed Europe and lasted from 2010 to 2012. Eventually Abu Dhabi and the UAE central bank intervened to bail out Dubai World in much the same manner as the EU and the European Central Bank intervened to bail out Greece, Portugal, Ireland, and Spain. These lessons from the UAE and Europe are not lost on Saudi Arabia, Qatar, and the other wealthy GCC members. An enforceable GCC fiscal pact with limits on deficit spending is likely to be required before the single-currency project moves forward.

  The other major issue looming over the GCC single currency is the question of an initial par value relative to the U.S. dollar. Too low a value would be inflationary, while too high a value would prove deflationary. This is the same dilemma that confronted the U.K. when it returned to the gold standard in 1925 after suspending it in 1914 to fight the First World War. The U.K. blundered then by setting sterling’s value against gold too high, which caused extreme deflation and contributed to the Great Depression.

  When a country or group of countries peg to the U.S. dollar, those countries effectively outsource their monetary policy to the Federal Reserve. If the Fed is engaged in monetary ease and the pegging country is running a trade surplus or experiencing capital inflows, the pegging country has to print its own money to purchase the incoming dollars in order to maintain the peg. In effect, the Fed’s easy-money policy is exported through the exchange-rate mechanism, which forces the pegging country to engage in its own easy-money policy. If the pegging country economy is stronger than the U.S. economy, this easy-money policy will produce inflation, as has occurred in China and the GCC since 2008. The simplest solution is to abandon the peg and allow the local currency to appreciate against the dollar. Such reductions in the dollar’s value are the Fed’s goal under its cheap-dollar policy.

  An alternative solution is to maintain a single currency with a value fixed to a currency other than the dollar. Monetary experts have suggested several candidates for an alternative peg. One obvious candidate is the IMF’s special drawing right, the SDR. The SDR itself is valued relative to a currency basket that includes the dollar but with significant weight given to the euro, sterling, and the yen. Importantly, the IMF retains the ability to change the SDR basket composition periodically, adding new currencies to better reflect trade patterns, changes in comparative advantage, and the relative economic performance of the countries whose currencies are included in the basket. An SDR peg would align the future GCC currency more closely with the economies of its trading partners and decrease the Fed’s impact on GCC monetary policy.

  GCC member economies are highly dependent on oil exports for revenue and growth. Volatility in the dollar price of oil translates into volatility in economic performance when the GCC currency is pegged to the dollar. A logical extension, then, of the SDR basket approach would be to include the dollar price of oil in the basket. By doing so, the exchange value of the GCC currency would move in tandem with the dollar price of oil. If the Fed pursued a cheap-dollar policy and the dollar price of oil increased due to the resulting inflation, the GCC currency would appreciate automatically, mitigating inflation in the GCC. This way the GCC currency can be both pegged and free of the Fed’s cheap-dollar policy.

  A more intriguing solution to the peg issue—and one with large implications for the future of the international monetary system—is more radical: to price oil and natural gas exports in the GCC currency itself, thereby allowing the GCC currency to float relative to other currencies. This could truly mark the beginning of the dollar’s demise as the benchmark currency for oil prices, and it would create immediate global demand for the GCC currency.

  This trend toward the abandonment of the dollar as the benchmark for pricing oil was dramatically accelerated in late 2013 as a result of White House efforts to legitimize Iran as the regional hegemon of the Middle East. Implicitly since 1945 and explicitly since 1974, the United States has guaranteed Saudi Arabia’s security in exchange for Saudi support for the dollar as the sole medium of exchange for energy exports and for Saudi promises to purchase weapons and infrastructure from the United States. This nearly seventy-year-long relationship was thrown into grave doubt in late 2013 by President Obama’s modus vivendi with Iran and implicit tolerance of Iranian nuclear ambitions.

  The U.S.-Iranian rapprochement occurred after Saudi-U.S. relations had already been badly strained by President Obama’s abandonment of Saudi ally Hosni Mubarak in Egypt in 2011 during the Arab Spring uprisings, and by the president’s failure to support Saudi rebel allies in the Syrian Civil War. The Saudis then spent billions of dollars to help restore military rule in Egypt and to crush the Egyptian Muslim Brotherhood favored by President Obama. More recently the Saudis publicly displayed their displeasure with the United States and moved decisively to secure weapons from Russia, nuclear technology from Pakistan, and security assistance from Israel. The resulting Saudi-Russian-Egyptian alliance removes another prop from under the dollar and creates a community of interest between Saudi Arabia and Russia, which had already announced its preference for an international monetary system free from dollar hegemony.

  For a GCC currency to become a true global reserve currency as opposed to a trade currency, further deepening of GCC financial markets and infrastructure would be needed. However, Saudi Arabia’s reevaluation of its security relations with the United States combined with the euro’s expansion and the efforts of the BRICS and the SCO to acquire gold and escape dollar dominance could presage a quite rapid diminution in the dollar’s international reserve-currency role.

  ■ The Island Twins

  Two nations stand apart from this survey of monetary multilateralism and rising discontent with the international monetary system: the U.K. and Japan. The U.K. is a member of NATO and the EU, while Japan is an important and long-standing treaty ally of the United States.

  Neither nation has joined in a monetary union or spoken out vociferously against U.S. dominance in international monetary institutions. Both Japan and the U.K. maintain their own currencies and their own central banks; they host the respective financial centers of Tokyo and London. The Japanese yen and the U.K. pound sterling are both officially recognized as reserve currencies by the IMF, and both Japan and the U.K. have the large, robust bond markets needed to support that designation.

  Still, Japan and the U.K. are weak in gold reserves, with only about 25 percent of the gold needed to equal the United States or Russia in a gold-to-GDP ratio; Japan and the U.K. have an even lower gold-to-GDP ratio than China, which is itself short of gold. The United States, the Eurozone, and Russia all have sufficient gold to sustain confidence in their currencies in the event of a crisis. In contrast, Japan and the U.K. represent the purest cases of reliance on fiat money. Both countries are out on a limb, with printing presses, insufficient gold, no monetary allies, and no Plan B.

  Japan and the U.K. are part of a global monetary experiment orchestrated by the U.S. Federal Reserve and articulated by former Fed chairman Ben Bernanke in two speeches, one given in Tokyo on October 14, 2012, and one given in London on March 25, 2013. In his 2012 Tokyo speech, Bernanke stated that the United States would continue its loose monetary policy through quantitative easing for the fores
eeable future. Trading partners therefore had two choices. They could peg their currencies to the dollar, which would cause inflation—exactly what the GCC was experiencing. Or, according to Bernanke, those trading partners could allow their currencies to appreciate—the desired outcome under his cheap-dollar policy—in which case their exports would suffer. For trading partners that complained that this was a Hobson’s choice between inflation and reduced exports, Bernanke explained that if the Fed did not ease, the result would be even worse for them: a collapsing U.S. economy that would hurt world demand as well as world trade and sink developed and emerging markets into a global depression.

  Despite Bernanke’s rationale, his cheap-dollar policy had the potential to ignite beggar-thy-neighbor rounds of currency devaluations—a currency war that could lead to a trade war, as happened in the 1930s. Bernanke addressed this concern in his 2013 London speech. One problem with the 1930s devaluations, he said, was that they were sequential rather than contemporaneous. Each country that devalued in the 1930s might have gained growth and export market share, but it came at the expense of the countries that had not devalued. The desired growth from devaluation was suboptimal because it came with high costs. Bernanke’s solution was for simultaneous rather than sequential ease by the United States, Japan, the U.K., and the ECB. In theory, this would produce stimulus in the major economies without imposing temporary costs on trading partners:

  Today most advanced industrial economies remain . . . in the grip of slow recoveries from the Great Recession. With inflation generally contained, central banks in these countries are providing accommodative monetary policies to support growth. Do these policies constitute competitive devaluations? To the contrary, because monetary policy is accommodative in the great majority of advanced industrial economies, one would not expect large and persistent changes in . . . exchange rates among these countries. The benefits of monetary accommodation in the advanced economies are not created in any significant way by changes in exchange rates; they come instead from the support for domestic aggregate demand in each country or region. Moreover, because stronger growth in each economy confers beneficial spillovers to trading partners, these policies are not “beggar-thy-neighbor” but rather are positive-sum, “enrich-thy-neighbor” actions.