Saturday, May 3, 2014

Gold Price Manipulation Masks Potential for Gold Demand Shock

Q  and A with James Rickards
Part 2 of 3
Part 1 here
Part 3 here

By Robert Stowe England

James G. Rickards is a lawyer, economist and investment banker with 35 years of experience in capital markets on Wall Street. His new book The Death of Money, published by the Penguin Group, is a New York Times bestseller. His first book, Currency Wars, published in 2011, and was also a Times bestseller. In his new book, he explores further the consequences of the weak dollar policy pursued by the Federal Reserve Bank, coupled with the huge run up in deficits and debt by the United States, and the failure of Congress and the Obama Administration to devise policies that would spur faster economic growth. Rickards is a portfolio manager at West Shore Group, LLC, Haddonfield, N.J., an investment fund set up in 2013, and an adviser on international economics and financial threats to the Department of Defense and the U.S. intelligence community. He gained first-hand experience on the front lines of a financial crisis as counsel for the hedge fund Long-Term Capital Management, when he was principal negotiator in the 1998 bailout of the fund by the Federal Reserve Bank of New York.

Q: Another thing I found intriguing in your book is the discussion of how gold prices have been manipulated to keep the price low to facilitate a stealth rebalancing of gold reserves from the west to the east, especially China. Obviously the central bankers know about this. How could they not?  The price manipulation has been done by selling numerous paper investments backed by same stash of gold in unallocated and leased sales. Could you explain how underlying stresses in the system could lead to a gold buying panic?  

Rickards: Well all these things are connected. They kind of work hand in glove. What’s the big thing that’s going on? The big thing that’s going on is that China needs to get gold. And Russia’s getting gold and other central banks are acquiring gold. But the 800 pound gorilla, if you will, is China rebalancing gold away from the west to China – a very well known story, very well documented. But the question is why and how. What’s going on here? Why is it being done? How is it being done? And that’s where the price manipulation comes in. Because if the price of gold took off, if there was sort of a buying panic, if you will, [it would create a] buying shock. I talked with the head commodities trader at one of the largest banks in the world. He told me that he’s looking for what he calls is a demand shock in China. The Chinese credit pyramid is clearly imploding, which I talk about in Chapter 4 of the book. [“China’s New Financial Warlords”]

When you look at the Chinese, they have a closed capital account so [the Chinese people] can’t buy stocks and bonds [outside of China]. The Shanghai stock market is a bit dismal. The real estate is the thing that’s going to collapse. And the banks pay them 25 basis points on savings. So you look around and say what the heck can I buy that will preserve wealth? And the answer is gold. And this is beginning already in certain ways but it will accelerate. So when this crash comes, it’s again a demand shock and that’s exactly right.

Now, China’s problem is they have the fastest growing economy in the world. Even with the problems and even with the slowdown it’s still the fastest growing economy in the world as a percent of global GDP. So, think about the right reserve mix of gold at the market price as a percentage of GDP, which is what I talk about in the book. It’s in that Chapter 9 [“Gold Redux”] and Chapter 11 [“Maelstrom”]. If you think about it, China is a moving target. No matter how much gold they buy, they have to keep buying more, first of all to reach the same ratio as the United States and they are not quite there yet – and then to maintain it because their economy is growing faster than the United States. That means they are going to buy more gold just to keep the ratio the same. If you combine that with a rising price, all of sudden the price goes to $2,000, $2,500, $3,000 et cetera, this gets to be out of reach.

I’ve got a moving target in the quantity. Now I’ve got a moving target in the price. Things are getting away from me. Things become more transparent as the buying power [decreases] so China might not ever got there. So dynamically they have to keep the lid on the price until the rebalancing is done. Then, at the point it doesn’t matter. So wherever the price goes, China’s on the bus. This is all about making sure China’s on the bus.

Q: What about all the paper gold? What role does that play?

Rickards: The leasing and the unallocated gold, and the paper gold and the gold futures and all that, those are the tools for price depression. By the way I don’t believe or I’ve certainly not seen any evidence that major banks are taking position risks to make this happen. They are just intermediaries. They are making spread. They are charging commissions. They are doing what the customer wants but the customer happens to be the BIS (Bank for International Settlements]. And it’s mentioned in the book and documented in the footnotes from BIS financial statements that they do transact with banks and central banks and commercial operations in gold leasing operations. So, if the customer happens to be the BIS, you are going to do what the customer wants.

So it’s coming from the central banks [who created the BIS and are its constituency]. So, that’s the price depression [of gold]. And, by the way there’s more and more statistical evidence coming out. And I’m sure you heard about the study at Stern School of Business at NYU [New York University]. [The authors of the draft research paper are Rosa Abrantes-Metz of New York University and Albert Metz, a managing director at Moody’s Investors Service.] I haven’t seen it because it’s not published yet, but I’ve seen some excerpts and synopsis that indicates that there’s powerful statistical evidence that gold is being manipulated.

I’ve also spoken to another guy,  a Ph.D. statistician for a major billion-dollar hedge fund and who is not a gold bug. He did the work and reached the same conclusion [the gold prices are being manipulated]. He did a 10-year price study of [changes in gold prices] on Comex [the Commodity Exchange, a division of the New York Mercantile Exchange] during trading hours versus after hours. When you’re talking about markets and statistics, those two accounts should be the same. But the answer was they weren’t anywhere near the same. The Comex [during working hours] actually performed dismally and the after hours account did multiples what actual gold did. There’s no explanation for that other than the manipulation of the Comex. And he agreed with me that is the right conclusion.

So the evidence is everywhere [of manipulation of gold prices] and it’s all designed to keep the price of gold low until China gets the gold they need to be on the bus and you kind of go from there. What has been surprising is that utter nonchalance of the U.S. government. Because I’ve gone down to senior officials in the Pentagon, the intelligence community and the Treasury and elsewhere and in Washington with a little bit of alarm saying, hey, do you know what the Chinese are doing? Do you see what’s going on here? The reaction is they are either completely non-plussed or they were unaware of it or they are aware of and they don’t see why it’s such a big deal.

But let me explain why it is a big deal – not for just geopolitical geostrategic reason I just mentioned, but in terms of the technical set up for where gold is going to go from here. If you think of stocks and flows in round numbers there are about 35,000 tonnes of official gold in the world and about 177,000 tonnes of total gold. And mining output is quite small. All the mining in the world increases the total stock by about a little over one percent a year. So, it’s a factor but it’s not a big factor.

So when 500 metric tonnes of gold moves from a GLD warehouse to China’s government vaults in Shanghai – which it did last year, by almost a straight line with a stop in Switzerland just to get re-refined. But, when gold does that, a lot of analysts look at that and say, well, so what? It was in a vault in London. Now it’s in a vault in Shanghai. They just turned it from a 400-ounce bar to a kilo bar. Whatever. It’s the same gold. It moved from one vault to another. Who cares? And that’s kind of where the national alarm comes from.

But here’s the difference. When gold moves from the GLD warehouse to the government vault in Shanghai, there is no change in the total supply, but there is a diminution in the floating supply. The floating supply is that portion of the total stock that’s available for trading. So, if I’m in GLD or I’m in a bullion bank and I’m a UBS, that gold is available for the kind of paper trading we just talked about. But if you put it in private storage, you put in a Chinese government vault, it’s not available for paper trading. It’s just gold being put away. Well, that’s exactly what’s going on.

If you think of the gold market as an inverted pyramid, and on the bottom there are a couple of bricks of gold. And then in the inverted pyramid on the top you have all the paper gold. So, it would be leasing, unallocated sales, Comex futures which totals up to 100 to 1 [paper claims against each a portion of physical gold]. That’s OK. That’s not unlike other derivatives markets. But if you start pulling the gold bricks, the gold out from the bottom you’re going to topple the pyramid. At least you’re going to force that pyramid to shrink.

And that’s what’s going on. Total gold supply is not changing. The floating supply is changing. And that means less gold to support the paper trading. And that means one of two things is going to happen. If you keep the paper trading just as big, you are going to destabilize it. If you shrink it, it’s going to increase the price of gold. Either way we’re in for some interesting times.

Q: Does Washington recognize that China is trying to assure its place in any future international monetary system by acquiring this gold? Do they at least recognize that?

Rickards: The only really top-level official I’m spoken to who does recognize that and thinks it’s fine is Min Zhu, deputy director at the IMF.  I’ve spoken with him and he says that just makes sense to him. By extension it makes sense to the IMF. Because he used a phrase – I was shocked to hear him say it – they make a distinction between what they call credit reserves and real reserves. That is exactly the right way to put it [meaning paper money is considered credit reserves, a claim on the central bank standing behind it]. But I was shocked to hear anyone say it; because who thinks that paper money is credit reserves? I do. But I’m not sure many other analysts do. Min Zhu said clearly China is, in effect – and these aren’t his exact worlds – is overweight paper and underweight gold. And so they ought to get some gold. So he could see it for what it was and he thought it made a lot of sense. Why does it matter – unless we’re somehow going rewrite rules of the game and gold plays a role? Because if we weren’t going to do that and gold didn’t play a role, then it wouldn’t matter. But Min Zhu clearly thinks it does.

Now, on the U.S. government side, people in the Pentagon are interested [in what’s happening with China’s accumulation of gold and what it might represent], but they feel constrained in what they can do because they don’t want to mess with Treasury. And that’s the other thing people don’t understand. The think of the U.S. government as a monolith with a single point of view and nothing could be further from the truth. The U.S. government is an octopus with eight legs and every leg is dancing to a different tune. And so, the Pentagon is kind of concerned but they feel they can’t really say anything because that’s the Treasury’s job. Over at the Treasury I’ve spoken to a number of people there. The risk people there, it doesn’t even factor in, that’s the kind of thing we were talking about earlier. Well, the Fed, it’s just not in their mental frame. [I am not sure where key current and former top Treasury officials stand,] people like Lael Brainard, [the former Under Secretary of the Treasury for International Affairs] or Secretary [Jack] Lew. [As for former Treasury] Secretary [Timothy] Geithner, well he is an IMF guy. His training, his experience, is all in the areas we’re talking about.  I haven’t spoken with him. I can’t read his mind, but I have some difficulty believing he doesn’t understand it and doesn’t somehow approve [China’s accumulation of significant gold reserves]. Certainly, the U.S. is in a position to stop it and we’re not stopping it. So, somehow, at least in principle he must think it’s OK.

Q: I guess the point of all of this is that if the dollar is in a crisis and some of the scenarios unfold that you talk about in Chapter 11 [“Maelstrom”], then China is going to have a say in the design of the next international monetary system that emerges and they don’t want the dollar as the world’s leading reserve currency.

Rickards: They will now [have a say]. I don’t think that was true four or five years ago. It’s definitely becoming true and I think that’s what’s going on. That’s exactly what’s going on. By the way, there was a secret meeting in Washington [Sunday, April 12] that was a dry run for Bretton Woods. [The town of Bretton Woods, New Hampshire, was the site for a July 1944 United Nations Monetary and Financial Conference of delegates from 44 nations. They met to jointly design and sign an agreement to establish a post-war international monetary system with the dollar, backed-by gold, as the centerpiece of the new order.] Friday and Saturday [April 10 and 11, 2014] was the IMF spring meeting. And these finance ministers and central bankers from all over the world were there. And when they get together they do all these things. They do G20 on the sideline. They do BRICS on the sidelines And there all these get-togethers.

Well, on Sunday [April 12, IMF Managing Director Christine] Lagarde hosted a meeting and the head of the Bank for International Settlement was there and the head of the Swiss National Bank was there. And of course senior IMF officials were there. And then, this is all in a press release [issued the next day by the IMF http://www.imf.org/external/np/sec/pr/2014/pr14170.htm that reports there were] a number of other prominent economists and officials were there. But, they didn’t disclose the names. But clearly a mix of senior national monetary officials and senior bankers and private economist and academics at a meeting behind closed doors to discuss the future of the international system.

The title of the seminar was “Monetary Policy in the New Normal.” What will the rules of the game be once we get into the post crisis period? Of course I’m the one saying we’re not going to get to the post-crisis period because we’ve got all the wrong policies. But, be that as it may, that’s what they were doing. So, it looks like it was a one-day practice round for a new Bretton Woods.



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