Gold The Store of Value

Gold The Store of Value 

The rebuilding of central bank gold reserves since the financial crisis in 2008 marks the latest phase in a two centuries long cycle of changing policies on the yellow metal, which fall into seven distinct periods or ages.

The Seven Ages of Gold have each lasted an average of about 30 years. And the current, Rebuilding period is the longest spell of gold accruals since 1950-65, when central banks and Treasuries acquired a net total of more than 7,000 tonnes during the postwar economic recovery.

Since 2008 central banks have added more than 2,800 tonnes or 9.4 per cent to reserves, equal to annual net purchases of 350 tonnes. This brings purchases in line with the 100-year average up to 1970  reflecting the metal’s renewed attractiveness as a haven asset in an environment of low or negative interest rates.

One reason for gold’s renaissance as a monetary asset has been developing countries hesitancy about relying on reserve holdings in dollars. China, in particular, seems to be using gold to counter the dollar’s weight. Last year China broke a six-year silence to reveal holdings of 1,658 tonnes as of June 2015 against the previously reported figure of 1,054 tonnes. As of this August it had 1,823 tonnes.

Beijing moved to a market valuation of gold worth $70.5bn, although this makes up only 2.3 per cent of total Chinese international reserves. China’s total official gold holdings are judged to be sizeably larger, as metal from local mine production is thought to be held in a domestic account separate from the international gold holdings.

While developing countries have been building reserves, developed countries have been conserving stocks. European central banks signed a five year agreement in 1999, renewed in 2014, pledging a restrictive policy on gold sales until 2019. One reason is that many banks inside the euro area see their gold reserves as a hedge against potential monetary losses from imbalances and tensions affecting the single currency.

The world’s biggest official gold holder is the US, with 8,134 tonnes followed by Germany with 3,378 tonnes, the IMF with 2,814 tonnes, Italy with 2,452 tonnes and France with 2,436 tonnes.

The Seven Ages of Gold started with the Pre Gold Standard before German unification in 1871, which triggered the system in which central banks gold trading at a fixed price in effect regulated the world economy.

Broad international adoption of the gold standard ushered in the second period, from 1871 to 1914, when central banks became guardians of a fixed-price system. That was followed by the War Economy age from 1914-45, spanning the reintroduction of the gold standard, the inter-war depression and the gold standard’s 1930s demise.

Then there was the 1945-73 period the Bretton Woods era of rising gold reserves. During the Demonetization, or fifth period between 1973 and 1998, gold’s role was in limbo after it was officially phased out of the monetary system. In the Sales period that followed from 1998 to 2008, central banks were unloading bullion holdings.

Central bank gold transactions have often been disassociated from the gold price. The current period since 2008 has been one of sharp price swings in the $1,000 to $1,600 per ounce range. But central bank purchases appear to have been a factor behind the post 2015 price recovery.

Based on long-term figures for gold holdings and world production, gold stocks in the hands of official institutions (central banks, treasuries and bodies such as the International Monetary Fund) appear to have steadied at around 17.4 per cent of total above ground stocks. This is down from 23 per cent in 2000 and 40 per cent in 1970, but marks stabilization over the past decade following an earlier period in which central banks were net sellers.

Total gold holdings are now back to early 1950s levels. But there has been a shift in gold distribution from the US Treasury to Europe and, latterly, developing nations. Illustrating this shift, the US accounts for just 25 per cent of total official holdings, compared with 19 per cent in 1900, 33 per cent in 1920, 76 per cent in 1940, 44 per cent in 1960 and 23 per cent in 1980. In future as economic clout moves from advanced economies, developing nations are likely to build up further gold reserves. In the further development of the Ages of Gold, the metal’s monetary renaissance that started in 2008 may have further to run.

With India having one of the largest consumption of gold in terms of investments and store of value, with the present demonetization exercise with the right aim but a complete failure and no cash in circulation the gold prices would take a hit in India in the near and mid term along with the very strong dollar. But then in the long term the age old rational of gold being a store of value where the value may dip but cannot become zero by any move by the local government a lot of investors have recognized gold as a great store of value and slowly move a part of the wealth as a pure story of value.

-Farzan Ghadially

Will the Chinese currency "Renminbi" take on the world ?

Fresh capital controls have cast doubt over the push to increase the global use of its currency. But what does that mean for Chinese policymakers?

Back in October 2015, China’s central bank issued one-year bills in London’s offshore Renminbi debt market. The move was viewed as cementing London’s status as the center of Renminbi business outside greater China.

The International Monetary Fund would later add the Renminbi to its reserve-currency club, the Special Drawing Right basket, this being a milestone in the integration of the Chinese economy into the global financial system.

But even before the IMF’s decision took effect in October, there were signs that SDR recognition might turn out to be the high water mark of the Renminbi’s internationalization rather than the dawn of a new, more diversified global monetary system.

Across a range of indicators, the extent of its global push has slowed and in many cases slipped into reverse.

The share of China’s foreign trade settled in its own currency has shrunk from 26 per cent to 16 per cent over the past year while Renminbi deposits in Hong Kong the currency’s largest offshore center are down 30 per cent from a 2014 peak of Rmb 1trillion. Foreign ownership of Chinese domestic financial assets peaked at Rmb4.6tn in May 2015; it now stands at just Rmb3.3tn. In terms of turnover on global foreign exchange markets, the Renminbi is only the world’s eighth most-traded currency squeezed between the Swiss Franc and Swedish Krona barely changed from ninth position in 2013.

What appeared to be structural drivers supporting greater international use of the Chinese currency now appear more like opportunism and speculation.

Between the Renminbi’s de pegging from the US dollar in July 2005 and its all time high of 6.04 versus the dollar in January 2014, the Renminbi gained 37 per cent as it followed a nearly uninterrupted path of appreciation.

An expectation that this would continue drew hundreds of billions of dollars in foreign capital into China, often exploiting loopholes in regulations designed to discourage speculative inflows, as investors hoped to profit from risk free currency gains.

But the tide has turned. The Renminbi hit an eight year low versus the dollar late last month and is on track for its worst one-year fall on record. Investors are offloading Renminbi assets and exploiting those same loopholes to move funds in the opposite direction.

After years of living in a hugely prosperous economy and behind a relatively closed capital account, domestic households and corporates have a strong desire to diversify assets offshore, in my opinion.  This has further swelled on the back of intensifying concerns about a domestic asset bubble.

The interest rate raised by the US Federal Reserve and the election of Donald Trump has recently pushed the dollar to its strongest level in 13 years. For China, that adds to the capital outflow pressure stemming from concerns over its slowing economy and spiraling debt. Interest rate cuts by the People’s Bank of China last year further reduced the appeal of Renminbi assets for yield hungry investors.

Against this backdrop, China’s recent moves to tighten approvals for foreign acquisitions by Chinese companies, as well as other transactions that require selling Renminbi for foreign currency, cast further doubt on China’s commitment to currency internationalization in my opinion.

There is a fundamental conflict between preserving stability and allowing the freedom and flexibility required of a global currency, I think now that the cost is becoming clear, Chinese policymakers may be realizing they are not willing to do what it takes to maintain a global currency.

Capital controls certainly set back the cause of Renminbi internationalization but they may well be the appropriate step for both China and the world, given the outflow pressure China faces.

Renminbi offered a way to express dissatisfaction with the US dollar dominated monetary system, as laid bare by the 2008 financial crisis, while signaling an eagerness to do business with China’s large, fast growing economy.

For China’s reform minded central bank, however, Renminbi internationalization and the prestige value of SDR membership in particular offered something else: a Trojan horse that could be used to persuade Communist party leaders in Beijing and financial elites to accept reforms that were, in reality, more important for China’s domestic financial system than for the Renminbi’s international status.

Since 2010, when the internationalization drive began, many of those reforms have been adopted: deregulation of bank deposit and lending rates, a deposit insurance system and a more flexible exchange rate.

The totem of currency internationalization also served as justification for China’s moves over the past half decade to open up its domestic financial markets to foreign investment, a process known as capital account liberalization that has been crucial to the global push of the Renminbi. If foreign investors are to hold large quantities of China’s currency, they must have access to a deep and diverse pool of Renminbi assets and the peace of mind of knowing that they are free to sell those assets and convert proceeds back into their home currency as needed, which I think is one of the most important points for most investors.

Most notable among those measures was the decision to eliminate quotas for foreign institutions to invest in China’s $8tn interbank bond market. Stock connects programs through Hong Kong now allow global investors to buy Chinese domestic shares in both Shanghai and Shenzhen. Until last few weeks, regulators had also steadily loosened approval requirements for foreign direct investment, in to and out of the country.

But those reforms occurred at a time when capital inflows and outflows were roughly balanced, which meant that liberalization did not create strong pressure on the exchange rate. Now the situation is very different.

I think the government’s assumption has been that they could open up the capital account to foreigners and suddenly money would flow in that certainly hasn’t been the case. Why would institutional investors want to hold Renminbi assets when there is this embedded exchange rate depreciation trend, on top of concerns about growth and financial stability?

Beijing faces a stark choice. Either row back on freeing up capital flows as it has already begun to do this year or relinquish control of the exchange rate and accepts a hefty devaluation in my opinion.

Trying to manage the Renminbi’s exchange rate while also allowing for freer cross border flow of capital is clearly hitting its limits, in my opinion. Many economists believe that a floating exchange rate is the optimal response. But the PBOC remains active in the foreign exchange market as buyer and seller. Over the past 18 months, this has mostly meant selling dollars from foreign exchange reserves to counteract the depreciation pressure weighing on the Renminbi.

The result has been a hybrid policy that traders call a dirty float: the exchange rate is responsive to market forces but PBOC intervention limits the extent of its movements.

This strategy has been expensive, contributing to a decline in reserves from $4tn in June 2014 to $3.1tn at the end of November. Defenders of the PBOC believe such aggressive action to curb depreciation has been worth the price because it prevented panic selling by global investors. Critics counter that costly forex intervention has merely delayed an inevitable exchange-rate adjustment.

For years, the IMF, US Treasury and other outside experts have urged China to embrace a floating exchange rate. In theory, such a step should eliminate the need to tighten capital controls or to spend precious foreign reserves on propping up the exchange rate. Instead, the currency would weaken until inflows and outflows balance.

 Some Chinese economists fear any movement of the exchange rate and that is where the problem in the overall approach lies.  They fear that if it falls 2 per cent, then it will fall 10 per cent and if it falls 10 per cent, then it will fall 100 per cent.

The fear is that an uncontrolled depreciation of the Renminbi would spark turmoil in the broader economy and, in an extreme scenario, even lead to political instability.

Many international economists feel that the Renminbi would remain relatively stable, even under a floating currency regime. China’s consistently large trade surplus, low foreign-currency debt, and the substantial capital controls that were in place even before the recent tightening. And I think If you take the whole balance of payments picture into consideration, the Renminbi will stabilize quite easily. Even if it overshoots initially on the downside, it would rebound in my opinion.

But many believe the PBOC is right to be prudent in limiting the outright float of the exchange rate.

In principal, floating the currency makes sense. It’s logical. But you’ve got to remember, we’re now in very unusual circumstances. With the dollar strengthening and all the uncertainty over US policy and a possible trade war, do they really want to let the currency go? It’s unrealistic.

China is likely to continue its hybrid approach. The State Administration of Foreign Exchange, the regulator said it would continue to encourage outbound investment deals that support the country’s efforts to transform its economy, advance up the global value chain and promote New Silk Road initiative to invest in infrastructure links with central Asia, the Middle East and Europe. But the agency said it would apply tighter scrutiny to acquisitions of real estate, hotels, Hollywood studios and sport teams.

That will probably mean fewer food additive tycoons buying second tier UK football clubs. It also suggests a crackdown on fake trade invoices, Hong Kong insurance purchases and gambling losses in Macau all channels used to spirit money out of China. But its state champion companies will still be allowed to acquire advanced technology and consumer brands that appeal to the country’s rising middle class.

They are trying to squeeze out all the low quality or suspicious or fraudulent outbound investment. But they have also made it clear they support genuine high-quality investment, in my opinion.

As early as 2012, PBOC governor clarified that loosening cross border capital flows and foreign exchange conversion did not mean abandoning all control.

Many economists argue that the fate of Renminbi internationalization ultimately depends on far reaching economic reforms rather than short-term responses to rising capital outflows. These include measures to tackle rising debt, restructure state owned zombie enterprises that are draining resources from more productive parts of the economy and recapitalize a banking sector where non-performing loans are widely believed to be a larger problem than official data indicate.

 Practical effect of tighter capital controls may be less significant than the message that the tightening sends. Instead, a lot of economist feels the authorities need to focus on reforms to restore the confidence of both domestic and foreign investors.

When you re impose capital controls after having rolled them back, it can sometimes have a perverse effect. It creates concern about how the authorities perceive the state of the economy and the risks inherent in it.

What they need to do is something much harder actually to get started on the broader reform agenda and show that they are serious about it. Right now the sense is that there is very little happening on other reforms.

Chinese policymakers may be realizing they are not willing to do what it takes to maintain a global currency they are trying to squeeze out all the low quality or suspicious or fraudulent outbound investment.

_ Farzan Ghadially

Electronic Traded Funds are the Future of the Market

Electronic Traded Funds are the future of the Market

Will Mutual funds be able to survive in Developed markets like US.

With their low costs and tax-friendly trading, ETFs have transformed US markets and are taking over other developed markets with this the popularity of this is increasing in the emerging markets

Stock markets have a new purpose. Once devoted to trading stocks and setting their prices, they are now the venue for buying and selling something other than shares: exchange traded funds.

ETFs are taking over markets. Shares in Apple, the world’s biggest and most heavily traded company, turn over more than $3bn each day. But that is dwarfed by the biggest ETF, State Street’s SPDR S&P 500, which trades more than $14bn each day. Five of the world’s seven most heavily traded equity securities are ETF's.

From a modest beginning, ETF's impact on stock trading has now reached mammoth proportions, and ETF's now account for nearly one-half of all trading in US stocks and may other developed markets have a large percentage of trade via these funds. It is not just in trading that ETF's dominate. Their assets under management were negligible 20 years ago, but now exceed $3 trillion. They hog flows of new money and are revolutionizing the business of long term saving, once led by traditional mutual fund groups. Over the past 12 months, $130.7bn has flowed out of all US mutual funds, while $240bn has flowed into US ETF's.

In my opinion they are the structure that people will use to get exposure to securities in future, and mutual funds will be banished to the dustbin, like typewriters have been replaced by computers. It’s just a better technology and so it will come to replace funds over the next 20 years.

Both mutual funds and ETF's are collections of securities packaged into a fund. Almost all ETF's track an index, like passive index tracking mutual funds. The difference is that mutual funds are open-ended investors can pay directly into the fund or withdraw from it. This is done once a day, at prices set at the close of trade. With an ETF, investors buy and sell shares without directly adding to or taking away from the fund itself. Instead, the shares trade on an exchange and market makers buy, sell and create new shares to ensure they move in line with the value of the fund.

The advantages, as far as investors are concerned, are twofold. First, they can buy or sell at any time of the trading day, at the latest price. Second, the fund itself bears fewer costs. And in the US there is a third advantage: ETFs’ tax position is superior. Once such provisions are available in other developed and developing markets the net overall yield on such funds would increase and there by the popularity would increase any fold.

Yet as ETF's have grown, so have the worries about them. Could ETF's dominance create new systemic risks, or trigger another market crisis? Because the securities they hold are often not as liquid as the ETF itself, there are risks of mismatches and forced sales.

The idea that they have underlying liquidity, seemingly whatever the asset, was always a rather dangerous one, and as they grow ever bigger I would suggest this is something regulators might like to look at, especially in a market like India where the market regulator SEBI is very conservative and the overall penetration of the equity markets on the whole is not very large having a limited market depth.

However, the ETF structure has now survived several bursts of market turbulence without causing system wide problems, and they may in any case not yet be big enough to have a systemic impact.  ETF's still have less than 5 per cent of the total investment universe, when measured by the assets they manage.

By themselves, ETF's do not as yet have the critical mass to kick-start a systemic crisis, in my opinion.  But I strongly feel that they do have the ingredients to create a snowball effect, once markets go south decisively. They do appear to lead markets now, rather than mirror them.

Since the financial crisis, markets have been dominated by politics and attempts to second guess central banks. By allowing investors to make focused bets on sectors or asset classes with the click of a mouse, ETF's have made this kind of trading much easier.

ETF's have been a very efficient way to play these themes that are running in the market at present and an overall broad play on such themes is easier to execute by the EFT structure, which are trickier for stock pickers. But whether ETF's have been behind these trends is open to question. Preliminary evidence from the remarkable market action that followed Donald Trump’s election in the US, which saw sharp moves upward for stocks and downward for bonds, suggests that ETF's may indeed be encouraging short-term movements. Since the election have already been enough to make it “the most concentrated asset allocation shift in history.

In the two weeks between the November 8 election and the Thanksgiving holiday, about $50bn flooded into equity ETF's while roughly as much capital abandoned fixed income funds. In the past, investors would have needed to pause to think through which of their stocks might be most affected. Now, ETF's allow them to make sweeping bets on sectors at the press of a button.

About 20 per cent of equity flows went into the financial sector alone in just 12 trading days. The market values of two ETF's that cover only financial stocks rose by 46.5 per cent and 31 per cent respectively.

This buying will have raised all the stocks in the index tracked by the ETF's equally. That implies that some of the weaker banks will now be under priced, while others are overvalued.

With this kind of flow and money flowing in EFT’s there’s little opportunity for people who are looking at a stock from the bottom up, rather than the top down from an ETF, in my opinion.  It makes the large stocks in the ETF's very inefficient because you get a constant inflow to the companies in the index.

Stocks now tend to move close in alignment with each other most of the time, and then divert sharply in response to corporate announcements. News has always had an impact on stocks, but this pattern has grown far more pronounced since the advent of ETF's,

The flow of ETF's will mask any issues in a big company’s business. The flow from ETF's into IBM, for example, is more appealing to investors than IBM’s business. Therefore you get greater reactions to corporate announcements whenever they happen.

This trend of rising correlations has serious consequences for active stock pickers, who will select bargains and then find that their stocks stay cheap.

Combined with the swift moves in markets, this has created an environment in which active investors have persistently under performed since the crisis. Clients have punished them for this, with some $336bn flowing out of US active funds in the past 12 months.

It also makes it harder for smaller companies to raise capital. Investors moving money through ETF's tend to put capital into the biggest companies with the biggest weight in the index. Others go without.

In particularly in relatively ill liquid and inefficient markets such as some emerging markets the fast turnover can create problems especially in markets like India where the overall market depth is limited and even though there are around 6,000 companies listed on the nationwide exchanges the market of which market depth is really present only it the top 500 companies out that 12 per cent of a typical stock turns over each year, compared with 880 per cent turnover for ETF's.

ETF, run by some major funds like Black Rock, turns over some $2.6bn each day, more than any individual stock bar Apple. Emerging markets tend to be dominated by a few large, partially state controlled companies, which automatically receive a large chunk of ETF money because of their weight in the index. Capital is hard to find for smaller companies which may otherwise look more attractive. This has led active managers to allege that the rise of ETF's and passive investing are making markets less efficient.

 In my opinion indexing increases as a proportion of assets, correlations between stocks do increase. Stock markets aren’t where capital gets allocated. It gets allocated in IPOs [initial public offerings] and secondary offerings.

Another area of concern is a change in the ownership structure of companies. ETF's and passive mutual funds are primarily taking business from actively managed mutual funds, which are the bedrock of the way people around the world save for retirement. Planned regulatory changes in the US are likely to accelerate the trend by pushing brokers towards selling lower price funds which means ETF's and passive mutual funds.

ETF's are a scale business and they work on economies of scale.  The more money they can attract, the lower the costs and the higher the profit margins  meaning that a few companies, all based in the US, have come to dominate. The top three hold more than 69 per cent of all ETF assets, or more than $2.3tn, between them. BlackRock, the world’s largest fund manager, is by far the dominant ETF provider, followed by Vanguard and State Street. These companies are now leading shareholders in virtually every large public company on the planet.

Active managers traditionally take a vocal role in corporate governance, and complain that this will no longer happen under ETF's a charge that the largest ETF issuers indignantly deny, saying that they can only protect their interests by taking an aggressive attitude to corporate governance.

But it is undeniable that the ETF revolution has left corporate ownership far more concentrated. The responsibilities of stewardship and overseeing corporate directors have been ceded to a few large companies.

Against this, they have opened up assets such as bank loans or emerging markets or commodities to retail investors, and even to institutions, that were effectively closed before. Gold, for example, is now far easier to trade, without the need to take possession of gold coins and guard them. Some $27bn in shares in the largest gold ETF change hands every day. And they have certainly brought down costs for investors.

It is clear that ETF's are bringing more liquidity and transparency to savers and that they are enabling small savers to invest at a very low cost, in my opinion.

From a modest beginning, ETF's impact on stock trading has now reached mammoth proportions, ETF's are just a better technology and so they will come to replace mutual funds over the next 20 years

_ Farzan Ghadially