»The Honest Truth by Ajit Dayal

Should the RBI sell its US Dollars?
23 AUGUST 2010

If Indian companies are a "chop shop" as described by Senator Charles Schumer, selling inferior and stolen goods, I wonder how the Senator from New York would describe the very Wall Street firms and individuals that seem to be large contributors to his campaign.
Or, on a more global level, how would Senator Schumer describe the actions of the Federal Reserve - the central bank of the United States - as it continues with its decade-old policy of flooding the world with US Dollars.

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Wikipedia notes that "A chop shop is a slang phrase for an illegal location or business which disassembles stolen automobiles for the purpose of selling them as parts. It may also be used to refer to a location or business that is involved with the selling of stolen goods in general, or a brokerage that sells non-existent equities, both fraud and stolen goods. Another common use refers to a business whose product, service, or equipment is of questionable quality. The term is often used in a tongue-in-cheek fashion for outlets specializing in choppers, and by butchers and barbers."

Why the US Dollar is of "questionable quality"
While the US still remains the world's largest economy (despite the debt crisis it is in), military power (despite its setbacks in the Middle East and Vietnam), and still remains one of the best places in the world to vacation in or to live in, the currency seems like the product of some "chop shop": of questionable quality.

But people get confused between "popular" and "value".
Something which is "popular" trades a lot, but that does not mean it has "value" or should be "owned". As a stock, ICICI, ITC, and Reliance may be high volume stocks depicting their popularity. Yet, the Quantum Long Term Equity Fund does not own any of these stocks as of their last reported fact sheet because the fund management team does not see "value" in it.

The US Dollar may still be the world's preferred choice of currency to trade in, and many commodities in the world may be priced in USD, but that does not mean the US Dollar should always be the preferred choice of currency to own for a central bank - or an individual.

Table 1: 29 years of ownership of a bad asset, namely, the US Dollar
August, 1971USD 41 per troy ounceUSD 3.60 per barrel
August, 2010USD 1,220 per troy ounceUSD 71 per barrel
Loss in purchasing power for owning the US Dollar note-96.6%; today you can only buy 3.4% of the gold you could have bought with one US Dollar in 1971-94.9%; today you can only buy 5.1% of the oil you could have bought with one US Dollar in 1971
Source: Bloomberg, www.InflationData.com

The US economy may regain its premier status for the next decade. Or longer. But the US dollar - a reflection of policies that got the US to where it is - has lost value. I would not be arguing for the price of gold to head to USD 41 a troy ounce. That was the average price level gold was at when President Nixon took the US Dollar off the gold standard on August 15, 1971.

Junkies on a bad trip?
But every seller of bad product needs a customer who is willing to buy the product which is of questionable quality.
And old habits die hard.
Or, sometimes, people wait for the perfect alternative before they make the switch from a bad investment to a better option.

So we see the central bankers of the world worrying about what the new reserve currency should be. They are shouting their fears of the US Dollar. In high-pitched public debates and discussions.
And, yet, the central bankers are stuck and don't quite know what to do.

What would happen if they sold their US Dollars? What should they buy?

For the week ending August 19, 2010, data from the Federal Reserve shows that foreign ownership of US Debt (Treasuries and "agency" debt - "agency" being the debt issued by now-government controlled Fannie Mae and Freddie Mac, the nationalised home loan companies) is increasing and now stands at USD 3 trillion dollars, out of the total debt of some USD 13 trillion dollars.

Table 2: The biggest customers of the US Dollar "chop shop" are China and Japan (in USD billions)
Foreign government ownership of:TotalHeld by ChinaHeld by JapanHeld by India
US Treasuries2,355nanaNa
US government agency debt821nanaNa
Total3, 176868787180
Source: US Federal Reserve, my estimates

Foreigners, willing to own paper issued by the US government, now own about 25% of total US debt. China and Japan, alone, account for over 50% of the foreign government ownership of US Debt.
And there lies the problem for China and Japan - and the opportunity for India.

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When you owe the bank a bit of money and cannot repay, you are in trouble - goes the old saying - but when you owe the bank a lot of money and cannot repay, the bank is in trouble.

China and Japan own 50% of the US debt. Every analyst, every trader is watching what they do. If China or Japan start to sell their US Dollars, the currency traders will all rush to sell the US Dollar before China or Japan can hope to complete their trades.

Let's say Japan sells 10% of its USD 787 billion in US Government debt at a "good" price. You can bet that when news of that trade hits the market - and it will, even if with a delay - the US Dollar will fall so sharply, that the rest of the 90% that Japan still owns will be worth a lot less. Maybe 20% to 30% less.

The truth is that no one knows how much the US Dollar can fall from here if foreign governments were to sell their US Dollar holdings.

What is the value of a US Dollar?
Which brings us to a very interesting question: what is the true value of a US Dollar?

Oil has a base cost level to it: the cost of exploring, producing, and transporting the oil. Some say that this is USD 40 to 50 per barrel.

Gold has a base cost level to it: the cost of exploring, producing, and transporting the gold. Some say that this is USD 350 per ounce of gold.

But what is the base cost of the US Dollar One currency note?
The cost of the printing press.
The cost of the special paper on which it is printed.
The cost of the ink with which it is printed.
The cost of transporting it from the left side of the vault to the right side of the same vault each time a foreign government buys it.
The cost of the vault where they store the paper.

And what is the base cost of the US Dollar One Hundred currency note?
Surely not 100 times the cost of producing the US Dollar One note.
The printing press is the same, but it gave an output 100 times more than that of the US Dollar One note.
The size of the paper is the same, but it now holds three digits on it, not just one.
Yes, you need to use a little more ink to print the two extra "zero" digits after the "one".

And what is the base cost of the US Dollar One Thousand currency note?

In November 21, 2002 Ben Bernanke, speaking at a conference before he was made the Chairman of the Federal Reserve, had this to say: Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation (source: lesjones.com).

Helicopter Ben, as he is now known, has given you the answer of what a US Dollar could be worth.
As much as your toilet paper is worth.
Maybe less.

And Bernanke has made it clear: he is willing to print more and more rolls of toilet paper.
Just as his predecessors have done in varying degrees between 1971 and 2010.

Oil, gold, rice, wheat, property - or pretty much any "real" product cannot be created so easily and so cheaply.
That is why the price of "real" goods and products increases.
That is why we have "inflation".
We need to pay more US Dollars to buy that same gram of gold, kilo of wheat, or bottle of cooking oil.

That is why you, as an individual, need to protect yourself from the biggest and most creative "chop shop" in modern economic history: the US Federal Reserve.

(Of course, don't forget to always protect yourself from the most creative, profitable - for them - and dangerous - for you - "chop shop" in human history: Wall Street and their clones in India.)

It is not possible to buy sacks of wheat, or barrels of oil, or bottles of milk and horde them in your home.
But maybe you should buy a currency that has preserved its value pretty well over the centuries: gold. Whether in solid form locked up in your safe or The Quantum Gold ETF.

The Reserve Bank of India bought 200 tonnes of gold on November 2, 2009 and got rid of USD 6.7 billion of US Dollar funny money.
And that was before the recent announcement by the Fed that the Bernanke printing presses are ready to work overtime to ensure an economic recovery.

The Fed could get it wrong.
They have been wrong before.

Sir Alan Greenspan, knighted by the Queen, is the author of this crisis.
He was the Chairman of the Fed before Bernanke.
He bailed out the geniuses of Wall Street in 1998 and set the foundation for massive risk taking - with all the losses from bad trades paid for by the US tax payer.
With money printed by the Fed's prized printing presses.
That is why the global financial system is in the mess it is in.
Ben Bernanke is on his way to being knighted, too.
And the US Dollar could be worth even less than it is today.

Source: The Golden Truth, Quantum AMC

Sell USD, move to gold and other foreign assets?
Given Bernanke's commitment to seeking a knighthood from the head of the declined British Empire, the RBI would be wise to sell some more of its US Dollars and buy gold; to buy debt issued by countries that wish to fight inflation (Germany, Switzerland); and to buy debt issued by countries that have commodities as a key asset (Australia and Canada).

China knows the US Dollar is a threatened currency, but it cannot sell its US Dollar reserves - it will destroy its own "wealth".
So, China is buying mining companies and assets wherever it can.
And sending the military and navy for strategic protection of those assets.
All a very expensive and round about way to own hard assets and to diversify away from the US Dollar.

The RBI is in a sweet spot and can get the same diversification as China seeks for a few basis points from investments in financial instruments.
Unlike China and Japan, the RBI's holdings of US Dollars are small enough not to cause a scare in case the RBI begins to sell a bit. Though this action will be noticed.

After the RBI bought gold on November 2nd, 2009 at about USD 1,059 per ounce, the price of gold shot up to USD 1,215 per ounce by December 2, 2009. By February 2010 the price of gold declined to USD 1,062 as that news ran itself out and other more powerful factors occupied the mind of the market. This is proof that the RBI's actions may cause a near term flutter but will be soon forgotten.

Which trader - or Senator - in his right mind would worry about the Indians selling the precious US Dollar notes in the foreign exchange markets?
After all, India is only known to run "chop shops" and "body shops".

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Disclaimer: The Honest Truth is authored by Ajit Dayal. Ajit is a Director at Quantum Advisors Pvt. Ltd and Quantum Asset Management Company Pvt. Ltd. The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and has not been authenticated by any statutory authority. The author, Equitymaster, Quantum AMC and Quantum Advisors do not claim it to be accurate nor accept any responsibility for the same. Please read the detailed Terms of Use of the web site. To write to Ajit, please click here.