Yuan use, prestige rise

 November 4, 2016

 Pat Heller

What was perhaps the most important news development in the last week that will impact precious metals prices in the long run?

No, I don’t think it had anything to do with the U.S. presidential elections. In my assessment, no matter whether the Democrat or Republican candidate is elected next week, the long term outlook for the U.S. dollar and precious metals prices will be pretty much the same.

If you don’t get your news from foreign sources, you probably don’t know that last Friday, Oct. 28, the Shanghai Gold Exchange (SGE) and Dubai Gold and Commodities Exchange signed an agreement for the Dubai operation to trade gold contracts using the Chinese yuan currency for pricing.

Until the SGE began operations all gold trading worldwide was priced in U.S. dollars. The SGE began domestic trading on a small scale about 10 years ago. In 2014, it began international trading. On April 19, 2016, it began setting a daily fix in competition with the London and New York markets.

Not only did the SGE start to challenge the dominance of the world’s largest gold trading markets in London and New York by pricing contracts in yuan, it also adopted three other trading practices that I consider to be long-term improvements over how the Western markets operate.

First, virtually all (96 percent) trades on the SGE are settled with immediate delivery of the underlying physical metal. In the London and New York markets, there is only a tiny fraction of gold in the respective bonded warehouses available for delivery against maturing contracts. Hence, the latter two markets are almost purely involved in the trading of paper contracts.

It is feasible for the SGE to make prompt physical delivery because of the second difference – no contracts can be offered for sale on the SGE until after the physical metal for that contract is delivered into SGE vaults. This makes it much more difficult to suppress precious metals prices by flooding markets with “naked” short sales of paper contracts.

Third, SGE gold contracts are for one kilogram metric weight, the measurements used almost everywhere around the globe. The London Bullion Market Association contracts trade 400 troy ounce bars and the New York COMEX contracts are for 100 troy ounce bars.

Thus, going forward, it makes sense that the form of contracts traded in Shanghai would catch on elsewhere. However, that is not all what is going on. In September last year, when it was announced that the Chinese yuan would become a component of the International Monetary Fund Special Drawing Rights (SDR) as of the beginning of October this year, that was a signal that the Chinese yuan would also further displace the U.S. dollar, the euro, Japanese yen and British pound, in central bank reserves.

Earlier I warned that there was some prospect that there could be a significant short-term decline in the value of the dollar as central banks rebalanced their reserves to mirror the changes in the SDR – by reducing their holdings of dollars, euros, yen and pounds to replace them with yuan. Alternatively, if this short-term decline did not occur, the long-term outcome would still be the same.

In announcing that the Dubai exchange would begin pricing gold contracts in yuan, SGE officials also stated that they are in talks with other exchanges about doing likewise.

This was not the first significant shift in international finance since the yuan officially became a component of the SDR at the beginning of October. At the beginning of last week, the Philippine central bank announced that it had decided to add the yuan to its reserves. This parallels previous announcements by the central banks in Nigeria, Tanzania, South Africa, Russia and Singapore.

As central banks and the customers of commodity exchanges need fewer U.S. dollars, the excess will eventually be repatriated to the U.S. Treasury in exchange for American goods, services, real estate and ownership of companies. In other words, the U.S. government will be delivery valuable tangible assets in return for taking in “paper.”

As this shift from the dollar continues over the medium to long term, expect it to accelerate. The result of this declining demand for dollars for use in international commerce will be a falling U.S. dollar. As this occurs, the U.S. dollar prices of gold, silver and other precious metals prices are almost certain to go up.