-- Posted Thursday, 28 April 2011 | | Source: GoldSeek.com
What happens when people actively shun their official currency...?
GOVERNMENTS are often tempted to live beyond their means. Today, that means national debts and quantitative easing. But a few hundred years ago, it meant debasing coinage.
Silver and gold coins would be 'clipped' with a tiny quantity of their metal shaved off the edge every time they passed through government hands or they would be minted with a lower precious metal content than their face value stated. This would enable the monetary authorities to produce more coins for the same amount of bullion, increasing the government's spending power in the marketplace.
The net result was that coins with identical face values did not necessarily hold the same commodity value. And this often led to a rather interesting phenomenon. When people knew there were both 'good' and 'bad' coins floating around, they tended to spend the bad and hang onto the good. Before long, all the good money disappeared into hoards. The only money in circulation was bad money.
This is known as Gresham's Law, named after the sixteenth century financier Sir Thomas Gresham. In its most simple form, Gresham's Law is often stated as "bad money drives out good money", and it's no mere historical curiosity. Gresham's Law is alive and kicking today, nowhere more than in Vietnam.
Vietnam's economy uses three different forms of money today. There is the official currency, the Vietnamese Dong. There is also the US Dollar, which Vietnamese people tend to trust a bit more. And then, there is gold.
Gold is a big deal in Vietnam. The average Vietnamese spends more of each Dollar of income on gold than anyone else on Earth. Total gold buying amounted to 3.1% of GDP last year. (By comparison, private gold purchases amounted to 2.5% of India's GDP, while China's were a mere 0.4%.)
All told, an estimated 500 tonnes of gold over $24 billion worth is hoarded away, reckons Huynh Trung Khanh, deputy chairman of the Vietnam Gold Business Council. It's hidden in mattresses and buried in the garden. But gold is not just a store of value in Vietnam. It is also used as a medium of exchange. Which is why, in the day-to-day sense, it also functions as money.
In Vietnam you can put gold in a bank and earn interest. People quote house prices in gold, and pay for them with tael gold bars each bar weighing approximately 1.2 troy ounces. This makes sense when you consider that Vietnam is a largely cash society. A single property can cost up to 4 billion Vietnamese Dong. That's a lot of paper to count and check.
But if the Vietnamese love their gold, the same cannot be said of the country's central bank. In recent years the State Bank of Vietnam (SBV) has issued several Decrees and Circulars whose combined effect whether by accident or design has been to undermine gold's monetary role:
June 2008 Gold imports banned (though smuggling continues);
March 2010 All gold trading floors closed;
October 2010 SBV issues Circular 22, banning banks from dealing with manufacturers and traders of gold bars;
May 2011 SBV bans all gold lending activity.
The latest Decree is an attempt to end the practice of banks paying interest on gold (presumably in the hope that people will substitute their gold for paper). Up to now, banks have offered interest on physical gold deposits. They sell the metal on, lend the proceeds as Dong loans and buy an equivalent amount of gold forward from an international bullion bank.
This has been profitable because domestic interest rates have tended to be high enough to cover both the forward rate and the rate they were paying the depositor. Essentially it was a carry trade; borrow gold (from depositors) cheaply, lend at a higher rate.
As of May 1, however, banks will be forbidden to undertake any gold lending activities. And from May 2013 they will have to stop paying interest on gold deposits.
This latter measure may largely be moot by then. As you might expect, with the lending channel blocked, there's no money in it anymore. Gold deposit rates have already fallen sharply.
So why all the rule changes? Well, the authorities see gold as a "bad influence", a destabilizing factor in already messy economic picture.
Consider the following problems afflicting Vietnam:
#1. A Large and Growing Trade Deficit The trade deficit in 2010 was around 12% of GDP. Even worse, it grew wider in the first four months of the year.
#2. Rising Inflation Latest figures from Vietnam's General Statistics Office show CPI inflation at a whopping 17.5% despite a supposedly tight monetary policy.
#3. A Falling Currency The Dong has been devalued six times since June 2008. Most recently was February 11 this year, when it fell 8.5%.
Sound at all familiar? The way the central bank sees it, the propensity of the Vietnamese to buy gold also makes these problems worse. Gold imports exacerbate the trade deficit (it has no domestic mine output). Buying gold thus weakens the Dong, which puts upwards pressure on inflation. Gold (and indeed Dollar) ownership also undermines the SBV's monetary policy, since its interest rates only apply to the Dong.
But you can hardly blame the Vietnamese people for buying and hoarding gold. Not when the official base interest rate is 9%...high by the near-zero standards of the West, but even worse when you remember that Viet inflation is running at 17.5%.
That means a real rate of return on Dongs of minus 8.5%. By spooky coincidence the exact same percentage by which the Dong was recently devalued.
In this regard, gold ownership is a direct consequence of economic conditions. The only way the SBV could provide Vietnamese with an incentive to save in Dong would be to raise the nominal interest higher than inflation, and thus provide a decent real rate of return. But this would mean rates of around 20% at least. Not only would this hit the domestic economy hard, it would almost certainly cause the Dong to appreciate, which would make the trade deficit even worse.
Unable, therefore, to directly incentivize people the hold paper money, the authorities have resorted instead to marginally disrupting gold's monetary function. But this won't work. People will still prefer to hold gold because the Dong is failing to fulfill one of the core functions of money. It is a terrible store of value.
That is why the Vietnamese continue to hoard "good" money (gold) while passing the bad stuff around. Just as Gresham's Law predicts.
Vietnam is stuck in an inflation-devaluation cycle. Ordinary people do not trust its paper currency, and sell it for something better. This reduces its value against other currencies. It also reduces its value against goods and services, which takes the form of rising consumer prices. All of which serves to make the Dong even less popular...
Could this vicious cycle ever strike the US Dollar, British Pound, or the Euro? Maybe it's already begun. Gold and silver prices have risen strongly over the last decade in all those currencies, and especially versus the Dollar so far in 2011. This tells us that many Westerners just like the Vietnamese are keen to swap their paper for metal.
If the Dollar and its paper cousins continue to leak value, many more cash savers could look to join them.
Editor of Gold News, the analysis and investment research site from world-leading gold ownership service BullionVault, Ben Traynor was formerly editor of the Fleet Street Letter, the UK's longest-running investment letter. A Cambridge economics graduate, he is a professional writer and editor with a specialist interest in monetary economics.
(c) BullionVault 2011
Please Note: This article is to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events and must be verified elsewhere should you choose to act on it.
-- Posted Thursday, 28 April 2011 | Digg This Article | Source: GoldSeek.com