By issuing the gold bond at a discount to par, early buyers get an enhanced yield. This rewards them for buying a new instrument which has yet to gain its potential market recognition. The market price of the bond will become linked to the yield on physical gold once the conversion rate is set, with an additional margin for issuer risk. And if currency balances invested in such a bond are rewarded with a yield payable in gold, demand for currency redemptions into gold are unlikely to be significant, so long as the public has confidence in the issue and the gold exchange standard. So, a country putting its currency on a gold exchange standard should, with a correctly priced bond, minimise redemptions.
A sinking fund should be established at the same time as the bond is announced to buy physical gold to cover anticipated demand for coupons paid in gold. Some gold from reserves can be allocated for this purpose initially but additional gold should be bought to establish sufficient cover to add conviction to the scheme by winding down existing foreign currency reserves where they are unbacked by gold, immediately.
From here on, we shall assume this scheme to introduce a sound, gold-exchangeable currency is taken up by the Chinese government. Government finances can be expected to improve from the arrangement, to the extent that borrowing costs are reduced. For example, China’s 30-year bond currently yields 4.1% having been as high as 4.4% earlier this year. A gold-linked irredeemable Chinese bond, even allowing for issuer risk would probably yield no more than 3% at the outset, which is slightly less than the current yield on 1-year maturities. If it was issued with, say, a 2.25% coupon, it would be priced at 75.00, giving the attraction of a capital gain to private citizens as the risk premium on Chinese government bonds declines.
This will also lend support to the currency in the foreign exchanges. The gold bond should be listed in Shanghai, Hong Kong, Tokyo, Singapore, Dubai, London and Moscow so that sovereign wealth funds and other conservative long-term investors have ready access to it. New York is not on the list because it is Chinese policy to exclude the American banking system from her monetary affairs as much as possible, and the conflicts that necessarily would arise with the US government. Ultimately, for funds based outside America, the gold bond itself would come to be regarded as a gold substitute for investment purposes, integrating gold into both Chinese-led monetary and investment reforms.
There can be little doubt that if these measures are taken gold convertibility would rapidly promote the yuan to foreigners in Asia and beyond as an acceptable store of value in exchange for trade. In time, all foreign currency held in China’s monetary reserves not backed by gold would have to be disposed for gold or yuan, as being inconsistent with the new monetary policy. As stated above, China’s gold buying using dollars would start immediately and continue until the price of gold has risen to the point where the gold exchange rate is finally established.
Furthermore, with no final redemption on the gold bond, there would be no need to make any repayment provisions. This model is the one that was adopted by the British government for financing the Napoleonic Wars by issuing Consolidated 3% Annuities at a deep discount, so that investors providing war finance not only got an enhanced yield, but also a substantial capital gain when peacetime returned. The fortunes created on the return to peace played an important part in financing the industrial revolution in the early nineteenth century.[vii]
In this sense, there are good parallels between Britain’s war financing two hundred years ago, and China’s current position. In both cases government expenditure exceeded and exceeds respectively tax income by a significant margin, and neither were and are on a gold standard. Britain had temporarily abandoned her gold standard in the 1790s, before reinstating it a few years after Waterloo.
In China’s case, excess government expenditure is due to planned infrastructure spending, which is likely to be ongoing for at least another ten years and extending well beyond her borders. However, Chinese instigated capital expenditure throughout Asia will increasingly be covered by project financing through the Asian Infrastructure Investment Bank, releasing the Chinese government from much of the financing burden.
The British came out of the Napoleonic Wars with an estimated debt to GDP of about 260%. In cash terms it was considerably less, because the debt figure is the total of nominal debt in issue. This was the beauty of irredeemable Consols, because they never need to be repaid, which meant a more accurate debt to GDP figure was 180%. As an historical footnote, it is interesting they were repaid only recently.
China’s government debt is considerably less at just under 50%, but still rising. China is blessed with a savings rate of close to 50% of GDP as well, so further issues of a gold-linked bond into the domestic market should be heavily subscribed. Once the current expansion of infrastructure spending diminishes, the Chinese government will easily return to a budget surplus, paying down its debt more rapidly than the British did in the 1800s.
I would suggest China undertakes the monetarisation of gold in two stages. The first would be to issue the new gold loan outlined above. Proceeds of the new gold bond would be used to finance government expenditure, to purchase existing bonds in the market for cancellation, and to build a sinking fund to provide cover for future coupon demands in gold. The price relationship between coupons paid in gold and yuan will be fixed at a later date and will be the rate for the gold exchange standard once it is set. It cannot be set at the outset, because it is clear that for gold to be rehabilitated into China’s monetary system, and consequently the likelihood it will be elsewhere, will require a far higher gold price than at present. In price theory, it is the introduction of a new use that will set a higher marginal price. That will be the second step, which is announced in advance when the new gold bond is first issued but at a rate yet to be decided.
- Source, James Turks Goldmoney
