The Edge, 19 August 2002
The 1997 East Asian currency crisis made apparent how vulnerable currencies can be.
The speculative attacks on the ringgit, for example, would have devastated the economy if not for the quick and bold counteractions taken by the government, particularly in checking the offshore ringgit transactions. The need for firms to manage their foreign exchange risk also became apparent.
Many individuals, firms and businesses found themselves helpless in the wake of drastic exchange rate movements. Malaysia’s being among the most open economies in the world in terms of international trade reflects the degree of its exposure to foreign exchange risk.
The Economist magazine’s Pocket World in Figures (2002 edition) ranks Malaysia the second-most trade-dependent country in the world. Trade as a percentage of gross domestic product is 92 per cent for Malaysia, even higher than for Singapore, which ranks third with a figure of 78.8 per cent.
Today, exchange rate risk is a marked phenomenon in the floating exchange rate regime. Many international investment, trade and finance dealings are shelved due to the unwillingness of parties concerned to bear the foreign exchange risk. It is, however, imperative for businesses to manage this foreign exchange risk so that they may concentrate on what they are good at and eliminate or minimise a risk that is not their trade.
Elsewhere, traditionally, currency derivatives — forward, futures and options contracts — have been used for this purpose. However, in many nations including Malaysia, futures and options on currencies are not available. The Malaysian Derivatives Exchange (MDEX) makes available a number of derivative instruments — Kuala Lumpur Composite Index Futures, Index Options, Crude Palm Oil Futures and Kuala Lumpur Inter-Bank Offered Rate Futures — but not ringgit futures or options.
Even in countries where currency derivative markets exist, not all derivatives on all currencies are traded. At the Philadelphia Stock Exchange in the US for example, derivatives are available only on selected major world currencies like the yen, sterling and Australian dollar — against the US dollar, mostly. For most other currencies of the world, including those of almost all developing nations, there are no formal tools for hedging the foreign exchange risk that has become immensely significant in today’s global business environment.
Recently, Prime Minister Datuk Seri Dr Mahathir Mohamad mooted the idea of a gold payment system — the gold dinar — to settle bilateral and multilateral trades among countries and thereby eliminate foreign exchange risk. In this mode, gold is to be used as a medium of exchange and as a unit of account instead of the national currencies. Prices of exports and imports are to be quoted in units of gold weights. It is important in this structure that gold itself, and not national currencies backed by gold, is used for pricing, for otherwise it would not then be different from the gold standard of the past. Instruments backed by gold are vulnerable to easy abuse — which is what brought on the failure of the gold standard.
In the gold dinar system, the central bank would play an important role of keeping national trade accounts and providing a secure place to keep gold. When Malaysia trades with Indonesia, for example, the gold accounting is kept through the medium of the central banks of both countries and only the net difference between the two is settled periodically. Nevertheless, every transaction in essence involves gold “movement”.
Since bilateral and multilateral trades are ongoing processes, any gold that needs to be settled can always be brought forward and used for future transactions and settlements. On the ground, commercial banks that support gold accounts are viable partners in the implementation of the gold dinar system.
International trade and finance participants would deal with the commercial banks that provide such gold accounts. These commercial banks would in turn have gold accounts with their respective central banks. The above structure may sound a lot like the gold standard, but it is not. Gold, and not gold-backed instruments, is the medium here.
As an example, consider that Malaysia exports 100 bullion gold worth of goods and services to Indonesia while importing 80 bullion worth. Hence, Malaysia has a surplus trade of 20 bullion. Indonesia needs to settle only this difference of 20 bullion. However, this amount could be used for settling future trade imbalances between the countries and hence a physical gold movement between the countries is not necessary. Note that this simple structure eliminates exchange rate risk.
This means there is no need for forward, futures or options trades on the currencies. All countries, including those without such derivative markets, can enjoy this benefit. After all, developing a derivative market is costly and time-consuming. It also introduces inefficiency to the market since additional transaction costs need to be incurred.
Unlike the forward, futures and options markets, the gold dinar does not depend on speculators for increased liquidity. By being a global currency, it is capable of providing the needed liquidity without bestowing any “unfair” seigniorage on any particular currency. Also, unlike imperfections of hedging that are likely to happen with forward contracts, futures and options due to the standardised nature of these contracts, the gold dinar does not introduce such imperfections.
With the gold dinar, the hedging cost is fixed against gold, but note that even when hedging is done in any currency denomination, there is still risk in the fluctuation of that currency. Gold is superior here because it has intrinsic value. A hedger also pays neither the initial margin nor daily variation margins, as is the case with currency futures. Such margins are potential cash flow burdens on hedgers.
Even though the international gold price may fluctuate, the participants in a gold dinar system realise that unlike national currencies, gold has a stable intrinsic value that can be depended upon for continuous trade into the future. Even though with the existence of national currencies speculation and arbitrage on the price of gold could tempt a participating country to redeem or sell its gold, it should resist such temptations for the sake of stable and continuous future trades.
A regulation requiring that the gold stock with the central banks be used only for settling real transactions may be necessary. At this juncture, one may ask the question: How does this structure differ from a simple barter trade between countries? The advantage is that gold acts as a unit of account and thereby eliminates problems associated with barter.
The gold dinar would also reduce speculation and arbitrage between national currencies. For example, if three countries agree to use the gold payment system, then it is akin to the three currencies becoming a single currency. Accordingly, speculation and arbitrage among these three currencies will be reduced or even eliminated. This “unification” of the three currencies through the gold dinar provides diversification benefits.
It is like obtaining diversification through a portfolio of shares. Individual currencies face risks that are unique to the issuer country. For example, political turmoil can cause a national currency to depreciate, but in a unified currency such risks would be reduced. In fact, since people of all races, creeds and nationalities treasure gold, it is a suitable global currency that will enjoy global acceptance.
This means no single country’s unique risk may be significantly embedded in gold. However, the gold dinar system entails legal obligations between the parties concerned, just like the forward and futures contracts; and it may not be easy for a trader to remove this obligation easily as is possible with futures.
In my opinion, the gold dinar if implemented is similar to the forward contract but with its problems of “barter”, speculative and arbitrage elements removed; and is also a superior tool for managing foreign exchange risk compared to the futures and options contracts.
The gold dinar is likely to reduce transaction costs too, since only accounting records need to be kept. Transactions can be executed by means of electronic media with minimal cost. Hence, for international trades in this system, one no longer needs to open a letter of credit with a bank, incur exchange rate transaction costs (that is, the different buying and selling rates for currencies) or even face exchange rate risk.
The gold dinar system also reduces the need to create large amounts of national currencies through multiple deposit creation in the banking sector. This therefore reduces the possibility of excessive speculation and future attacks on the ringgit like the one in 1997. The banking sector can compensate for this “implied” loss by viewing the gold dinar system as an opportunity and thereby providing the necessary services in collaboration with the central bank.
The current global financial system is showing signs of instability, which in my opinion is partly but significantly due to the fiat nature of money. The problem lies with its attribute that it is created and destroyed in the financial system. Such instability is currently observable in the US. The financial distress depicted by a number of huge firms lately is bound to destroy a large sum of fiat money that in turn can be expected to bring about a banking crisis just like that experienced in Malaysia in 1997-98.
Gold, on the other hand, has all the characteristics of a good currency; it is desired and highly valued for its own sake, homogenous, stable, durable, divisible and mobile; and can neither be created nor destroyed. It can thus play the role of a stable international unit of account that is profoundly missing in the current floating exchange rate system since the demise of the Bretton Woods in 1971.
Perhaps we can take our cue from Nobel laureate Robert Mundell, who predicted that gold would again be part of the international monetary system in the 21st century.