New threat to US dollar hegemony

“Abu Bakr ibn Abi Maryam reported that he heard the Messenger of Allah (may Allah bless him and grant him peace) say: ‘A time is certainly coming over mankind in which there will be nothing [left] which will be of use save a dinar and a dirham.’ “

— The Musnad of Imam Ahmad ibn Hanbal

Gold-price action in the world markets has been choppy through the month of June, with plenty of sudden, multi-dollar gains being wiped out hours later by equally swift declines.

When the market is trying to find a direction like this, it’s a good time to step back and look at the big picture, and at what has been driving the gold price these past two years — the weakening of the U.S. dollar.

The downward pressure weighing on the U.S. dollar today is enormous, and the list of negative factors is long: a sluggish U.S. and global economy; global political instability; a huge U.S. trade deficit; U.S. federal budget deficits as far as the eye can see; stimulative federal tax cuts that will be neutered by hikes in city and state taxes; massive spending on an overstretched military; negative real interest rates; a ballooning money supply; a once-widely-admired capitalist system riddled with greed and insider scandals; the spectre of deflation compounded by the slowing velocity of U.S. dollars; the mountain of “toxic-waste” derivatives accumulated in the U.S. financial sector; and frenzied U.S. housing and bond markets that feel as if they’ve peaked.

Now, add to this list one more development: the imminent birth of an Islamic international-settlement vehicle, called the gold dinar, which is intended to replace the U.S. dollar in exchanges between Muslim countries.

The new dinar isn’t mainstream news in the West just yet, but the plan was formally announced last October by its champion, Malaysian Prime Minister and Finance Minister Mahathir Mohamad, in a speech titled “The gold dinar in multi-lateral trade,” the text of which is available on the Internet at www.myglobal.gov.my/misc/speech.html

The address was delivered in Kuala Lumpur in the weeks leading up to the inauguration of the Islamic Financial Services Board, which is based in Kuala Lumpur and designed to boost the Islamic banking and financial sector by establishing best practices.

Malaysia is a founding member of the IFSB, along with Bahrain, Indonesia, Iran, Kuwait, Pakistan, Saudi Arabia, Sudan, and the Islamic Development Bank, which has 54 members.

Behind the scenes, Malaysia has one of the best records of corporate governance in the Muslim world, and Kuala Lumpur sees itself as a burgeoning regional centre for Islamic banking and finance.

Islamic banking principles require financial transactions to be supported by genuine trade or business-related activities, and forbid non-trade related activities such as currency speculation, derivatives and other unproductive financial manipulations.

Furthermore, the Islamic financial system prohibits the payment or receipt of any predetermined, guaranteed rate of return, which in effect prohibits the concept of interest (usury).

Mahathir’s principal motivation in pushing for the new dinar seems to be to avoid another currency crisis like the one experienced by Southeast Asia in 1997-98, when many currencies collapsed more than 50% against the greenback.

Malaysia stopped the freefall of its currency, the ringgit, by pegging it to the U.S. dollar at a 3.8-to-1 ratio in 1998.

Many Americans perhaps underestimate the lingering resentment in Southeast Asia caused by those currency meltdowns, which were blamed — rightly or wrongly — on malevolent currency speculators in the West and the U.S. government’s “strong-dollar” policy, which was initiated in the mid-1990s and is now on its last legs.

Mahathir began his speech by remarking that, for some time, Muslims and their countries have become “synonymous with backwardness, authoritarian and frequently unstable governments and lately with terrorists and terrorism.”

The remedy, he said, is for Muslims to “unite in order to build up our capacity and our strength. Simply by being united and strong, we would be freed from oppression.”

He characterized the current currency system as “chaotic and anarchic,” but because it “benefits the powerful countries, they are unwilling to correct it. . . If we want to protect ourselves, we must evolve our own payment system, our own trading currency.”

Enter gold.

As any gold bug can recite by heart, gold has all the characteristics of a strong currency: it’s widely desired, highly valued, durable, stable, and it can’t be created or destroyed.

Gold has a deep resonance in the Muslim world: gold dinar coins have been circulated as far back as the second caliphate in 632 AD, and were used continually until the collapse of the Ottoman Empire in the 1920s.

At a more subtle level, the Zakat — one of the pillars of Islam that compels believers to contribute to the poor — is somewhat tainted by the giving of fiat money rather than a tangible asset such as gold dinar or silver dirham.

Under Islamic law, one dinar is 4.22 grams of 24-carat gold, or 0.0135 troy oz. gold (worth about US$48 today), while silver dirhams are 3 grams each. However, the Malaysian prime minister has suggested that one dinar will equal one troy ounce of pure gold, since it is the most convenient unit of measure. In the end, the choice of the new dinar’s weight is not really a significant issue since it won’t exist in a physical form anyway.

(There is still some confusion over the term “dinar,” in that over the past decade, dinar coins consisting of 4.25 grams of 22-carat gold have been minted and distributed on a limited scale among private individuals in the Muslim world using such mechanisms as www.e-dinar.com, which was launched in 1999.

As well, another form of dinar is already being used as a currency by the Islamic Development Bank, but it remains pegged to Western currencies, with one dinar equivalent to one special drawing right [SDR] of the International Monetary Fund. The SDR, in turn, is set to a basket of currencies made up of the U.S. dollar, the British pound, the yen, and the euro.)

While gold is by no means stable, Mahathir considers it more stable than fiat currencies, and he believes gold does have an intrinsic value that fiat currencies lack. Furthermore, he maintains that gold is less susceptible to manipulation and speculation than fiat currencies.

Malaysia’s plan is, in some ways, modest in that it doesn’t back a currency with gold but instead uses gold as money. That means gold won’t be used for everyday transactions in domestic markets, which will continue to employ national currencies, but rather for the settlement of trade balances between countries, perhaps every quarter or so.

For example, if, over a 3-month period, Malaysia exported 1 million dinar worth of automobiles to Saudi Arabia and imported 900,000 dinar of oil from the gulf state, then the Malaysian exporters and importers would respectively receive ringgit from, or pay ringgit to, Malaysia’s central bank, while the Saudi importers and exporters would deal similarly with their own central bank. But at the central-bank level, the beneficial ownership of 100,000 gold dinar would be transferred from Saudi Arabia to Malaysia at the end of three months.

The transferred gold could be held in bank vaults in London and New York. Or, if the political uncertainty in the Middle East were to be reduced and a Muslim country were preferred, the Persian Gulf tax haven of Dubai could someday emerge as a major centre for gold-dinar settlement.

On top of that, it remains to be seen what arbitrage and speculative activities could arise from this new settlement system.

Mahathir concluded his speech by stating that Muslim countries are “in the best position to demonstrate the viability of the [gold dinar] system. [They can] manage their economies rationally and, in the process, show the world that they are capable of growing with stability and peace. This will do more
to counter oppressions by their enemies than futile violent retaliations.”

While Malaysia hopes to launch the gold dinar later this year, Mahathir wants to proceed slowly so that there’s time to eliminate any early defects.

He proposes that the dinar first be adopted bilaterally between Malaysia and those Muslim trading partners with which it has only a small trade deficit or surplus.

Iran has already indicated its interest in being one of Malaysia’s first partners, and it supports additional study of the matter.

In the meantime, Malaysia continues to sponsor meetings to promote the gold dinar. The next one, to be held in early July, will be hosted by Mahathir.

Still, there are hurdles to cross before the new dinar takes hold: Malaysia’s trade with Muslim countries is less than 5% of its total, and few of these nations produce much gold or possess extensive gold reserves.

And, of course, one of the unspoken questions that arises from Mahathir’s efforts is, would Malaysia be so keen on the gold dinar if it wasn’t such a strong exporting nation and stood to benefit greatly from an influx of gold?

More contentiously, the dinar plan is strictly against the dictates of the International Monetary Fund, being, in many ways, a return to the post-Second World War, Bretton-Woods system of fixed exchange rates pegged to gold. (Bretton Woods collapsed in 1971 when U.S. President Richard Nixon’s administration cut the final link of convertibility between the U.S. dollar and gold, and allowed the greenback to float freely against other currencies.)

Furthermore, the adoption of the dinar effectively extends existing boycotts of U.S. goods in the Muslim world into the currency realm, and in the longer term, for those Muslims who yearn for a global, unified ummah to replace Muslim nation states, the gold dinar is a necessary first step in bringing the economies of these states closer together and creating a single Islamic currency.

Whether you’re Osama bin Laden or George W. Bush, it’s clear that the proposed gold dinar is a political challenge to a status quo that has been supported by most Western governments and businesses for decades.

Putting politics and religion aside, we see that the successful re-monetization of gold through the gold dinar can only be bullish for gold, since the central banks of participating countries would inevitably need to unload some of their fiat currency to build up their gold reserves.

James Sinclair, chairman of gold junior Tan Range Exploration and creator of the daily gold-commentary website www.jsmineset.com (a must-read for gold investors), describes the gold dinar as a “tactical nuclear weapon of self-protection in the Islamic perspective. It is a statement by them of Islamic self-consciousness and self-esteem.”

He considers the Malaysian dinar to be the “most important development for gold since Bretton Woods. It is truly a watershed event, and there is no question in my mind that gold will be re-monetized by the gold dinar.”

Sinclair takes it one step further and suggests that the creation of the Islamic gold dinar has the tacit support of the Chinese government and could be a test run for a gold-backed Chinese currency or some other Asian trade-settlement mechanism.

In other words, the dinar could lead to a financially earth-shaking re-monetization of gold by Asian-Islamic interests — an event that would explain why Islamic countries and China have been building up their gold reserves and why the Shanghai Gold Exchange has reopened after a 50-year hiatus.