Year 2000 is less than 16 months away. Instead of planning the celebration we are all worried about the potentially catastrophic situation caused by the inability of some Computers, chips and software to correctly interpret the millennium change. There has been a talk of Bank runs and collapse of the financial system. On the positive side some analysts say that the Financial sectors including Banks are the best prepared. Even the most optimistic forecasts predict a minor jolt to the Financial sector. Therefore, the main question is whether the existing Financial system is strong enough to withstand even "a minor jolt"?

To effectively answer this question we must also go back to history and look for some clues there. We must review the period from times when there was only Barter Trade to present times when paper money and plastic money are the favorites.

It has taken us a few hundred years to come from Barter Trade to Credit Cards. Imagine how inconvenient it would have been when the only known means of trade was Barter. As civilization developed, Gold coins were introduced to replace Barter trade. A person could then sell his merchandise in exchange of gold coins and then chose the time when he would exchange his gold coins for goods and services of his need. Rulers/governments of those times then decided to float paper money and metal coins of different denominations to replace Gold coins. This was done to encourage trade by making the denominations small and handling easier. To gain public's confidence in paper currency the then Rulers/governments backed the currency fully by Gold (Gold Standard). Without Gold backing the public would not have parted with their goods in exchange of paper. People then had full confidence that they could anytime exchange paper money for Gold. Paper currency was the Treasury's "IOU" and the treasury promised to pay the bearer the face value of the currency note with Gold equivalent. Remember US$ was pegged to certain amount of Gold for a long time.

Now that paper currency has become widely popular, most of the governments have forgotten their obligation to back its currency by Real assets. It has now become a common practice to print more notes or issue Bonds to cover deficit. The US government has issued T-bills/Bonds worth trillions of dollars to cover their deficit. They will keep paying back on the due dates by issuing more Bonds. Debt servicing by raising more debt!! Going by past trends the net debt is going up year after year. The expenditure of most governments exceeds their revenue year after year and as a result a stage has come when only a small fraction of the currency in circulation and other debt instruments are backed by REAL assets. The situation is under control only as long as people continue their confidence in the government's ability to pay back. A slight loss of this confidence is followed by massive devaluation and the currency becomes 1/10th or even 1/100th of its value in Gold terms (a hyper inflation situation). The currency devaluation in the Far East and Russia are recent examples.

To understand the inherent weakness of the financial markets' one must try to recall the time when there was a run on US$ and everyone wanted to exchange their paper currency for Gold. The government realized that they did not have enough Gold to even partially replace the currency in circulation at the then fixed price. To save the situation it was then decided to let market forces determine the price of Gold. Gold prices then soared to US$ 800 per oz. In other words, those who trusted paper assets lost out heavily to those who held Gold and Real assets.

In countries where local currency is not convertible into Hard currency the situation is artificially kept under control. India is one such example. Current account deficit (Trade deficit) is taken care of by external borrowings. As the currency is not convertible, the speculators are kept out and volatility is curtailed. Borrowings have a cost and if trade deficit continues year after year then debt servicing is done by raising more debts. Such a situation can not carry on forever. The lenders such as IMF realize this and are trying to force such countries towards full convertibility so that demand supply forces determine the exchange rate. What the lenders do not understand is that when full convertibility is introduced then there is no way to prevent currency speculators from jumping in for quick profits. If the local currency has very little backing of REAL assets then it is bound to go into a free fall on a slight shift in people's confidence.

It is a common practice to talk about the foreign currency reserves of a country. Confidence in the country is directly proportional to free reserves. A high percentage of these reserves is held in US$ and a very small percentage is held in Real assets like Gold. It is a known fact that the Japanese and the middle East are the biggest investors in the US. The internal problems of Japan's economy or political considerations of middle Eastern countries or low oil prices or launch of EURO or any other reason may force withdrawal of investments from the US. Today the US$ enjoys the safe heaven status. This is despite the fact that the US debt has been rising year after year. The ability of the US treasury to honor its debt has not been threatened. At every given time there are more buyers than sellers of US$ denominated paper assets. In this context the Y2K computer problem is the most serious. Major and minor computer failures are expected around the world. What makes the Y2K problem frightening is that all failures will occur at the same time. People desire to hold on to real assets in times of widespread failures will most likely test the underlying strength of US$ based paper assets. If the US$ runs into a crisis of confidence then all the countries holding US$ reserves will find themselves holding paper of no REAL value. A crisis of confidence in the US would certainly mean death of the financial system as we know today. We would then have to build a new payment system based upon foundation of Real assets.

The following are some FAQs related to the Y2K problem.

• Will people queue up to buy canned food, drinking water, metals, commodities, gold etc. instead of holding Cash?
  
• Will it trigger a crisis of confidence in the paper currency and paper assets (stocks & Bonds) all over the world?
  
• If tested, will any government/treasury be in a position to honor its "promise to pay…"?
  
• Will the profits of all businesses suffer because of Y2K related expenses?
  
• Will there be a Global recession?
  
• Will the Stock markets (all over world) crash as a result of a global recession?
  

I refer to a news article posted at CNN where it is mentioned that the US FED is planning to hold an additional US$ 50 billion in its vaults up from $150 billion normally held in reserve. This is just in case people decide to withdraw more Cash from the Banks due to the Y2K computer crisis. What they have not yet visualized is that people are not going to hold this extra Cash in their pockets, they would, instead, put this Cash to work and buy goods. Too much Cash chasing too few goods would cause hyper inflation and result in shattering the people's confidence in their currency.

US Stocks and some European stocks have been trading at many times the Book Value. Stocks keep going up or down based on the sentiment. When the prices are going up then everyone buys in the hope of being able to sell higher. There are people willing to take loan and buy stocks. When the sentiment is negative people short sell in the hope of buying back cheaper. Therefore, stock prices rarely consider the Real value. In the current Bull trend every buyer has a lot of floating/paper profit. Y2K related costs are going to cause a big dent in the profits of all the companies. There are bound to be disruptions and the indirect costs are going to be extremely high. A Global depression is a worst case but highly probable scenario. On the side of extreme pessimism there has been a talk of Dow going down to 2000. Extreme high valuation of paper assets and extreme disregard for Real assets makes the current financial system very unsound.

Gold has been out of favor for a very long time. The Asian crisis and Russian Crisis have given an excuse to sell Gold. Analysts have cited slowing demand as people's purchasing power has gone down and is going down further. If Gold was in an up-trend then the same analyst would have cited Safe heaven status of Gold. US$, US stocks and some European stocks have been the favorites till now. Already there is talk of people storing canned food, water and buying generators and keeping Gold instead of Cash. If every American decided to hold an extra oz of Gold then additional 9300 tons of Gold would be required (more than 3 years worldwide production). People in India and China have traditionally looked at Gold as an item of value in times of crisis. With a population exceeding 2 bln these countries rely more upon humans than computers. The effect on these economies due to Y2K is expected to be comparatively less. A crisis in financial markets all over the world and inborn craze for Gold among the vast Indian and Chinese population could combine together to consume the floating Gold stock.

If one is convinced that a shake out in the financial markets is inevitable then the best thing to do is to cushion the fall. It may be worthwhile to consider the following:

• No borrowings and no leverage
  
• Hold some part of the portfolio in Real assets like metals and Real estate. The Loss would be smaller.
  
• Split the paper assets like currencies, bonds and stocks to cover as many countries as possible. Give higher weightage to those countries that have real assets backing their currency.
  

Sunil Madhok skmoi@emirates.net.ae 14 September 1998