Gold and money have had a close relationship for thousands of years. So close that, for many centuries, they were the same: gold was used to pay for goods and services. Subsequently, money was born that, at first, was backed by the precious metal. But even when gold stopped supporting so-called fiat money, its influence on international currencies is very important. In this post we are going to explain how gold affects these currencies.
For hundreds of years, gold was used by men as a means of payment: first, in the form of dust or nuggets and, later, as coins minted by the mints of different kingdoms.
The appearance of local currencies and banknotes, which for many years were backed by gold itself, changed the concept of money.
This evolved until it was no longer backed by gold and based on the trust of citizens in the state that issued it. That is why current currencies are called ‘fiat’ money , that is, based on trust.
However, gold has never ceased to exert its influence on the value of world currencies. In fact, there is an important correlation between its value and the strength of the currencies that are quoted in the international markets.
As explained by Investopedia , to understand the relationship between gold and international currencies, five characteristics of the precious metal must be taken into account:
Gold was used for centuries to back currencies
Precious metals were used to mint legal tender coins from the 6th century BC. C., a system that worked for many centuries.
However, paper money, that is, money backed by gold or silver, did not appear until the 9th century in China, when bills began to be used as promissory notes, which were backed by the number of pieces of gold or silver that was stipulated in them. In this way, merchants could transport money more comfortably and safely.
This formula spread to various states, empires and kingdoms, which began to support the currency they issued with precious metals. The system was established internationally in the 19th century and continued to function, with a fixed exchange rate, until the aftermath of World War I led to the currency crisis and hyperinflation of the Weimar Republic in the 1920s (see image). and the Great Depression of 1929 .
When the Second World War was about to end, in July 1944, representatives of 44 countries met at Bretton Woods (New Hampshire, USA) , to bring to light the agreements of the same name, which established the dollar as the international exchange currency, with a convertibility in gold at a rate of 35 dollars an ounce.
This system worked until 1971, when President Richard Nixon ended the convertibility of the dollar into gold, due to the enormous expense derived from the Vietnam War and the scarcity of precious metal in the United States reserves.
Until then, the states could not print all the banknotes they wanted, since they had to be backed by the same amount of gold, deposited in the national reserves.
Since direct convertibility ended and they based their currencies on the trust of citizens, countries have been tempted to print more banknotes when they need financing, which has triggered inflation.
Gold is a hedge against inflation
Precious metals, and gold in particular, are considered the best hedges against inflation: investors tend to buy large amounts of gold when the economy hits high levels of inflation.
The precious metal has a greater capacity than any other asset to retain value, as we saw in another post on this blog, dedicated to stores of value .
In April 2011, for example, the fall in the value of fiat currencies spooked investors into buying gold, sending its price up to $1,550 an ounce.
This bet on gold indicated low investor confidence in world currencies and instability in the global economy.
The price of gold affects the countries that import and export it
The value of a nation’s currency is strongly linked to the value of its imports and exports. Thus, when a country imports more than it exports, the value of its currency falls.
On the other hand, the value of its currency increases when the country is a net exporter, that is, it exports more than it imports.
For this reason, countries that export gold or have access to gold reserves will see their currency become stronger when the price of gold rises, since this means that the value of the country’s total exports increases.
In this way, an increase in the price of gold can cause a trade surplus or help to cover a deficit.
Conversely, countries that specialize in the manufacture of gold products but have no production of their own (such as India, which has come to import more than 900 tons of metal per year) will inevitably end up with a much weaker currency when raise the price of gold, as they become net importers.
Buying gold tends to reduce the value of the currency used to buy it
As explained by Investopedia, when central banks buy gold, it affects the supply and demand of the local currency and, ultimately, can cause an increase in inflation.
This is because central banks rely more on printing money than increasing their gold reserves, which creates an oversupply of the local currency, which depreciates against other currencies.
The price of gold is used to measure the value of a local currency
Gold has been mistakenly used as an indicator to measure the value of a country’s currency. While there is undoubtedly a relationship between the price of gold and the value of a fiat currency, it is not always an inverse relationship, as is often believed.
For example, if there is significant demand from an industry that requires gold as a raw material, this will cause the price of the metal to rise. But this has nothing to do with the local currency which, at the same time, can be highly valued.
As they explain from Investopedia, gold has a profound impact on the value of world currencies. Even after the so-called ‘gold standard’ is abandoned , the precious metal can replace fiat currencies and act as a hedge against inflation.
Without a doubt, gold will continue to play an important role in the international currency markets. The world’s central banks continue to rely on it to form part of their reserves. In fact, in the case of some like the US Federal Reserve , gold constitutes almost 80% of them.
The confidence of international central banks in gold is growing: a recent Central Banking survey among representatives of 26 central banks around the world reveals that 62% of them are willing to increase their gold reserves in the next 12 months.
And above all, we must not lose sight of the fact that, in times of economic crisis, currency devaluation or hyperinflation, whoever has gold at hand truly has a treasure.