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Sanctions Busting, European Style

This blog post is a guest post on BullionStar's Blog by the renowned blogger JP Koning who will be writing about monetary economics, central banking and gold. BullionStar does not endorse or oppose the opinions presented but encourages a healthy debate.

U.S. officials were infuriated last week when Germany, the UK, and France unveiled plans to create a European payments channel to help Iran to avoid U.S. sanctions. Even more surprising was their chosen allies: in announcing their sanctions busting plan, the Europeans were joined by Russia and China.

There has been very little detail provided on the proposed payments channel. The press release describes it as "a Special Purpose Vehicle, to facilitate payments related to Iran's exports (including oil) and imports." Nor did EU High Representative Federica Mogherini's comments after the press release contain much information about the special purpose vehicle's technical specifications, other than to say that it would be "opened to other partners in the world."

Despite the lack of particulars, I'll make some educated guesses in this post about the intended role of the Special Purpose Vehicle (SPV) and how it will be designed. I think that the SPV will probably be able to carve out some space for the rest of the world to engage in Iranian trade, but we shouldn't overestimate its power. The U.S., after all, wields an incredible amount of economic might and under Trump hasn't been shy about deploying it.

Trump leaves the Nuclear Deal

The background for the creation of the new European payments channel is the Trump administration's recent departure from the Iran nuclear deal, officially known as the Joint Comprehensive Plan of Action (JCPOA). This was a deal signed by the France, UK, Germany, U.S., Russia, and China, or the E3+3, in 2015. The JCPOA promised to normalize Iran's economic relations with the rest of the world in return for fully-audited limitations on Iran's nuclear efforts.

The U.S.'s exit from the JCPOA this spring brought with it a re-imposition of the same harsh U.S. sanctions leveled on Iran prior to the deal. The most damaging of these, oil-related sanctions, will go into effect on November 4. Oil is by far Iran's largest export. Without the ability to export oil, Iran can expect to be stuck in an autarkic limbo.

In response to the U.S.'s re-imposition of sanctions, many multinational companies that had previously recommitted to Iran after the JCPOA's passage have been exiting, including Total, Daimler, Maersk, and Mitsubishi UFJ. Nevertheless, Iran continues to keep its end of the deal, the International Atomic Energy Agency verifying that it is implementing its nuclear-related commitments. But the economic damage that the U.S. is creating threatens to undermine the remaining five signatories' pledge to normalize economic relations with Iran. If Iran ceases to get enough economic benefits from the JCPOA to justify its promise to give up on nuclear weapons, it may simply walk away.

The E3+2's new payments channel is an attempt to counteract some of the negative economic effects of the Trump administration's sanctions and thus keep Iran in the deal. To gauge the effectiveness of the tool, we first need to touch on how U.S. sanctions work.

Blacklists: Economic Weapons of Mass Destruction

The U.S. has been using a set of blacklists to sever Iran from the global economy. These blacklists were devastatingly effective during the previous round of Iranian economic sanctions (2010-2015), and given the current parade of multinationals leaving Iran, they have not lost any of their potency.

Some of these blacklists designate specific individuals, companies, and organizations owned or controlled by Iran as offenders. The National Iranian Tanker Company (NITC), for instance, has landed on one of the U.S.'s lists, as has Bank Melatt, one of Iran's largest banks. Another set of blacklists targets activities. For instance, buying Iranian oil has been blacklisted, as has the sale of automotive goods to Iran.

Any foreign institution that does business with blacklisted entities, or engages in blacklisted activities, will be sanctioned by the U.S. The punishment for this involves a restriction of access the U.S. economy. This might mean no longer being able to business in the U.S., having its access to U.S. currency curtailed, or being cutoff from U.S. financial markets and banks.

For instance, a European bank that facilitates Iranian oil purchases may find that it can no longer open a correspondent account with U.S. banks. These sorts of accounts are vital for facilitating U.S. dollar payments. A European auto parts firm that sells suspension systems to Iranian automakers might find that it can no longer buy products from U.S.-based car parts companies. Because losing access to the U.S. economy is so much more damaging than being unable to transact with Iran, many companies have chosen to comply with U.S. sanctions and have left Iran.

The only companies that will risk doing business with blacklisted organizations or deal in blacklisted commodities are those that have no connection to the U.S., and thus little to lose. Government-owned enterprises might qualify. For instance, Chinese and Indian state-owned refineries have little need to access the U.S. market, and can therefore serve as natural buyers of blacklisted Iranian oil.

This option has its limits however. If Iranian oil traders were to sell exclusively to Chinese and Indian buyers, they can expect to be paid with Chinese yuan or India rupees. But Iranians need to import a broad variety of products and services, many of which China and India simply cannot offer. The result would be large amounts of sterile yuan and rupees accumulating unspent in Iranian accounts.

A European tool for countering U.S. Blacklists

This is where a European payments option may come in handy. Large European firms simply cannot afford to export to Iran or buy Iranian oil. The biggest refiner in Europe, for instance, is France's Total. Because it has 6,750 employees in the U.S. and millions of American customers, Total has too much at stake to risk offending American rules. But as Iran sanctions veteran Richard Nephew points out, European small & medium size enterprises (SMEs) may step up as a group of "willing to be sanctioned." These European SMEs might not have U.S. subsidiaries nor depend on U.S. supply chains, and little to lose from being sanctioned. If so, they would be able to provide Iran with the sorts of goods and services that India and China cannot export.

To complete this European connection, Indian and Chinese firms would have to open euro denominated accounts in Europe. They could then buy a portion of their Iranian oil imports with those euros. These euros would flow into Iranian accounts, only to be spent  at European SMEs, say to buy manufactured goods, which would be sent back to Iran. The SMEs could then draw down their euro accounts to pay their employees and suppliers.

The recently announced European SPV could be a way to formalize this trading circuit. All three groups - Indian & Chinese state-owned refiners, Iranian oil merchants, and European SMEs - would establish euro denominated accounts at the SPV. The SPV would act as a euro-based clearing house between these various parties, matching buyers with sellers. In theory this clearing function could also be provided by private European banks, but in practice they would be wary of playing such a role due to concerns about being punished by the U.S. A newly-constituted SPV that has no U.S. function or appendages needn't share those concerns.

The effectiveness of this payments channel depends on how many European SMEs would be willing to participate. In our interconnected world, many SMEs will have some sort of existing U.S. connection, whether these be American suppliers or customers, and may not be willing to jeopardize this relationship. If a limited number of SMEs sign up to use the SPV, only a small amount of oil trade will be settled in Euros, and Iran will find that the SPV does not provide them with much shelter from sanctions.

It is possible that European governments could incentivize SMEs to join the SPV arrangement.  The European Union's ‘blocking statute’, for instance, would allow SMEs to recover damages that might result from sanctions. The blocking statute was originally proposed by the EU in 1996 to counteract an American trade embargo on Cuba and sanctions related to Iran and Libya

However, if an SPV were to become too successful, that would doom it. An SPV that attracts large amounts of European exporters would encourage Trump to advance the front lines of his sanctions war and attack the SPV participants themselves. He would go about this by blacklisting all European SMEs that are directly engaging in SPV-backed Iran trade. European suppliers to these black-listed firms would suddenly face immense pressure to stop doing business with their black-listed customers. Even if blacklisted SMEs have no direct U.S. dependencies, odds are that their domestic suppliers will have some sort of vital connection to U.S. supply chains or customers. If they wish to retain this connection, these firms will have to immediately dissociate from SMEs that engage in Iran trade.

Additionally, European banks would face pressure to freeze the accounts of black-listed SMEs for fear of being cut off from the U.S. banking system. This combination of a collapsing supply chain and an exile from the banking system would leave blacklisted European SMEs incapable of doing business not only with Iran, but everywhere else too. In short, they could go bankrupt.

One way or the other, American dominance of the global economy necessarily limits the ability of any European SPV to successfully bust U.S. sanctions. It is certainly possible that the creation of a new payment channel encourages some round-trip trades, say between India/China, Iran, and European SMEs, that wouldn't otherwise occur. But in the end, the European SPV can never nullify the effects of U.S. sanctions, it can only slightly dampen them. It remains to be seen if this will be enough to keep the Iranians in the JCPOA.

Oil & US Dollar & Gold

In the midst of upwards trending oil prices a decade ago, a US senate committee recommended actions to curb the high oil price to mitigate the negative effect on growth.

Ok, great, the oil price went from north of USD 140 in 2008 to around USD 30 now.

But now, mainstream economists are disappointed that the sliding oil price hasn’t had much positive effect on growth and instead tell us that a decreasing oil price is a double-edged sword at best and a threat to the US economy at worst. This despite the US being a net importer of oil, importing about 20 % of its oil consumption.

oil production US

Source: Cornucopia

According to most mainstream economists, a fall in prices, oftentimes mislabelled as deflation, is a horrific thing that must be avoided at all costs.

Before countering the deflation scare, let us first establish that deflation by definition is a shrinkage in the money supply whereas price deflation is the resulting effect of the general price level for goods and services when the money supply decreases.

The mainstream economist argument is that price deflation is bad because people are said to hold off consumption anticipating even lower prices in the future. Really?

Do people hold off their oil consumption because of falling prices? Do people hold off their consumption of food if prices are anticipated to fall? Are people waiting to buy a mobile phone if the price of the product is anticipated to decrease in the future?

Global oil production has increased, with a corresponding price decrease, in recent years due to innovative technological advancements.

The decreasing price of oil is, despite its negative short-term effects on the producers, a positive event enabling the economy to operate more efficiently. Less resources and costs are needed to produce and consume 1 litre of oil today compared to a year ago. The resources liberated from the increased efficiency can instead be put into something else and thus increase productivity further.

US Dollar

We already know that the banking system is inherently incentivizing reckless debt behaviour to the extent that banks have got to increase their balance sheet continuously, for the fractional reserve based monetary system not to collapse.

Savings used to be the backbone of an economy. With savings, it was possible to accumulate capital used for investments. Nowadays, savings has nothing to do with investing as the money is simply created out of thin air as debt by commercial banks and called capital.

Today, debt, and particularly US Dollar denominated debt, is used as a store of value around the world. This skews everything.

A strong US Dollar is to be expected in such a system.

The US Dollar will continue to strengthen until… it collapses.

The US has been running a trade deficit for some four decades by now and has in the process accumulated a humongous national debt.

How is that even possible?

According to Economics 101, the currency of a country running perpetual trade deficits is supposed to depreciate to balance the trade. With a depreciating currency, imports will be more expensive and exports will be cheaper for others to buy. The trade deficit will thus decrease.

This doesn’t happen in the US though. Why?

The reason is that the value of the US Dollar, functioning as a reserve currency, is dictated by the (savings) demand for the US Dollar in the rest of the world. The US doesn’t have a choice on whether to run a trade imbalance or not. It’s the net producing countries (read China) exporting to the consuming countries (read USA) that is dictating to what extent the US can utilize the exorbitant privilege of issuing debt in the world’s reserve currency.

It’s the demand of the US Dollar as a reserve currency that sets the pace. For the US Dollar to function as a reserve currency, the US is required to run trade deficits for the purpose of distributing US Dollars to the net producers/savers.

When savers save in the same medium as is used for the Medium of Exchange, a collapse always follows the monetary expansion when the debt savings are undone. The trigger point of this may very well be when the flow of physical gold dries up. Freegold is instructive in explaining the mechanism that is likely to correct the current imbalance between the paper world and physical world.

The Prudence of Saving in Gold

Following a collapse of our monetary system, it will be vital to own gold as a store of value. Paper assets will no longer matter. For us to get a glimpse at life beyond this transition, India may provide a good example since basically the whole population are avid gold savers.

In India, people have protected their wealth with gold over generations. For Indians, gold is an asset class that bridges inequalities by giving individuals a shot at protecting themselves against foolish government policies. The government does everything in their power, with the Indian trade deficit as their go to excuse, to have people surrendering their gold. The government has introduced a gold monetization scheme, there’s gold import duties, documentation requirements for buying gold and campaigns to convince people to open bank accounts.

Who’s right? The government or the people?

Let’s compare the track record of the Indian Rupee versus Gold. At the start of 1960, 1 gram of gold cost 5.37 Indian Rupees. On 1 February 2016, 1 gram of gold cost 2,443.59 Indian Rupees excluding the premium stemming from the 10 % import duty. The Indian Rupee as measured in gold has thus lost about 99.8 % of its value since 1960.

Indians don’t expect the government to take care of you from cradle to grave, they realise that they need to save to educate their children and to look after their aging parents and themselves when retiring.

Isn’t the world upside down when prudent savers have to fight the government’s reckless policies to keep their wealth?

When fiat money hyper-inflates, paper gains or paper deficits will no longer matter. Owning physical gold will.