Nations attempt debt tricks worthy of a spoilt child

The principle reason why the world economy is suffering is the realisation that most of the western world economies are on the brink of bankruptcy.

My son this week started his new student life at Bristol University, where he will study mathematics and economics. It has been a long and tortuous path, but he has made it in grand style (two A* and an A) and I am very proud of him.

Part of the survival package is that he will take a government loan of £6,000 (Dh34,344) in each of his three years, with his ever-loving, ever-supporting father providing another £8,000 per annum. I sat down with him a few weeks ago and estimated his daily expenditure and we figured that this amount of money would be sufficient for an enjoyable, but not extravagant, life.

This is a large loan for him, but he knows the lifestyle that he wants and is willing to do this in the belief that the education will enhance his future prospects and his ability to pay back the debt. This kind of budgeting exercise is pretty straightforward and if my 18-year-old son can do it and commit to the loan repayment, I wonder why the governments of the western world find it so difficult.

The principle reason why the world economy is suffering so much at the moment is the realisation that most of the western world economies are on the brink of bankruptcy. In Europe, the Greek population, unlike my son, seems unwilling to accept that they should pay back their loans and are waiting for their surrogate "father" - the so-called troika of the International Monetary Fund, the European Central Bank and the European Commission - to bail them out. And, in the United States, where the mountain of debt is quite horrendous, they are contemplating another round of money printing (euphemistically referred to as quantitative easing) that will debase the value of the currency and lead to inflation. It's a neat but dubious way of reducing the value of the loan they need to repay.

No wonder investors have lost faith in the world's equity markets and its major currencies and have been turning to gold and, to a lesser extent, silver as a substitute for cash. Over the course of this year, gold has risen by more than 30 per cent to its recent high of US$1,920 (Dh7,051) per ounce. Equity markets, on the other hand, have lost anything from 10 per cent to 25 per cent, with the biggest losses coming from Europe (excluding the UK), Asia and emerging markets.

But hang on a minute, I hear you say, gold in the past few weeks has fallen 20 per cent to $1,534 and silver fell off the cliff with a 41 per cent drop from its August high. This is hardly the performance that you would expect from an asset class that is widely regarded as the ultimate "store of value". In a perfect storm, where investors panic or lose faith, all asset classes appear to be correlated and move down together. Even gold appears to be suffering.

So, if you can't trust paper money (because of inflation and/or devaluation) and gold has lost its shine, what can you do to maintain your asset value? You move to the safest haven you can find, which, at the moment, is judged precariously to be US Treasury bills. The US economy may be in a dire state, but the US government has never failed to pay back its debts for more than 200 years. And this is why the US dollar has been rising in value against most other currencies and especially against the euro. But it will not last.

Much of the recent fall in gold's price was caused by investors having to generate cash to settle debts. And gold was the only asset in their portfolios showing any profit. The price has already started to climb back.

Many analysts believe that gold will get back on track because the world's economic woes will not be solved quickly. If you believe this, but are reluctant to invest in gold in case it rises and falls again, then you might consider investing in the Auto-Call Note currently available from Citigroup.

The performance of this note is linked to the price of gold and silver in a very interesting way. Your money is invested on October 13, when the opening "strike" price of gold and silver are determined. After six months on a specific "observation date", the new price of gold and silver is determined. If both prices have risen above the original strike price, then you get paid 6.625 per cent plus the return of your capital.

If this is not the case, then your money is rolled over for another six months and so on, until both prices are higher than their strike price. If this happens after three years, for instance, you will get back six times 6.625 per cent plus the return of your capital.

This is looking pretty good so far. Eventually, the two prices must surely increase, especially since they are currently way down from their recent peaks. Something has to give somewhere and it does - in the form of a limited five-year term and the potential loss of some of your capital.

If, after five years (and 10 observation dates), gold and silver have both failed to increase in price, then you will not receive any dividends. However, your capital will be repaid in full on the proviso that neither gold nor silver has dropped by more than 40 per cent from its strike price set five years earlier. If this is not the case and gold, for example, has dropped by 41 per cent, then you will lose 41 per cent of your capital. This is equivalent to having invested all your money at outset in gold.

At this point in time, with gold and silver both having experienced significant falls in price, this looks like a reasonable bet. And is an interesting way of capitalising on the potential rise in the value of these precious metals.

Minimum investment is $50,000, but it is available through portfolio bonds at about $20,000. In addition to the market risk, you must also be aware of the bank's ability to pay back your capital. If the bank goes bust, as Lehman Brothers did, then your capital is at risk.

Bill Davey is a wealth manager at Mondial-Financial Partners in Dubai. Contact him at [e-mail]