China still on the gold rush

2011-DEC-27

Gold and silver prices have fallen slightly on news of a clampdown on gold trading in China.

According to Reuters, Chinese regulators have stated that the Shanghai Gold Exchange and the Shanghai Futures Exchange are enough to meet investor demand for spot gold and futures trading. In the words of the People's Bank of China, the Ministry of Public Security and other regulators: 'No local authority, institution or individual is allowed to set up gold exchanges.' They cite lax management and evidence of illegality as reasons for the crackdown.

However, other news from China is more bullish for the yellow metal. In particular, comments reported in China Daily from a senior official at the People’s Bank of China (PBC) – the country’s central bank – indicating that the Chinese government should continue acquiring gold as a means of diversifying its foreign exchange reserves, as a means of moving away from US dollar and euro denominated assets. US Treasuries currently make up one third of the PBC’s assets, with euro assets around 20% of its assets. The Bank also holds 1,054 tonnes of gold, according to the latest data from the World Gold Council.

In the words of Zhang Jianhua, director of the research bureau affiliated with the PBC: 'The Chinese government should not only be cautious of the imported risk caused by rising global inflation, but also further optimise its foreign-exchange portfolio and purchase gold assets when the gold price shows a favourable fluctuation… No asset is safe now. The only choice to hedge risks is to hold hard currency – gold.” This news comes on the heels of reports that China and Japan are to engage in increased yen-yuan currency trading, aimed at reducing currency risk and reducing trade costs. Japan will also apply to buy Chinese bonds next year. Currently around 60% of trade transactions between these two nations are settled in dollars.

As the China Daily article points out, however, the country’s communist leaders face a dilemma. Though gold mining in China is currently adding to PBC reserves at the rate of around 300 tonnes per year, this is too slow an acquisition pace for the Chinese government. The 1,054 tonnes currently held by China represents just 1.8% of the country’s total foreign exchange reserves. To put this in perspective, the USA’s (presumed) official gold reserves of 8,133 tonnes represent 76.6% of America’s foreign reserves, while Germany’s 3,396 tonnes make up 73.7% of its reserves.

The Chinese cannot buy in the open market without causing a price spike – which would likely go hand-in-hand with a fall in the value of the dollar and Treasuries, thus shooting themselves in the foot. Yet as long as they remain reliant on domestic gold production to slowly increase their reserves, they remain vulnerable to falling mine production as well as the risk inherent to its currency reserves.

This risk is especially relevant to its dollar holdings, given the Obama administration’s stated aim of doubling US exports from 2010 to 2015. This can only be accomplished by a drastic devaluation of the dollar – something that will obviously hurt the Chinese central bank, given its huge exposure to the greenback.

This drastic devaluation of the dollar will of course mean higher precious metal prices.