China, Gold and Reserve Currencies

In case you missed it, gold looks to be declining again (USD per troy ounce):

But let’s keep some perspective:

It’s still way above where it was a decade ago. Personally, I’d be looking for an eventual pullback to the USD600-800 range, but hey don’t listen to me – I’m no great shakes at forecasting commodities.

In any case, what I want to write about today is one of the purported reasons for this week’s price decline –the PBOC’s announcement of its gold holdings last week.

At 1,658 tonnes, China’s gold reserves are nearly 60% higher than it was six years ago, and is the fifth largest hoard in the world. The kicker was that this was well below market expectations – people were thinking something like 2,000 tonnes or more. The news that the PBOC hasn’t bought as much gold as people thought helped push gold down to USD1,100 per ounce.

What I found strange about some of the commentary (here for instance) is the claim that because China is keen on internationalising the Yuan and turning it into a major reserve currency (including inclusion in the IMF’s SDR), they should have been buying more gold to provide people “confidence” in the currency. Hence the wedge between reality and market expectations.

But that’s a bogus argument. Given that gold is nowhere near backing any significant amount of the global money stock, adding more gold “backing” to the Yuan will go nowhere.

The real policy move towards making the Yuan more internationally accepted was announced this Monday, but with much less fanfare or commentary.

To wit:

In landmark move, China opens up interbank bond market

SINGAPORE (REUTERS) - China has announced a landmark liberalisation of its domestic bond market only weeks after clamping down on the stock markets to halt a crash.

The People's Bank of China has granted full access to the 25 trillion yuan (S$5.49 trillion) interbank bond market to overseas central banks, sovereign wealth funds and international financial institutions.

The move indicates that the internationalisation of the renminbi, or yuan, remains on track despite the recent turmoil in the country's stock markets….

For the Yuan to become a top reserve currency, you need other central banks to be willing to hold that currency as part of their own international reserves. Reserves are not held as bank deposits or vault cash – that would entail an opportunity cost for the central bank holding those reserves. On the other hand, they aren’t likely to go for higher risk, higher return investments like equities because of the need for security and liquidity (but especially liquidity).

So the first requirement of a having a reserve currency is a highly accessible, deep, broad and liquid bond market. Not more gold.

The two key steps China has to fulfil is allowing unrestricted foreign access to its bond markets, which is why Monday’s announcement was so critical. The other requirement is to increase the availability of sovereign and quasi-sovereign debt securities. The irony of having or aspiring to have a reserve currency is that the government ends up borrowing a lot (Japan anyone?). That’s a bit more problematical.

China’s official government borrowings are a relatively “low” 41% of GDP last year. Contrast that with Japan’s 230%, 105% in the US, and 94% in Europe (all as of 2014). There’s plenty of Chinese quasi-sovereign debt (local government, SOEs), but how safe or liquid these are I won’t hazard a guess. My bet is that other central banks would only be comfortable with official sovereign debt, and give the quasis a miss. The lack of sufficient government debt papers would therefore be a significant hindrance to international adoption of the Yuan. Not insufficient gold reserves.

But in one sense, the goldbugs are right. Government debt is “backed” by the monopoly governments have on the right to tax. Tax revenues in turn are a function of the ability of an economy to produce goods and services. What’s really backing all currencies in the world today is really the indirect claim on national income – paper money is backed by the much more tangible GDP.

Not, dare I say it again, gold.