Wednesday, July 22, 2015

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.


  1. Classic!!!!!

    Especially the last sentence. Go chase gold!!!! HA.

  2. This is an interesting article which i came across today which i like to share with you. Any comments ?

    Is China Lying About Its Gold Reserves?

    By Matt Badiali, editor, Stansberry Resource Report
    Wednesday, July 22, 2015

    The gold sector just took a big hit…

    On Friday, the People's Bank of China published its gold reserve figure for the first time since 2009. The official announcement said the country has just 53.3 million ounces of gold. That's less than half of what analysts expected.

    The news sent the gold price plummeting 16% from its January high. It's now at a five-year low.

    But this may be exactly what China wants. So that begs the question: Is China lying about its gold reserves?

    The short answer is: probably.

    China is a closed society, so information is tough to get and official numbers aren't reliable. And there are several reasons why the number should be higher.

    For example, when China reported its gold reserves back in 2009, it said it held about 33.9 million ounces. In its recent announcement, it said it had about 53.3 million ounces.

    That means China's reserves have grown at about 3.2 million ounces per year. At that rate, it would take China until 2079 to reach the same level of gold reserves as the U.S.

    This is highly unrealistic. I don't think China wants it to take that long. For starters, the president of the China Gold Association, Song Xin, said in July 2014 that China should accumulate 273 million ounces of gold to help support the renminbi as an international currency. This is more than the U.S. claims to have now.

    China is also gold crazy. In the past decade, it has ramped up domestic gold production. The country has been the world's largest gold producer for the past eight years. It should be the largest this year, too.

    At the end of June, the chairman and secretary general of the China Gold Association, Zhang Bingnan, said the Chinese produced more than 90 million ounces of gold domestically from 2007 to April 2015.

    And that doesn't include China's gold imports. The chairman of the Shanghai Gold Exchange, Xu Luode, said China imported nearly 50 million ounces of gold in 2013.

    Overall, Bloomberg Intelligence, a market analytics group, believes China has around 112.8 million ounces of gold.

    Remember, the official announcement said the country has 53.3 million ounces. So nearly 60 million ounces of gold are missing…

    That's why I believe China is "sandbagging" the market. In short, by reporting low gold reserves, China has created a lower gold price. This allows the country to import gold more cheaply.

    We've seen this type of move before…

    The U.S. Treasury has criticized China for years for "significantly" undervaluing its currency. You see, keeping the renminbi weaker makes China's exports cheaper to the rest of the world.

    We can't know for certain how much gold the Chinese hold. But regardless of whether or not China is lying, I still believe gold prices are likely headed higher. As I've shown you in these pages before, sentiment toward the metal is terrible – which points toward a bottom.

    And world banks are printing massive amounts of money right now. Europe, Japan, and China have all followed the U.S.'s lead in adding money to their systems to boost their economies. By doing this, they're devaluing their currencies. For example, the euro has fallen 20% versus the dollar in the past year.

    With the world's governments continuing to print more and more paper money, it will take more and more of it to buy gold.

    Unlike paper currency, you can't just print more gold. There's a finite amount of it in the world. According to market research firm Thomson Reuters' 2015 GFMS Gold Survey, just 5.9 billion ounces of gold have been produced to date.

    That's why I'm using the recent decline in gold prices as an opportunity to build up my personal gold holdings. You might want to do the same.

    Good investing,

    Matt Badiali

  3. Salam,

    Paper money being backed by GDP is seem ideal. However, China is one of the country continually accused of devaluing their currency. Sure, they have assured us they have not resorted to such measure currently, one still can't overlooked that their economy is slowing down. Suppose they do decide to devalue their currency in the future, shouldn't the decision affect other countries that hold their reserve. Or have I misunderstand the concept of monetary policy here. Does the possible devaluation of currency hold insignificant matter for it to be considered as reserve.

    1. @akubas86

      You're confusing two similar sounding terms. China to my knowledge has only ever devalued the Yuan once, about 22 years ago. A propensity for devaluing the currency would certainly be grounds for not using it a a reserve currency, but not for ruling it out entirely.

      The British Pound and French Franc (while it was still around) are and have been used as reserve currencies, despite undergoing multiple devaluations in the 1950s-1960s.

      China on the other hand, has often been accused of undervaluing (not devaluing) their exchange rate.

      This may sound the same, but are really two very different conditions. In a devaluation, which is always in the context of a fixed exchange rate regime, the exchange rate is moved from one administered level, to another but weaker one.

      An undervaluation on the other hand, refers to a situation where a currency is deemed to be weaker than is justified by its economic fundamentals.

      Currency valuation remains a somewhat contentious issue in the economics profession, as different currencies are affected by different fundamentals, and these fundamentals are constantly in flux.

      Thus you can have a situation where the market exchange rate does not change, yet the degree of over- and under-valuation might significantly.

      To take on example, during the period when the MYR was fixed to the USD, it gradually went from being undervalued, to being overvalued, all while maintaining a RM3.8 to US$1 exchange rate.

    2. I would explain it in simple terms that the large balance of payment/current account surplus that China has accumulated because of its trade exerts upward pressure on the yuan, leading it to be undervalued at current parity. But as with fixed exchange rates, the central bank has to buy up foreign currencies(USD) with yuan to prevent the yuan from appreciating and maintain the parity

    3. I would explain it in simple terms that the large balance of payment/current account surplus that China has accumulated because of its trade exerts upward pressure on the yuan, leading it to be undervalued at current parity. But as with fixed exchange rates, the central bank has to buy up foreign currencies(USD) with yuan to prevent the yuan from appreciating and maintain the parity