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Gold, the U.S. Dollar, and the Yuan

In late April, a Chinese sovereign wealth fund, the State Administration of Foreign Exchange, announced that China had purchased 454 metric tons of gold over the past six years. Officials indicated that this increase was accomplished by tapping domestic mine supply and refining scrap gold. As China reported gold production of 282 t last year, the reserves have absorbed about 25% of this output since 2003.

China now has the fifth largest official gold reserve, 1,054 metric tons, surpassing Switzerland. While this was a 76% jump in gold holdings, the yellow metal is still only 1.6% of China's foreign reserves. Just to reach the global average of 10.5%, China would have to grow its gold hoard to nearly 7,000 t.

This announcement was a huge coup for the Gold Anti-Trust Action Committee (GATA), which has reported since 2003 that China was surreptitiously buying large tranches of gold. Contrary to the official communication, GATA's intelligence indicates that China's purchases were made on the open market through intermediaries in New Zealand and Australia. Ellison Chu, director of precious metals at Standard Bank in Hong Kong, backs the GATA theory that China has obtained foreign gold, stating that "China has been buying via government channels from South Africa, Russia and South America." I would be astonished if China hadn't purchased significantly more than 400 metric tons, and are continuing to carefully accumulate every time the price is slammed by the Gold Cartel. Notably, none of the mainstream gold analysts accounted for this huge Chinese demand, nor have they acknowledged they were totally wrong about their supply numbers.

Why Announce It?

China reported six years of purchases at once, but why admit to buying gold at all? Officials stated they were contemplating raising the nation's gold reserve to 4000 t back in November, which was clearly a hint as to their intentions. However, the Chinese were unchallenged about their static claim of 600 metric tons of gold, so there was no external impetus for them to disclose their activity in the metals market. In fact, the gold price rose sharply after the announcement, making any purchases in May and June much more expensive.

I believe this gold news was a "shot across the bow" to warn about the irresponsible speed at which the Federal Reserve is debasing the U.S. dollar. While I believe that China holds much less of its reserves in dollars than is generally assumed, the Chinese government does not appreciate the attempt to dilute the nation's Treasuries to near worthlessness. This dovetails with a suggestion by both China and India that the IMF sell its 3217 t of gold to help poor countries, implying they want to buy it all. Even if China purchased the whole lot, it would cost $103 billion at $1000 per ounce, just 5.25% of the country's reported forex reserves. The IMF may finally carry out its threat to "sell" 403.3 metric tons of gold, but this is likely just accounting for the central bank reserves that have already been leased clandestinely and moved East into strong hands.

China's announcement is very bullish for gold, as it will encourage other central banks to buy in addition to those already doing so like Russia and Venezuela. With the legitimacy bestowed on gold as a monetary asset, and the justified criticism of Britain's gold sales in 1999, many nations will follow Germany's lead and refuse to sell more gold. Large private investors as well as other sovereign wealth funds are likely to copy the Chinese. In fact, trader John Paulson's giant hedge fund is heavily weighted in GLD, which purports to hold real metal. As fiat currency loses the confidence of the public, the "barbarous relic" will become the money of choice.

Golden Yuan?

China's increase in gold reserves has another more profound implication that most commentators haven't realized. It's clear to me that China has plans to replace the U.S. dollar as a reserve currency with an at least partially gold-backed yuan. I have to give Jim Sinclair credit, as he predicted the Chinese were moving to a gold-backed yuan in 2002 as part of their "long term plan of Economic Ascendancy." He deduced that the Chinese government allowed the private ownership and sale of gold by their citizens in order to re-monetize gold. China has experienced the folly of paper money many times before and - as Mr. Sinclair puts it - "their memory is culturally infinite." The Chinese are aware they must step in to facilitate the move back to hard money.

China is doing little to hide its intentions. Chinese officials have long complained about the excesses allowed by the dominance of the USD, and have recently called for the use of Special Drawing Rights to settle trades. In April, the Chinese completed currency swaps with many countries including Indonesia, Malaysia, South Korea and Argentina for use in bilateral trade, avoiding the USD. The BRIC countries (Brazil, Russia, India, and China) just discussed a "supranational" currency to reduce dependence on the U.S. dollar at a summit in June, and American officials were not permitted to attend.

However, to have a true reserve currency, China would need to allow full convertibility. The Chinese government would need to loosen the trading band which manages the yuan-U.S. dollar exchange rate. The yuan has gained more than 6% since the dollar peg was eliminated in July 2005, but the currency is sure to rise sharply if permitted as it's clearly undervalued. However, the central bank will be reluctant to let the currency float freely with exports down sharply.

Nevertheless, China is now selling yuan-denominated bonds domestically as an intermediate step, and allowing some import and export contracts to be settled in yuan for the first time. To ease out of supporting the dollar by suppressing the yuan, China's central bank is transitioning toward shorter term Treasuries to increase its flexibility. Zhang Guangping, vice head of the Shanghai branch of the China Banking Regulatory Commission, has mentioned plans to transform Shanghai into a financial center to rival New York and London by 2020. This would clearly require a floating currency with a much higher relative value.

Of course, China will make sure the transition leaves it as the world leader for the 21st century. Even with only 5% of forex reserves in gold, the yuan would be a serious contender for reserve currency status. The European nations have sold much of their gold since 1990, and the U.S. hasn't allowed an audit of its alleged 8,136 tons of metal since the 1950s. With the additional assets of commodity stockpiles and the dominant manufacturing economy, China is going for all the marbles. History has shown that the dominant country has the dominant currency, from the Romans through the British Empire.

Paper currencies are backed by faith and confidence in the nations that issue them. As the Federal Reserve prints the dollar to worthlessness with its "quantitative easing," governments will increasingly question why they hold paper promises that are rapidly losing their value. They will look for a market big enough to diversify into. With over 1.3 billion potential consumers, China is certainly large enough. While I believe many countries will follow the Chinese lead and will secure strategic commodities like oil and copper, it would make sense to acquire the yuan if this was a viable option. For many nations across the globe, China is their largest trading partner. It's inconvenient and adds expense to acquire USD when not even purchasing goods from America.

Once the yuan has gained the status of pre-eminent global currency, China will have many advantages currently enjoyed by the U.S. dollar. Even when not conducting business with China, countries will use yuan. The Arab states will accept yuan in exchange for oil, and demand for this essential fuel will keep the currency strong. Commodities like wheat will be priced in yuan per kilo, not dollars per bushel. Once China improves the transparency and governance of its banking centers, capital will migrate from the West to the East. Nations will accumulate the Chinese equivalent of U.S. Treasuries.

For those who doubt this outcome, I want to stress that China's ascendancy will not occur overnight. It will take a few decades as China rises and the American star fades. However, few British citizens envisioned the end of their Empire at the dawn of the first World War, even though their nation would soon be eclipsed by their former colony, the United States. Paradigm shifts only seem obvious in hindsight. Change moves slowly until the end, when the poles seem to shift overnight. Share/Save/Bookmark

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© 2009 Jennifer Barry

ABOUT THE AUTHOR

Jennifer Barry writes the monthly newsletter for Global Asset Strategist. Her primary areas of analysis have included the metals markets (both precious and base), energy, housing, and structural stress within the financial system.
Disclaimer: The opinions expressed above are not intended to be taken as investment advice. It is to be taken as opinion only and I encourage you to complete your own due diligence when making an investment decision.

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Posted in Monetary Commentary, China, Guest Commentary, Gold, Predictions, Jennifer Barry

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