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Breaking news: China has been secretly stocking up on gold

China is really looking at a lot of other options to get away from the U.S. dollar.  The latest report is that it has been building huge gold reserves.  There is no doubt that China wants to get out and away from the U.S. dollar now.  We have heard SDRs, copper and precious metals all mentioned as plays out of U.S. dollars. How this will play out on currency markets and in the U.S. government bond market is not at all clear.

China revealed on Friday that it built up its gold reserves by three quarters since 2003, making it the world’s fifth largest holder of bullion.

The move comes as European central banks continue to sell their gold and the International Monetary Fund has discussed selling some of its bullion reserves.

“This is probably the most significant central bank announcement since the Central Bank of Russia announced at the LBMA gold conference in Johannesburg in 2005 that it wanted to hold 10 per cent of its foreign exchange reserves in gold,” said John Reade of UBS.

Ahead of this month’s G20 meeting in London, China said reliance on the dollar as the world’s reserve currency should be reduced by making greater use of special drawing rights, the synthetic currency run by the International Monetary Fund.

This led to speculation China was considering changing its policy which has seen the majority of its foreign exchange reserves channelled into the US government bond market and other dollar denominated assets.

This has raised the question of whether China plans to increase the proportion of its foreign exchange reserves that it holds in gold and how much it could buy

Now, let’s review the chain of events:

  • The U.S. sub-prime mortgage market implodes, causing Fannie and Freddie to go bust.  The Chinese start dumping GSE paper. (27 Aug 2008 post)
  • Meanwhile, Tim Geithner was putting his foot in his mouth and telling everyone the U.S. was ‘manipulating’ its currency.  Vice President Biden had to correct him, but the damage was done and the Chinese went on a rampage, savaging the U.S. at Davos (Geithner: 28 Jan 2009 post ; World Economic Forum: 29 Jan 2009 post)
  • Then, in March, the Chinese premier started making the same noises about Treasuries that he had about GSEs earlier (13 Mar 2009 post).  Was he bluffing?  Marshall Auerback said so at the time.  I am a bit more concerned.
  • Showing increasing signs that they were not bluffing, the Chinese started avoiding using dollars in transactions in deals with countries like Argentina (31 Mar 2009 post)
  • Then, before the G-20 summit this past month, the Chinese start floating the idea that it wants to move to a SDR (special drawing right)-centric world, loosening the U.S. grip on being the world’s reserve currency.  Of course, there was the chatter about the Chinese pegging their currency to copper instead of the U.S. dollar. Obviously, they had worked this out with the Russians ahead of time. (1 Apr 2009 post)
  • After the summit, the whole lets-not-settle-trade-in-dollars meme continued as the Chinese struck yet more deals to do so (9 Apr 2009 post)

So, here we are, three weeks out from the G-20 and now we learn the Chinese have been buying gold.  In my mind, there is no doubt that China is looking to topple he U.S. dollar as the world’s reserve currency.  And this will happen over time.  The Europeans want it – they are a rival in currency terms.  The Asians want it – they want to stick it to an arrogant country which caused great hardship to Asia through the IMF in the Asian Crisis.  And the oil exporters like Saudi Arabia, Iran and Venezuela all want it too.  It will happen.  The question is when and what will replace the dollar.

Another question comes to mind as well.  Isn’t this de-stabilizing for a world in a global recession?  The economists over at Vox have a few points to provide on that score using France and the United Kingdom as 1920s parallels for China and the United States. I have highlighted some important bits.

China’s “dollar trap” has many analysts worried about its future resolution. This column discusses a similar situation in the in the 1920s when France held more than half the world’s foreign reserves. France’s “sterling trap” ended disastrously. Sterling suffered a major currency crisis, French authorities lost a lot of money, and subsequent policy reactions deepened the Great Depression.

What are the lessons for today? China’s objective function today certainly differs from those of France in the interwar years. But French experiences in the early 1930s are a reminder that when there is growing risk on reserves currencies, foreign reserves can be both a source of instability for the international monetary system, and a burden for large holders.

China’s huge volume of dollar reserves is now at the centre of serious concerns about the future of the US currency. The origin of this situation dates back to the early 2000s, after the East Asian and Russian crises. At that time, accumulating foreign reserves was considered benign policy. Developing and emerging countries were encouraged in this way in order to insure against sudden reversals of capital inflows. China was pegging its currency against the dollar and, due to the US trade deficits, started acquiring US assets.

Ten years on, the People’s Bank of China (PBOC) has an extraordinary stock of dollars, and one pressing question: “What to do out of them?” Increasing political tensions have given rise to fears that it might get rid of this huge bulk of securities and precipitate a dollar crash. In August 2007, a Chinese official indeed reminded that Beijing was in a position to provoke a “mass depreciation” of the dollar if it decided to do so. Recent suggestion by Zhou Xiaochuan that China’s central bank might shift from the dollar has put the issue on newspapers’ headlines once again.

But bold statements are one thing, and actual policy another. Up to now, China’s authorities have shown few signs of attempting to weaken the dollar. The reason for this seems straightforward. After all, China is the world’s largest dollar investor, and no one else would have less interest in seeing the value of the US currency plummet. The PBOC might be the promptest to support the dollar, not least because it would suffer a huge capital loss in the event of a dollar depreciation. In a recent New York Times column, Paul Krugman argues that China has “driven itself into a dollar trap, and that it can neither get itself out nor change the policies that put it in that trap in the first place.”

This situation might appear unprecedented. But in truth, all this is not brand-new.

French foreign reserves policy during the Great Depression

Economic history offers one striking example of a country being trapped by the huge volume of its foreign reserves. This country was France, the period was the early 1930s, and the currency at stake the pound sterling. The episode ended up dramatically. Sterling suffered a major currency crisis, French authorities lost a lot of money, and their subsequent policy largely contributed to the Great Depression.

The origin of the problem lay in the government’s decision of 1926 to peg the franc to the sterling and dollar, two years before re-establishing the gold standard. Since the trade balance was in surplus and capital was flowing into the country, this goal was achieved through public purchases of foreign exchange. The Bank of France therefore accumulated a bulging portfolio of foreign holdings. At the end of the 1920s, the country held more than half of the world’s volume of foreign reserves.

French policy over subsequent years has been heavily criticized for being destabilizing. British contemporaries, like Paul Einzig, accused France of using its reserves in order to weaken the pound before the sterling crisis of September 1931. Others have noted that French conversions of foreign assets into gold after 1931, by imposing constraints on their money supplies, put intense deflationary pressures on other countries on the gold standard.

France’s Sterling Trap in 1931

Why did France engage in a policy that had such dramatic consequences? In a recent work, I explore the motivations behind the French reserves policy of this period. Spending time in the archives, I was able first to reconstitute the evolution of the reserves currency composition, and second, to identify the reasons invoked for the allocation decisions. Last, I have combined this information with market indicators of the perceived risk of reserves currencies.

France’s problems were similar to those of China today. The Bank of France was a private institution and its primary objective was to avoid capital losses. Its reserves were allocated between sterling and dollar. From 1929 to 1931, there were fears that the pound might be devalued and the Bank started shifting to the dollar.

However, in implementing this policy, the Bank was also constrained by its position as a large player on the exchange market. So, as sterling’s weakness worsened at the end of 1930, the Bank was in a trap: it could not continue selling pounds without precipitating a sterling collapse and a huge exchange loss for itself. The only workable option left was to support the pound. French policy therefore suddenly turned cooperative. The Bank halted the sterling liquidations, and even intervened on the market in order to support the British currency.

When the pound eventually collapsed, the Bank of France was put into a state of technical bankruptcy. It was only able to survive thanks to a state’s rescue, obtained under tough conditions. Moreover, there were now rising fears over the dollar. The will to avoid further losses therefore led authorities to convert all their dollar assets into gold (figure 2), a policy that heavily contributed to the global monetary contraction of the 1930s.

Lessons for today?

What are the lessons for today? China’s objective function today certainly differs from those of France in the interwar years. But French experiences in the early 1930s are a reminder that when there is growing risk on reserves currencies, foreign reserves can be both a source of instability for the international monetary system, and a burden for large holders.

There are some graphs on Vox’s site associated with this essay that you should have a look at. My analysis is this: The Chinese want to weaken the U.S.’s power derived through its currency status. They have been setting the stage to do so for some time. However, they want to act in a way that benefits them in the short- and long-term. Cutting loose in an uncontrolled fashion now benefits no one with the world economy in dire straits. However, when the economy does right itself, you should see some major changes in the currency markets.

Sources
China reveals huge rise in gold reserves – FT.com
China’s Syndrome: The “dollar trap” in historical perspective – VoxEU

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.

11 Comments

  1. AC says:

    I thought the above currency reserve management activities are fairly normal activities by any central bank and reported regularly by each central bank the world over.

  2. egghat says:

    I’d say the assumption that China begins to move away from the US Dollar ist massivly flawed.

    The facts:

    China’s holdings of gold has increased 75% in 6 years. Gold then was at 350 per ounce and is at 850 dollars at the end of 2008. So the value of gold has increased four times.

    China’s currency reserves at the end of 2002 were below 300 billion and are now at 1,900 billion. That’s an increase of nearly 7 times.

    So essentially the percentage of gold of China’s reserves has *de*creased.

    Or is my reasoning flawed somewhere?

  3. egghat, while China was accumulating gold reserves, all the other central banks including the Swiss were dumping gold. I hear what you’re saying but the preponderance of evidence suggests that China is looking for a way to diversify out of the dollar, gold being just one way.

    If you recall, the Unocal purchase, which was blocked, was yet another attempt along the same lines. The Chinese want hard assets, not paper money. Unfortunately for them, they are going to get stuffed by being linked to the dollar.

  4. Man says:

    When I heard this news today, I also have a few reactions.

    1. How can China bought so much gold from the free market without being noticed? Although there are rumors about China’s intention to accumulate more gold for reserve but we hardly heard any big transactions in the last few months.

    2. China smartly responses to the current crisis. A few years ago, a professor in metallurgy told me that the whole world’s copper natural reserve for copper is decreasing although the price of copper is dropping at the same time. If each Chinese uses the same amount of metal as American or European, we will have a big problem to the commodity prices. There is not enough metal in the world. And in the last few years, China needed to negotiate with the world major metal players, like Rio, BHP about the ferrous. There is no question that China will rise in the next 10/20 years. China will certainly take this opportunity to buy as much resources as possible for future use. Recently copper tells the tale.

    3. Does gold really have it value? A few years ago, there was a debate about whether gold could still be a reserve asset. One day, when the rest of the world dry up in their gold reserve, all may vote for not using gold as reserve. Gold becomes useless by that time. In fact, gold has very limited industrial uses other than jewels.

    4. Many Chinese ordinary people are not happy about US. On one hand, U.S. requests yuan to appreciate against US dollars. On the other hand, china purchases so much T-bonds each year. Of course, Americans have their different views on this matter too. Diversify their investment is a sensible way to deal with this crisis.

    Just my two cents.

  5. kynikos says:

    I’ll ask you this same question that I asked Dean Baker…

    Do you think a decline in the dollar would be beneficial to th US, especially against the reminbi?

    Maybe a decline in the dollar wouldn’t actually solve anything:

    “A major revaluation is unlikely to provide even incremental relief. Until now, the Chinese attitude toward exports has been that they would take any manufacturing job to boost employment. As a matter of state policy, they were not picky. The likely Chinese response to a renminbi revaluation is to slough of the lowest value-added industries like apparel to even more desperately poor countries such as India, Pakistan, and Indonesia; keep those industries where China is collectively a price-setter; and focus growth on higher value-added products. But, in addition to fueling US infation, this would just move the Chinese threat up the value chain, and threaten even more sophisticated industries and more-valuable jobs in the US. In other words, far from alleviating pressure on the US, a renminbi revaluation is quite likely to make things worse.”

  6. Thomas says:

    Does it say anywhere how much China’s gold reserves are actually worth?

    Is it substantial compared to all their other stuff? Or is it rather minor?

    (If the latter, I tend to agree with Egghat: That we shouldn’t read too much into it, because it’s not substantial and anyway even decreasing in percentage terms.)

  7. OSR says:

    It’s not just gold that they’re stocking up on. The Chinese have been acquiring copper, aluminum, iron ore, and other industrial pre-cursors with their dollars. Why not? The dollar has likely seen its final high and commodities are depressed.

    • OSR, you have hit the nail on the head. The Chinese are trying desperately to invest their massive dollar holdings in something of valuable. They need to use commodities for industrial production, so why not commodities?

      As for the stock of gold, this is peanuts as a percentage of reserves. Back in November, I wrote:

      Aggregating the gold holdings of the ECB and the legacy central banks that comprise the Eurozone would imply a $6,300 gold price. Again using the Bretton Woods system as a model, the U.S. dollar and Euro might be designated as “global reserve currencies” because they could most easily be converted to gold. The remainder of participating global currencies could then be made exchangeable into U.S. Dollars/Euros at fixed, but amendable rates (floating foreign exchange rates).

      The trickier part of converting paper currencies to a global gold standard would be persuading economies with high paper currency-to-gold ratios. Their paper currencies would suffer devaluations versus currencies with higher gold reserves. For example, the Japanese Yen’s gold price equilibrium would equate to nearly $40,000/ounce when calculated against the Bank of Japan’s gold holdings and the Chinese Renminbi’s gold price equilibrium would equate to about $117,000/ounce when calculated against the People’s Bank of China’s published gold holdings.

      See post here:
      http://www.creditwritedowns.com/2008/04/new-world-order.html