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A Chinese Gold Standard?

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China's grab for gold is accelerating at a rapid pace, and it's raising questions about the country's ultimate intentions.

China consumed 175.2 tons of gold in the fourth-quarter of 2010, bringing its grand total for the year to 579.5 tons, or 18.5 million ounces.

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That's a lot of gold. The US, in comparison, bought 233.3 tons.

It's unknown how much of that gold was consumed by citizens or its central bank, but the question still remains -- What will China do with all that gold?

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There is a controversial theory percolating in the gold community that China wants the yuan to become the world's reserve currency and is buying gold and silver in order to do it.

A Chinese gold standard?

The idea is staggering and not to mention fraught with difficulties. China's central bank currently holds 1,054 tons of gold, about 1.8% of its total reserves.

China holds $2.85 trillion in foreign reserves, which means the country would need to buy roughly 66,000 tons of gold to fully back its currency. Even if the country upped the ante to just 3%, the country would need to buy 1,000 tons.

Technically, a full gold standard isn't an option. Under the IMF's first amendment to Article IV of Agreement, ratified in 1978, participating countries are not allowed to peg their currency to gold.

But that doesn't mean that China won't try to legitimize its currency by ramping up its gold holdings. The US, which sports the current world reserve currency, holds more than 8,000 tons of gold, more than 8 times the size of the SPDR Gold Shares (GLD).

Not only has China been furiously buying gold, but local gold producers have been looking outside the country to find more gold. State-controlled China National Gold Corp bought half of Coeur d'Alene Mines' (CDE) gold concentrates from its Kensington gold mine in Alaska.

China has also been telling its citizens to buy gold, promoting different gold funds, giving investors access to overseas products and launching a global gold contract based in yuan by Chinese Gold& Silver Exchange. The ICBC and World Gold Council recently teamed up for the creation of the Only Gold Gift Bar in China, where a customer can buy gold as a gift complete with engraving and can sell it back to the ICBC for cash.

"Private citizens have bought more gold in the last 30 months than the People's Bank of China owns altogether," says Adrian Ash, head of research for BullionVault.com. There are also no individual property rights in China, so all the gold citizens own really belongs to China, whether the country would confiscate it is a different story.

China has also been trying to beef up the yuan to make it a more viable global currency.

The People's Bank of China's Website said it is trying to allow banks and businesses in countries like Russia and the US to be able to make direct investments in the yuan, which essentially brings the once-isolated currency onto the world stage. The Website says this move "better supports Chinese enterprises to go abroad and facilitate trades and investments."

There are now retail bank branches in the US where you can trade in your dollars for yuan. The country is also negotiating currency swap agreements with trading partners where the US dollar is taken out of the transaction and goods are traded in yuan.

Despite grumblings over letting its currency appreciate versus the dollar, from 2005 to 2008 before the financial crisis hit, the yuan rose 30%.

China is also a country that plans long term. Once the largest holder of US debt, China has stopped loaning money as aggressively. According to the US Treasury department's Website, in November 2010, the country lent the US $895.6 billion, which was down 3.6% from the same period a year earlier.

"China has shortened all their maturities to less than 5 years and now they are not as strong in the auctions," argues Chuck Butler, president of EverBank, who believes China wants the yuan as the world's reserve currency. Speculation is bubbling that the country is shying away from the dollar to make more room for another asset.

Some experts say that asset could be gold.

"The world needs to get off the dollar standard," says Peter Schiff, CEO of Euro Pacific Capital. "If China were to back its currency by gold, its currency could be the world's reserve currency."

Yan Xiaomei, deputy director at the People's Bank of China, says "if China holds more gold and silver, it would make RMB more confident in people."

Xiaomei believes that China would buy more gold and silver at the "proper time, but not as a critical policy, the quantity would also be not too big."

According to a report supposedly published by the Economic Information Daily, which is sponsored by the state run Xinhua News Agency, and a statement by a central bank advisor, Xia Bin, China is actively trying to buy gold and silver on price dips with the specific goal of globalizing the yuan.

There are some glaring holes with the article, but it circulated in the gold community nonetheless. First, no one could find the report. Second, if China is buying gold, it is unlikely to announce it for fear of moving the price. China usually makes a formal announcement when it is done with its purchase.

"Once again, we have seen 'news' that is but at the embryonic and certainly not fact-supported stage at this point," says Jon Nadler, senior analyst at Kitco.com.

Nadler also argues that China loves growth too much to switch to a gold standard, "forget about 8% growth." If China supports its currency with gold then it will be forced to limit the amount of money in circulation, which could hurt the economy. "This is a far-fetched dream by the gold bugs," says Nadler.

Ash warns "never say never... But throwing over the world's 40-year experiment with un-backed money? That really would be a historic move by any power."

If China does increase the size of its gold reserves with the express purpose of backing the yuan, the result would be explosive for gold prices.

Butler says that the consensus is "$4,000 to $5,000 gold within the decade."

Jim Rogers, legendary investor who is bullish on China, says a gold standard "would be good for gold if it happened, but it is a long way away."

GFMS executive chairman Philip Klapwijk was unable to comment on how much gold China bought in 2010 or will buy in 2011 due to the sensitivity of the information but did say that even if China just raised its reserves 1,000 tons to 2,000 tons with yearly purchases of 200 tons, the result would still be good for gold prices.

"Not only because of its impact on the global supply/demand balance but also due to its positive effect on investor sentiment and, to some extent, the negative signal it would send about the US dollar."

With gold prices stalling out so far in 2011, down 3.4%, and large gold stocks like Barrick Gold (ABX) and Newmont Mining (NEM) down 6% and 5%, respectively, year to date, the gold world is looking for any kind of catalyst to shake it out of the doldrums.

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