If China is buying gold, what should you do?
As we reported last week, China recently launched a new yuan-based benchmark price for gold bullion. The Shanghai-based gold benchmark will compete with London, where the world’s daily gold price has been set for years. As the world’s largest gold miner and importer, China wants to have more influence over the price of the precious metal.
The announcement rekindled debate among gold watchers as to why China has been accumulating so much gold over the past few years. Why would a communist government with a managed economy and managed markets covet an asset revered by investors who don’t trust government decisions? What are the Chinese up to when it comes to gold?
No one outside the Communist Party really knows the size of China’s gold reserves. Last July, China announced that it held 1,658 metric tonnes of gold. That’s up about 600 tonnes since 2009, the last time it updated its reserves.
However, experts who analyze mining statistics and global gold flows believe the country’s reserves are significantly higher – possibly 3,000 tonnes. That would put China in sixth place globally – but still well behind the U.S., which holds over 8,000 tonnes.
For some reason, the People’s Bank of China (PBoC) is secretive about how much gold it owns. Of course, conspiracy theorists say this is because China is “up to something.” A popular theory is that the PBoC is hoarding gold as part of a plan to convert the yuan to the gold standard and supplant the dollar as the default global currency.
Under the gold standard, the value of a country’s currency is directly linked to, or “backed” by gold. (The U.S. dollar was on the gold standard as recently as 1971.) If backed by gold, paper money can, in theory, be exchanged for a fixed amount of gold. For example, China could set the price of gold at US$1,000 an ounce and make the value of a yuan equal to 1/1000 of an ounce of gold. You could then walk into a bank with 1000-yuan worth of bank notes, and leave with a one-ounce piece of gold.
Since the U.S. abandoned the gold standard in 1971, all countries use “fiat currency” – legal tender that is backed exclusively by the faith of its government. Without ties to gold, governments are free to print money as needed. During economic recessions, central banks can print extra money to stimulate the economy.
However, if a government prints too much money, its currency can lose value. In a worst-case scenario, if the confidence in a government evaporates, its currency can collapse and even become worthless.
That’s why gold is attractive. It’s not based on government promises, but on a real asset that holds real value. Proponents of going back to the gold standard believe the money printing by central banks is out of control and will end in disaster.
Maybe the Chinese agree, and are stockpiling gold at low prices. Possibly, the sly Communist Party planners are doing this because they want to dethrone the U.S. dollar and elevate the yuan as the world’s reserve currency.
According to some gold enthusiasts, one day we’ll wake up, and boom! China announces the yuan is backed by gold. Global capital then runs from the U.S. dollar into the Chinese yuan, and the price of gold surges higher.
The question is whether or not China even could back the yuan fully with gold. The yuan is currently backed by foreign exchange reserves worth over US$3.2 trillion. Of that, about two-thirds, or about US$2 trillion, are believed to be in U.S. dollars. The exact amount is, you guessed it, a secret.
But, let’s assume China does, in fact, have 3,000 tonnes of gold reserves, almost twice what it officially says it has. At today’s gold price of around US$1,290 per ounce, China would control roughly US$136 billion worth of gold. That’s a small number compared to the US$3.2 trillion it has in foreign exchange reserves.
So, for China to fully convert to a gold standard, it would need to sell huge amounts of its foreign currency holdings and buy thousands of tonnes of gold. Doing so would cause the value of its dollar holdings to fall, while at the same time driving up the price of gold. Although the Chinese government made plenty of blunders manipulating its stock market in 2015, they must know this move would be economic suicide.
How much gold would China need to fully back the yuan? A Bloomberg Intelligence story last year estimated that at prevailing exchange rates, China would need about 525,000 tonnes of gold, or about three times the amount of gold that has ever been mined in all of history.
Of course, if gold were significantly more valuable, China would need less of it to back the yuan. Bloomberg estimated that if gold were valued at US$64,000 per ounce, China would then only need about 10,000 tonnes of gold to back the yuan fully. That’s only about 6 percent of all the bullion ever mined. But China will never bid up the price of gold to US$64,000 per ounce.
So, based on the amount of gold and the price of gold needed for China to go back to the gold standard, it’s not likely to happen any time soon. Sorry, conspiracy theorists.
The more likely reason for China to buy gold is a lot less exciting. Like any smart investor, China is simply diversifyingits holdings. Viewed as a percentage of all foreign exchange reserves, China’s gold reserves remain tiny – about 1.6 percent, as shown above. Compare that with 73 percent for the U.S., 67 percent for Germany and 65 percent for France and Italy. Given the size of China’s economy it should own more gold, just like the other big players in the global economy.
By increasing its gold reserves, and reducing its holdings of U.S. dollars, China is spreading its risk and reducing itsvolatility. Like a wise investor, China has ramped up buying as gold prices weakened. Also like a savvy trader, the Chinese central bank is keeping its cards close to its chest. No point in telling the world its investment strategy.
What should you do? We’ve written before about the appeal of holding gold. It can act as a hedge against currency risk and inflation and it tends to hold its value when stock markets go down. Regardless of what China is doing, every investor should own some gold. (However, it’s not going to US$64,000 an ounce anytime soon.)
China is also selling the U.S. dollar. But it still holds trillions of dollars’ worth of U.S. dollars, and that’s not going to change much anytime soon. And China’s slow-but-steady buildup in its gold holdings isn’t going to hurt the U.S. dollar much – yet, at least.
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