As China has stepped up its efforts to protect its foreign exchange reserves from the declining dollar, one possible diversification strategy has shined brighter than others: gold.
In late April, the State Administration of Foreign Exchange (SAFE) announced that China’s gold reserves had risen by nearly 76% since 2003 to 1,054 metric tons. However, most of the gold was bought from domestic refiners over a five-year period.
"It may have stepped it up a little bit this year, but gold still represents a very small fraction of its total portfolio,"said Brad Setser, a fellow at the Council on Foreign Relations in Washington DC.
While most analysts agree that China’s increasing appetite for gold is understandable, there is a debate about the feasibility of its strategy. The global gold market is relatively small, and gold is illiquid as an asset class.
"Any visible buying by China will send the price skyrocketing… Even that will make a huge difference in terms of reserve diversification because of how small the gold market is,"said Wang Tao, senior China economist at UBS.
However, Shi Yanping, a finance professor at the University of International Business and Economics, argues that when the US dollar depreciates, gold appreciates. The implication is that Beijing should buy gold as a hedge against a further decline of the dollar.
But China is not alone in its concern over the greenback’s plight. The decline of what has long been the world’s safest and most liquid asset has seen individual investors and central banks flock to gold, creating price volatility.
"The gold price a few years ago was very low compared to now where it’s near US$1,000 per ounce,"said Yang Laike, a professor of international trade at East China Normal University.
With annual global production of gold decreasing by 12% since 2001 and central bank sales worldwide totaling just 246 metric tons in 2008 the amount of gold available on the open market is limited. Wang of UBS notes that, even if China were able to buy all the 2,356 tons of gold produced in 2008 for nearly US$66.68 billion, its net gold holdings would then only represent 3.3% of its total foreign exchange reserves. It would appear that the reality of a golden safety net is far from certain.