Golden opportunity

As the US dollar weakens, China’s stock of dollars and dollar-denominated debt is falling in value. Unwilling to be caught holding the bag, bankers have been seeking ways to reduce their risk. In any other currency regime, this rebalancing would be simple: swap dollars on the open market. But Beijing’s restricted system forbids this.

China’s export-dependent economy thrives on an artificially strong dollar and a relatively weak yuan. Lack of faith on the part of the world’s largest buyer of dollars could trigger a run against the US currency and hurt China’s export sector.

Diversification demands

Local economists have seen the writing on the wall and are calling on the government to identify alternatives. One of them is gold.

“More gold reserves will help the government prevent risks and handle emergencies in case of future possible turbulence in the international political and economic situation,” said Yan Tanling, a researcher at the Bank of China.

Gold currently accounts for 1.3% of China’s foreign currency reserves, according to the Beijing Gold Economy Development Research Center. For some years now, experts have been petitioning the central bank to increase this from 3 to 5% of reserves. Such a move would bring China’s gold holdings more in line with global averages.

To do this, China would have to lay its hands on an additional 2,500 tons of gold at today’s prices – an amount equal to nearly a quarter of America’s own mammoth reserves.

“It’s impossible to do something like that over a short period of time,” said Paul Walker, head of the World Gold Council, an advocacy group.

There may also be supply issues. Bill Murphy of LeMetropole Café, a gold-industry think tank, said the current gold market would be hard-pressed to meet the needs of a Chinese buying binge.

“There is no way the Chinese could buy anywhere near that amount of gold without sending the gold price bonkers.”
That is, unless China can leverage its own domestic gold resources to support its reserve rebalancing. Several prominent mining firms made share offerings this year as part of efforts to bring forward consolidation in the sector.

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Meanwhile, the country’s economic planners have also announced a significant expansion of China’s existing gold mines in the past year. Production is expected to top 260 tons in 2007, so China may well have the domestic supply in place to expand its gold reserves.

There are signs that Beijing may be putting in the structures required to support this. In June, the China Securities Regulatory Commission gave the Shanghai Gold Exchange the green light to begin trading gold derivatives futures.

Another factor is, paradoxically, the current low price of gold. A large buy by China would likely create a major price spike as investors anticipate a tighter market. This would see the value of their reserves appreciate.

Rather than embark on a risky commodities drive, many prefer the more subtle technique of using the dollars to invest in US securities. Buying into American firms would reduce currency risk and boost returns while avoiding the appearance of abandoning the troubled dollar. Indeed, this is the principal objective of China’s recently established first state-owned foreign investment agency.

However, the new agency is likely to operate in a conservative manner and, even if it did not, bold takeover efforts would face stiff opposition in the US.

As it stands, gold may not be an immediate fix for China’s reserve imbalance but it is a viable option. Walker remains convinced that gold will be part of whatever exit strategy China chooses.

“There’s no doubt in my mind at all that they will be in the [gold] market. I would expect to see baby steps towards gold in the future.”