China assesses its gold strategy
By Russell Hsiao

Chinese leaders convening in Beijing for the annual plenary session of the National People's Congress (NPC) - China's ceremonial legislature - this week will, among other things, hammer out a blueprint for the ascendancy of the country's currency, the yuan (or renminbi).

China's 2010 economic blueprint, which was officially unveiled at the plenary's opening, set the country's target growth rate at the proverbial 8%, which is the rate Chinese economists deem sufficient to generate enough domestic demand to make up for dwindling exports to regions such as the United States and Europe.

The 8% growth target has remained the same since 2004 and is also widely seen as politically necessary to create enough jobs to stave off social unrest. While the world's largest economy - the United States - struggles to stem the bleeding of jobs in its ailing economy, its biggest creditor - China - has been quietly increasing its gold reserves in an apparent effort to hedge the weakening value of the US dollar and stabilize the value of its massive foreign exchange (forex) reserves.

Depending on the pace and scope of China's forex reserves diversification strategy, this trend will have broad implications for the internationalization of the yuan and China's US$2.27 trillion forex reserves, which are mostly parked in US Treasuries.

One of the key issues that Chinese leaders will have to tackle is whether to let the yuan rise to help restructure the domestic economy and rebalance the global economy. If they decide to allow the yuan to appreciate against the dollar and other currencies, gold may increasingly become an attractive alternative to include within the basket of China's reserves.

As one of the world's largest holders of US Treasury bills - the general estimate is that China owns close to $1 trillion of US Treasury securities - Chinese leaders have become more vocal in expressing their concerns over the United States' fiscal discipline and in calling for an alternative international reserve currency.

Since the outset of 2009, Beijing has taken pains to diversify its monetary risks, which include signing multiple bilateral currency swaps, and pushing for the restructuring of international financial institutions. An instrument less discussed in mainstream analysis but with long-term implications for the viability of the US dollar as the universal reserve currency, can be gleaned from the fact that in 2009 China reportedly bought 454.1 tons of gold from its domestic market, which is equivalent to nearly 50% of the total purchases of 890 tons of gold made by the world's central banks last year.

China increased its gold reserves by 76% in six years (2003) to 1,054 tons in 2009, Xinhua News Agency reported, citing the head of the State Administration of Foreign Exchange (SAFE), Hu Xiaolian. China's present gold holdings make up about 1.2% of its total forex reserves, according to Market Watch.

US gold reserves totaled 8,133.5 tons in September 2008, accounting for 76.5% of its total forex reserves. Japan's 765.2 tons accounted for 1.9% of its forex reserves.

The Guangzhou Daily reported in 2008 that China's central bank was considering raising its gold reserve by 4,000 metric tons from the then 600 tons to diversify its forex risks. A China News report last year, citing Ji Xiaonan, the chair of the supervisory board for big state-owned companies under the Chinese State Council's state assets commission, said that "China's gold reserves should reach 6,000 tons in the next three to five years and perhaps 10,000 tons in eight to 10 years".

According to statistics released by the World Gold Council (WGC) - an association of the world's leading gold mining companies - in 2007, China surpassed South Africa as the world's largest gold producer, and in 2009 passed India as the world's largest consumer of gold.

While China bought nearly 50% of the total gold purchases by central banks in 2009, the volume of China's gold reserve in terms of its forex reserves only ranks fifth in the world, and is well below the global average. According to some experts, in light of the uncertainty posed by the global financial crisis, as a large forex reserves holder with a small gold reserve, China's forex reserves are at risk and the stability of its value is in question. Thus, increasing China's gold reserve is critically important for the currency's long-term prospect and the country's comprehensive national strength.

A senior official from the People's Bank of China (PBoC) suggested, "China should formulate a long-term plan and constantly and secretly increase its gold holdings, claiming that at present the percentage of gold in China's total reserve was too low ... PBoC should try to buy as much gold as possible from China's annual gold output of almost 300 tons, while the gold needed by industries and residents could be imported."

Since the International Monetary Fund (IMF) on February 17 announced its plans to sell 191.3 metric tons of gold, there has been speculation whether China would be a purchaser. The IMF has not officially commented on the prospect. Soon after India and Sri Lanka bought IMF gold in late 2009, Wei Benhua, former SAFE deputy head, said in an interview with the reputable Chinese-business journal Caijing that, "At present we should not buy. Instead we should wait for the IMF to sell gold next time, when the price of gold drops to a relatively low level ... . Although Chinese leaders may have avoided buying from the international gold market before to steer clear of triggering market fluctuation, there is clearly a growing chorus that supports abandoning this conservative strategy.

According to Xia Bin, the director of the Financial Research Institute of the Chinese State Council - the Chinese government's executive branch - China should continue long-term buying of gold and take advantage of when the international price is low to increase the volume of China's gold reserves, which will help strengthen the position of the yuan as an international reserve currency and China's long term economic development.

Furthermore, Xia and other Chinese economists recommended that China allow its private enterprises to purchase gold from the international market. In either case, the long-term implications of Chinese debates to increase its gold reserves will have far-reaching impact on the stability of China's forex reserves and the yuan's ability to become the next reserve currency of the world. The question for Chinese leaders now appears no longer if, but how, that will come about.

Russell Hsiao is the editor of China Brief at The Jamestown Foundation.

(This article first appeared in The Jamestown Foundation. Used with permission. Copyright 2010 The Jamestown Foundation.)