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What Snow in Beijing means
for gold
By Michael R Preiss
US Treasury Secretary John Snow visited Beijing
recently to raise the yuan-revaluation issue with
China's senior leadership. While the media focus was on
currency values and unfair trade advantages, what is
sometimes overlooked is the potential implications it
has for gold.
First, let's us consider the
background behind the pressure for yuan revaluation, and
why for the foreseeable future the interests of the
United States and China are interlinked. At the root of
the international unhappiness with China's currency
level is the country's rapidly growing trade surplus
created by its "rented economy". The term "rented
economy" applies since foreign investment controls much
of China's low-cost production. China is becoming the
"workshop/factory" of the world and is holding down
global inflation.
China's senior leadership
might still call themselves "communists", but in reality
the country is run like a holding company along strict
reporting lines with one clear objective, namely 7-8
percent annual growth. The currency peg between the yuan
and the US dollar is facilitating this growth objective
while at the same time it results in lower interest
rates in the United States. This is because, in order to
keep the yuan at the 8.3 percent level, China needs to
buy up surplus dollars and reinvest them abroad,
foremost in US Treasury bonds. The peg is mutually
beneficial to both China's growth target and US Federal
Reserve Board chairman Alan Greenspan's need to keep
long-term interest rates and inflation low in the US.
As of last month China's holdings of US Treasury
bonds rose to a record US$122.5 billion, less then
Japan's but far more than any other country's. Together
Japan and China hold 41.9 percent of the $1.3472
trillion debt the US government owes the world.
Even though hot money is not allowed in, an
unprecedented amount of foreign currency is flowing into
China, to buy land and construction material and to pay
workers to build new factories. As these factories start
producing, much of their production is exported and sold
for US dollars, while the raw materials used and the
workers' wages are priced in yuan. As more foreign
exchange flows into the current account, the People's
Bank of China (PBC) buys up these dollars, because the
government is committed to keeping the exchange rate
stable.
If it were to stop buying the dollars,
the value of the yuan would quickly appreciate. But the
People's Bank has a problem. If it simply uses new yuan
- creating a liability on its balance sheet against the
dollar assets - the extra money in circulation within
China would soon cause inflation, as indeed happened in
the mid-1990s. That would damage the economy and
eventually hurt China's export industries, since the
prices of Chinese goods would rise.
So instead
of causing inflation inside the country, China is
exporting deflation. This in turn has allowed the Fed to
spark an economic revival in the United States by
lowering interest rates to 45-year lows without risking
inflation.
One weak spot of the recovery,
however, is the stubbornly high US unemployment rate.
And this is where Snow comes in. President George W Bush
has already seen 2.7 million factory jobs disappear on
his watch and he needs to be seen to be doing something
about it in order to be re-elected. Viewed from this
perspective, Snow's visit to Beijing is more about US
domestic political issues than about seriously
pressuring China to un-peg the currency.
All of
the above leads us to the question of what full yuan
convertibility would eventually mean for gold prices.
China can press on toward convertibility on the
capital account, which would allow Chinese people more
freedom to move their savings abroad, counterbalancing
the inflow of US dollars. In many ways that is the best
option and it is already being implemented, but it would
threaten the steady increase of savings put in
low-interest accounts at the state banks. This is the
one thing that keeps China's financial system stable at
the moment. Historically, the less trust there is in the
financial system, the more demand there is for gold.
In addition, strong capital inflows and rising
foreign-exchange reserves are already sharply boosting
official demand for gold in China. This is because if
the PBC is to retain its proportion of gold holdings at
the current 2.4 percent of total reserves (European
Central Bank standard: 15 percent), it will need to
increase its gold holdings by an estimated 120 tons, or
60 percent of gold consumption in China in 2002.
China already enjoys, at 40 percent, one of the
highest savings rates in the world. The closer we get to
revaluation, the more US dollar savings will be
converted into gold.
In order to pave the way,
the PBC last year relinquished its monopoly on imports
and exports of gold, the Shanghai Gold Exchange was
established, and many Chinese commercial banks are
planning to launch personal-gold-investment businesses.
The way forward for China's central bank and
savers in the coming years is, surely, to diversify out
of their huge dollar holdings and move to back its
currency by gold as it heads slowly but surely toward
convertibility on the capital account.
After the
Beijing Olympics when the snow falls in the winter of
2008, gold might truly glitter.
Michael R Preiss serves as
chief investment strategist at CFC Securities. He wrote
this for KWR International Inc, a
consulting firm specializing in the delivery of
research, communications and advisory services. Posted
with permission.
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