China's Gold Ambitions

China's announcement that it has more than doubled its official gold holdings to over 1,000 tonnes is significant as much for the politics of its timing as for the news itself. Indeed it is only one of several recent announcements made to position China for greater influence as the world financial system faces the prospect of its biggest changes since the 1971 Smithsonian Agreement.

The more than doubling from 454 to 1054 tonnes in 2002 when it last gave figures is not exactly surprising. Even allowing for a more than doubling in the gold price over that time, gold's percentage in China's reserves has not changed significantly. Currently valued at some $30 billion, gold is still only a fraction of reserves of US$1.9 trillion.

Nor would China have had to be a buyer in international markets. It is now the world's second largest gold producer, having overtaken South Africa, and so it would have made sense for the People's Bank of China to absorb some of that production rather than sell it and acquire even more dollars. Keeping some mine production off the market would also have helped boost the gold price.

But the increase has probably been gradual and does not indicate that China sees itself as champion of an intentional return to some sort of gold standard. However, the fact that it has chosen to announce it now clearly indicates its desire to gain a louder voice, and to indicate that it favors the continuation of some international role for gold.

That is now a matter both of self interest and of concern about the long term value of the dollar and other fiat currencies in which it holds reserves. Its official holdings are now surpassed only by the United States, Germany, France, Italy and Switzerland. China's citizens have also become significant buyers. It is not clear how far it favors the IMF selling any of its gold. Last year the People's Bank of China governor, Zhou Xiaochuan was on an International Monetary Fund panel which recommended selling 400 tonnes of its gold -- 20 percent of its holdings – to generate cash for lending to members. However, the turmoil of the past months may have changed China's mind, and those of other large gold holders.

Other significant recent announcements are intended to gradually increase the role of the yuan in international trade and investment. China cannot realistically expect to be a major player until such time as its currency is fully convertible and sufficiently used in trade to make other countries want to hold it in their reserves.

The yuan has in fact been used in cross border cash transactions for a number of years, in Hong Kong and Macau and in neighboring regions of Russia and Vietnam. However, for the first time its official use in trade between Hong Kong, Macau and ASEAN neighbors and the border provinces of China, plus the Yangtze delta, is to be permitted. This is particularly important for Hong Kong, which will also gain the advantage of being the main place of settlement for such trades, providing a boost to its banking industry.

However, it is easy to exaggerate the immediate impact of this development. Hong Kong's trade with the mainland mostly involves imports of good for outward processing and exports of finished products to other countries. Almost all of this will continue for the foreseeable future to be denominated in dollars, and in some cases yen or euros.

The dollar may seem fundamentally weak and a poor store of value but it reigns supreme as a transaction currency, particularly in Asia. Even were the yuan to be fully convertible and the all trade permitted to be settled in it, it would take a long time for it to become significant. There was a time when it was believed that the yen would play a major role in Asian trade denomination and settlement. But though it is significant for some of Japan's exports, particularly to Japanese-owned factories in Southeast Asia, it is not otherwise widely used.

Indeed, East Asia's years of trade surpluses act against its currencies becoming more international as others have limited opportunity to acquire them. Meanwhile US profligacy has created a huge supply of dollars which lubricates global trade.

Huge US external deficits may be on the wane and Japan and even China may find themselves in external deficit, in which case they may want to finance that by encouraging others to hold their currency. But for now at least that is not the case.

Indeed, while China remains in large surplus, any yuan acquisition by foreigners will simply add to its holdings of dollars – not a good bargain.

This also explains why the development of offshore yuan bond markets will be slow. For sure, some small issues have been made through Hong Kong by mainland entities. It now looks likely that Hong Kong banks will be able to issues yuan bonds to fund their mainland operations. But China's desire to develop its international financial role is constrained by what the stability-focused leadership in Beijing may see as the macro-economic disadvantages, at least in the short term, of increasing capital movements which would complicate money supply and exchange rate policies.

A significant gesture more than practical help is also a definition which could be applied to China's swap agreements with other central banks including Korea, Indonesia and Argentina. These are supposed to help protect the smaller economies from currency attacks and panics. Indeed they would be very useful if China were swapping excess dollars for their domestic currencies. But while yuan may look good on the balance sheet, for market intervention purposes it is largely irrelevant unless converted into dollars.

Use of the yuan will grow as China offers long term yuan-based funding for big ticket exports such as power stations. However, borrowers are likely to be wary, even if terms appear attractive, fearing that the yuan is destined for a sustained period of revaluations like the yen in the 1970s and 80s.

In short China's recent announcements about gold, the role of the yuan and its concerns about the dollar have two main aims. Firstly, at the global level to strengthen its hand in dealing with the west over changes in the financial system and its representation in the IMF in particular. And secondly at the regional level to emphasize its role as leader in efforts to enhance cooperation in East Asia through the ASEAN+3 group and related arrangements such as the Chiang Mai Initiative on central bank and currency cooperation.

The long term implications are enormous but it is easy to exaggerate the short term impact.