What China's Gold Buying Means

China Buying Gold means much more than the raw numbers suggest...

LATE IN APRIL this year, Hu Xiaolian, head of China's State Administration of Foreign Exchange (SAFE) informed the world that Beijing's gold reserves had risen by 454 tonnes from 600 tonnes since 2003, when China last adjusted its state gold reserves figure, writes Julian Phillips of GoldForecaster.com.

Since the days last century when Peter Fava, then head of HSBC's US gold department, visited the Bank of China to persuade them to Buy Gold bullion (they thought it was a simple sales pitch initially), China has been a buyer of local gold production. This includes the period before 2003.

China has risen to now be the largest gold-producing nation in the world at around 270 tonnes. The amount bought in by the government initially looks like 90 tonnes per annum or just under two tonnes a week. Before 2003 the announcement by the Chinese central bank that gold reserves had been doubled to 600 tonnes, accounted for similar purchases before that date.

But why so small an amount you may well ask? We think local and national issues clouded the central bank's view as it was the government that bought the gold since 2003 and have now placed it on the central bank's Balance Sheet. So we would conclude that the government has ensured central bank gold purchasing must continue.

Will China increase the amount it buys? First, let's ask why only one-third of domestic production was bought? Again, that has been a government issue and with the sudden concurrence of the central bank, it is possible that the portion bought will be increased.

But despite the inflationary implications of this road, the amount bought relative to the Balance Sheet of the central banks is insignificant. So do not be surprised if China buys more from local producers. That amount can then, of course, be deducted from "open market" supplies to the international dealer in future.

Why not buy the entire domestic Gold Mining output? The times we now see ahead of us don't look good for the global financial system, so China may wish to avoid becoming a victim of floods of paper money, turning to gold as far as it is able. The amount it can access without disturbing the Gold Price are small and very visible, however, so any opportunity to buy large amounts off-market may be jumped at.

The fact that China is a buyer for reserves is far more important than how much it currently holds. There is no conclusion we can reach other than China recognizes gold's worth as a reserve asset.

On the bigger global screen, this revelation further reverses the concept of gold as a "barbarous relic" as bankers had hoped it would become in the last 50 years of the 20th century, and brings it back into a monetary role, even if it is minor at this point.

Buying Gold for currency reserves is not limited to China's central bank. And if China buys a larger percentage of local production going forward, then it is probable that central bank buying will overtake central bank selling in the years to come. This alone takes gold away from the perception of its being an archaic relic. More than that it brings gold back to a particularly valued asset "in extremis" – precisely those times we are now living in.

This has to force a rethink of the role of gold by unwilling bankers and the recognition that selling it will not elevate the value of paper money any more. The confidence lost in the last two years cannot be shored up by such foolish practices. It is now time to recognize the dangers not only of today's crises, but of the dangers that lie ahead, even if the world economy returns to the halcyon days of early 2007 (which appears to be the clear aim of central bankers and governments now).

The dangers that led to the 'credit crunch' will return, if successful. So prudence demands recognition of gold's value when life gets painful. Germany and Italy have recognized this, as has the United States – still keeping an iron grip on its own gold reserves. Russia and now China are recognizing this too, so more nations are bound to follow. Future large sales may well be snapped up by other central banks (Russia is currently buying 4 tonnes a month from the 'open market') which brings us back to the potential sale by the International Monetary Fund of 403 tonnes at some point in the future.

In the past both the US and the IMF used the auction method of selling gold when depleting their reserves, and they were able to dispose of 500 tonnes at one shot in this way. It is now incumbent on the IMF Gold Sales to maximize the proceeds, if indeed the sale is approved later this year. Hence they should use the 'auction method' again.

If the IMF Gold Sales are instead made into the "open market" using a small-amount-per-week system – such as that currently used by the Central Bank Gold Agreement (CBGA) signatories, first clubbing together to cap European gold sales per year in 1999 – it will take many years for the full 403 tonnes of IMF gold to be released. With the policy that both China and Russia are presently using to Buy Gold, one or both of them would be prime candidates to buy the whole lot, and such a purchase would confirm gold as a sought after Reserve Asset.

This view will certainly affect other central bankers and persuade them to re-build their gold reserves, as South Africa has now said it would. Why? Because Gold Bullion would still be rare enough and too expensive to take a traditional role as real money, but governments would want it to sit in their vaults, almost as collateral for paper money. The art would be to imply gold-backing for paper money, but make the metal inaccessible to all but other central bankers and only then in a "default situation" such as Mexico and Brazil experienced when they sold gold to the IMF several decades ago, raising cash to for one of their regular bail-outs.

Gold's role would, therefore, still be truncated, as it would certainly not become a circulating medium. For gold-backed paper to reach down to the man-in-the-street, acting as hand-to-hand money, the Gold Price would have to be five-figures high. This could only happen slowly over a decade or so.