Why gold will rise as China's currency breaks into the big league...

SUDDENLY the pressure from China to change the world's monetary order is pressing, writes Julian Phillips of the GoldForecaster.com.

At the G-8 meeting in Italy recently, China asked for the forum to debate proposals for a new global reserve currency. They were largely ignored! But China's rising presence in the global economy (now with $2 trillion in foreign currency reserves) plus the threatening weakness of the Dollar is prompting China to act in this way and with speed.

Not only the Chinese but the French finance minister and central-bank president called for greater currency stability and a system to avoid piling up currency reserves as we see with the Dollar. It is clear that more and more countries are objecting to the debasement of the US Dollar through trade deficits and Quantitative Easing.

In March, the People's Bank of China governor, Zhou Xiaochuan, proposed that the Special Drawing Right, a synthetic currency – but one aimed at being a basket of the world's most-traded currencies – be used as an international reserve currency that's delinked from sovereign nations. The People's Bank of China reiterated this idea in its 2008 review. It said "the IMF should expand the functions of its unit of account, Special Drawing Rights".

The new reserve currency should be managed by the IMF, as well as for closer international supervision and scrutiny of "overly loose" US financial and monetary policies. Any opposition to these proposals brings much uncertainty to the globe's monetary system, a climate in which gold will rise strongly. Right now central bankers across the world are renewing the gold debate, should they hold more gold in the light of the dangers to the global monetary system?

Previous Chinese proposals on this subject were not welcomed at either the IMF or in member nations of the Organization for Economic Cooperation and Development. Because the G-8 did not entertain the Chinese proposal and it essentially reaffirmed the US Dollar's status as a reserve currency, China is likely to act unilaterally on the matter, much to the detriment of stability in currency markets and future cooperation in global monetary reform. The boldness of these moves implies a sense of urgency by the Chinese. We believe that action will be seen on this front soon – and suddenly, too.

The possibility of a sudden Dollar devaluation prior to the end of 2009 will only make the Chinese act more forcefully a large positive for Gold Investment.

The Yuan looks as though it will be fast tracked from a protected national currency to an international reserve currency with the first sprint to be completed in 2010. The pace will be dictated by two factors, firstly the pace at which the Chinese dictates and secondly by the IMF schedule for the review of the composition of the SDR in 2010. By that time the Yuan must have a heavy presence in international markets in at least trade flows.

For the Yuan to move in large amounts, eventually as capital, it must be well used internationally and in such volumes that a large capital amounts can move through the currency markets without disturbing the Yuan exchange rate. This means that the Yuan must be readily available in large amounts in all the international markets that China wants to see the Yuan traded in. What does this imply?

China must release huge amounts of the Yuan into international markets between now and 2010. This would require following a similar route to the one taken by the US Dollar from 1971 onwards, which led to the Dollar being the most sought after international currency. With the US in control of the security of the biggest oil producing area in the world the lands surrounding the Persian Gulf they ensured that oil was priced in the US Dollar. This forced it into the coffers of every nation on earth.

While China does not have the same leverage, it does sell the cheapest and most sought after manufactured goods everywhere. As Chinese expertise grows, their goods will take a larger and larger path into international markets. Until the rest of the world earns as little as Chinese workers do, the "China advantage" will assist in this growing international presence. The threat to the Dollar is huge, because eventually in almost every transaction where the Yuan will be used, it will replace the US Dollar.

This will leave a growing amount of the US Dollar with nowhere to go but home. If this happens, forget rising interest rates, even in the face of inflation?

But will they price Chinese goods in the Yuan and change their pricing from the US $? Yes, tentative steps are already being taken in this regard:

• Currency Swaps: China has issued large tranches of Yuan "Swaps" to a few countries, including South America. This allows them to pay for Chinese goods in the Yuan, while China can add foreign currencies such as the Reis to their foreign exchange reserves. Like a movie being tested in a country town, the next step will be to go global.
• Loans to foreign banks in Yuan: The main exit point for goods from China is via Hong Kong. Such loans are now being issued to Honk Kong Banks, where they can be closely monitored from China. Likewise these are trial runs to remove teething problems.

Foreign banks will be able to buy or borrow Yuan from Chinese mainland lenders for the first time to settle trade in Hong Kong and Macau under a pilot scheme set up by the PBoC.

This is a prime step in the international use of the Yuan. The People's Bank of China, fill permit foreign banks to settle imports and exports in Yuan in Hong Kong and Macau and will allow them to buy Chinese currency from mainland banks within certain limits. The rules make clear that China will be checking to ensure that banks and companies do not try to use the pilot program to get round the country's capital controls.

Exporters will be allowed to keep their Yuan earnings outside China. Chinese banks will also be allowed gradually to extend trade finance in Yuan to overseas companies, the PBOC said. The program will initially be piloted by about 440 firms in Shanghai and the southern province of Guangdong. Chinese export firms involved in the trial will continue to qualify for export tax refunds.

Yes, this will increase the pressure on the Yuan to appreciate, but as we said above, China wants the Yuan to be an international currency by 2010 so it must push a huge quantity of them into foreign markets. This can be made to counter an excessive appreciation if enough Yuan are created. Additionally, we can be sure that in selling, loaning and swapping the Yuan, China will move to desist from accumulating more US Dollars than is required for US trade.

It will sell the Yuan for the currencies of its trade partners across the world. This will stabilize or lower the Yuan exchange rate against these currencies, while placing some downward pressure on the US Dollar as its global reserve currency role wanes.

Eventually we expect even the Opec oil cartel to accept Yuan in payment of oil. Thus the downward pressure on the Dollar is inevitable and we believe such a depreciation has been accepted by the Chinese.

The moves to resurrect the SDR are part of this acceptance and an attempt to avoid the Dollar's depreciation. There will simply be far more US Dollars internationally than are needed, so the only way to avoid suffering from the Dollar's fall is to diversify, via the SDR into other currencies. If China can replace the US Dollar with newly composed SDR's they can protect the buying power of their huge currency reserves, at least to some extent.

What will the US do in the face of this? Will it act defensively ahead of this? Is a devaluation of the US Dollar about to happen? What will be the impact on the gold market and price? Will governments do something about gold ownership? Whatever comes, we appear to be just ahead of major global currency market moves.