People's Bank of China Chairman Zhou Xiaochuan said in Frankfurt that China is considering various options for diversification.

Statements from a man this senior in the decision making process are to be taken notice of. Other academics and economists have been recommending this path for some time, but few have taken notice of them. Now it is believed that action will be taken, why?

Earlier this week Chinese state television said foreign exchange reserves have reached $1 trillion.

China found itself with large $ reserves once it embraced Capitalism more than 15 years ago. Then the reserves turned from large to huge. This was a worry, so measures had to be taken to manage such money, so spending on imports to assist in the development of the country was instituted, foreign investments were allowed and encouraged and all was well, but still the reserves grew far beyond the pace of the ability to use them and keep them in proportion to requirements. And now they have reached a level of U.S.$1 trillion, after China's trade surplus surging to a record $23.8 billion in October. Please note that China has a trade surplus with almost every other nation on this planet! So the problem is not to do with surpluses, just U.S.$ surpluses!

Its measures to accumulate its reserves in a basket of currencies in line with the trade it has with other nations is getting there for sure, but it is the $ component that is the worry! China Business News cited the executive vice secretariat of the Chinese Society of Macroeconomics, who warned that the US dollar is currently “unstable” and that as 70% of China’s foreign exchange reserves are held in dollars, the country could lose 1 trillion Yuan if the U.S. $ fell 20%. We understand this to mean that this fall would be against the Yuan. Seen from outside this could be translated as the Yuan appreciating against the $, which is what the U.S. and others are baying for. We’ve seen a 3% fall in the last couple of weeks!

In an interview last March, the Chairman Zhou stated clearly that the P.B.O.C. would not sell the U.S.$ and he is unlikely to change course. So how can China diversify from the $? If it set one foot in the foreign exchanges to do so the alarm bells would ring and the $ would tumble, so that’s not really a good option with that many $’ to sell.

China has about 70% of its foreign exchange reserves in the U.S.$ but is adding to overall reserves at the rate of U.S.$15-20 billion per month. To diversify away from the dollar, the Chinese authorities could ensure that all non-U.S. transactions are denominated in currencies other than the U.S.$ even accepting the local currency of the nation it is trading with?

Another danger with accumulating so many U.S. $’ is the growing dependency of the U.S. on China’s ownership of its dollars. On the other side of the coin there is the vulnerability of the U.S. to Chinese ownership of so large a part of the U.S.’ monetary instruments, as well as its money. After all just how many U.S.$’ can they accumulate before they realise that they are as dependent on the States as the States are on them?

The country should spend its excess foreign exchange holdings overseas says Xia Bin, director of the financial research department of the State Council, or cabinet. Clearly the reserves should be spent on building up the infrastructure of the nation and securing future important supplies to enable the Chinese economy to continue to expand and be self-sufficient, but the accumulation is so speedy that they just can’t do that.

The Chinese and ‘Official’ Gold.

So will the Chinese buy gold? When asked if gold was on the list of instruments to be used by the Chinese central bank as it diversifies its foreign exchange reserves, Chairman Zhou replied, “That’s a separate thing”. Of course it is!

China has a government that controls its people, even if it is acting to serve and enrich them. Banking systems on the one hand are there to make profits, but also to control money. We may believe they benefit us and many do, but be sure, they will not willingly allow or encourage systems they cannot control when push comes to shove. Gold is uncontrollable! India gives adequate proof of this where the banking system has failed to bring most Indians under it wing. The Indian government has even failed to effectively tax or regulate the average Indian middle class citizen. Both these institutions are disrespected in India and have failed to develop the same rapport with their people that has occurred in the West.

It is also unlikely to be able to do so because of the assistance of gold in defeating such objectives. So no wonder the Chinese authorities are slow in embracing gold. After all gold is money when all else fails!

But the worry of the Chinese is the instability of the U.S.$, so the time is rapidly approaching when such control will be lost amidst volatility and instability that attends monetary crisis. At such times confidence transfers from government controlled money to gold. The Chinese are fully aware of their inability to accumulate sufficient gold from their own sources and the international gold market. We do think they will buy their own locally produced gold, but would be surprised if they bought other gold.

But to affect the gold price, they just have to act on their fears of the instability of the $. Then others will! This is enough to make Investors, traders, et al, go for gold. Certainly such statements from China bring the $ crisis closer and for confidence to move closer to gold! After all if the world’s foreign biggest owner of offshore $’ thinks its $ investments are unstable how could all of the rest of us not do so?

© 2006 Julian D. W. Phillips
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