glint for gold in snow's drift

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    The yuan peg to the USD will have consequences for gold demand in China. It's good news for gold!!! Where will the Chinese put those USDs they have in abundance.
    This story is from the South China Morning post.



    Saturday, September 6, 2003

    Glint for gold in Snow's drift
    Rhetoric aside, the yuan peg is a benefit to both the mainland and the US


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    The media spotlight this week may have been on US Treasury Secretary John Snow's visit to Beijing and his call to revalue and float the yuan, but what has been overlooked is the implication for gold.
    At the root of the international unhappiness with China's currency level is its rapidly growing trade surplus created by its "rented economy", which 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 to 8 per cent annual growth.

    The 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 US. This is because, in order to keep the yuan at the 8.3 level, China needs to buy up surplus dollars and re-invest them abroad, foremost in US treasury bonds.

    The peg is beneficial to China's growth target and Alan Greenspan's need to keep long term interest rates and inflation low.

    As of last month, China's holdings of US treasury bonds rose to a record $122.5 billion, less then Japan's but far more than any other country. Together, Japan and China hold 41.9 per cent of the $1.35 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, construction material and to pay workers to build new factories. When these factories start producing, much of their production is exported and sold for US dollars, while the raw materials used and workers' wages are priced in yuan.

    As more foreign exchange flows into the current account, the People's Bank of China 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 PBOC 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 price 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 by lowering interest rates to 45-year lows.

    One weak spot is the stubbornly high US unemployment rate. And this is where Mr Snow comes in. President George W. Bush has already seen 2.5 million factory jobs disappear on his watch and he needs to be seen to be doing something about it to be re-elected. From this angle, Mr Snow's visit to Beijing is more about US domestic political issues rather than seriously forcing China to de-peg the currency.

    The above leads us to the question: what does full yuan convertibility eventually mean for gold?

    China can press onward towards 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, which is the one thing that keeps China's financial system stable.

    Historically, the less trust there is in the financial system the more demand there is for gold.

    In addition, strong capital inflows and rising Forex reserves are already sharply boosting official demand for gold in China. This is because if the PBOC is to retain its proportion of gold holdings at the current 2.4 per cent of total reserves (European Central Bank standard: 15 per cent), it would need to increase its gold holdings by an estimated 120 tonnes or 60 per cent of consumption in China last year.

    China already enjoys, with 40 per cent, one of the highest savings rates in the world. The closer we get to revaluation, more US dollar savings will be converted to gold.

    To pave the way, the PBOC 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, towards convertibility on the capital account.

    After the Beijing Olympics, when the snow falls in the winter of 2008, gold might truly glisten.

    Michael Preiss is the chief investment strategist for CFC Securities.

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