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Executive summary:

  • Central bank buying of gold is a double edged sword.
  • A contraction of monetary policy will result in gold being sold.
  • Uncertainty about China's central bank's true gold holdings results in speculation and confusion.

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I've written various articles attempting to outline a theory that central banks buying gold is a double edged sword. The theory is simple. If central banks are buying gold, they are doing so as part of a broader monetary policy. When the Federal Reserve buys bonds it injects new money into our system; when the Federal Reserve sells bonds it pulls money back out of the system. That is how our system works, the US uses bonds as its preferred instrument to manage the money supply. Until the crash of 2008, many other nations did the same. After 2008 however other countries started to rethink their monetary strategy and diversify away from the US dollar. Most important of those countries was China, who decided to target a "basket" of currencies instead of just the US dollar.

Many of those nations' central banks began to buy gold instead of US dollars.

"There's a concerted effort to diversify to some extent away from the U.S. bond market, U.S. dollars, and buy hard assets like gold, China being the leader," Carter told IBTimes.

"With China, they want to obtain enough gold to back their currency," he continued.

In a decade, China could have 6,000 to 8,000 tons of gold backing the Chinese yuan, which could be a "game-changer" in global markets in terms of reserve and dominant currencies, he said.

China now holds about 1,025 tons of gold, according to International Monetary Fund data. Carter underlined countries who are long on the dollar, or who have large pools of U.S. Treasury bonds, as the ones most likely to accelerate buying.

What this means is that instead of buying US bonds to expand their money supply, foreign central banks are buying gold instead. Gold is now a tool of monetary policy, and that can be both good and bad for the price of gold.

The reason that is good is because the increased demand will likely drive gold higher. As central banks diversify away from the US dollar they drive up the price of gold and effectively drive down the price of US bonds, i.e. drive up US rates.

That is all fine for gold until there is a shift in monetary policy. Once central banks go from a stimulative monetary policy to a contractionary monetary policy, they go from buying gold to selling gold. That is why it is a double edged sword.

The key then is to anticipate when central banks may be changing from a stimulative policy to a contractionary policy. Recently China has been greatly expanding its money supply.

(click to enlarge)

Along with expanding its gold purchases...we think. Because the PBOC doesn't release official gold holdings the secrecy leads to speculation, which makes it hard to discount the true impact on the price of gold.

According to Nichols' sources, the Peoples' Bank of China (PBOC) bought 654 metric tons of gold from 2009 to 2011, 388 tons in 2012, and more than 622 tons in 2013. There is no recent official data about Chinese central bank gold holdings, as the institution last announced its gold holdings in April 2009, at 1,054 tons.

The PBOC doesn't regularly report on its gold buying, as many other central banks do, and it hasn't said when it might update the gold market on its purchases. Estimating how much gold the Chinese central bank has bought in recent years is something of a parlor game for Wall Street analysts and gold investors, though official announcements could have real price impacts.

The last part of the above quote highlights the dangers of the PBOC holding gold, "though official announcements could have real price impacts." Relative to the US dollar, gold is extremely volatile. Volatility is the last thing a central bank wants in its reserves, and why I think central banks will regret their decision to diversify away from the US dollar.

The reason volatility is so bad is because central banks must have a mechanism to take currency back out of circulation once it has been put into circulation. If the PBOC buys 1 oz of gold when it is trading at $2,000/oz, and someone in the vault leaks to Wikileaks that the PBOC has far more gold than the markets think, triggering the price of gold to plummet to $1,000/oz, the PBOC is stuck with $2,000 in circulation but only $1,000 in gold to sell to bring it back out of circulation. To make matters worse, when the PBOC starts to sell its 1 oz of gold it will drive gold even lower than the $1,000, so it won't even be able to take back $1,000. It is a vicious cycle because to take more and more currency out of circulation the PBOC would need to sell more and more gold at lower and lower prices to take fewer and fewer yuans out of circulation. Once other central banks realize what is happening, they too will rush to sell gold, turning a slow-ball into an avalanche.

It would be like a run on the central banks, as each central bank hopes to get to the gold window before it is too late. Ironically, the impact this will have will be to trigger inflation fears in the home country, and greatly strengthen the currencies that remained on the US dollar based system. I'm pretty sure sooner or later central banks will discover that gold is infinitely more volatile than the US dollar and that fears of the US dollar's demise were overblown, and when they do, the trend will reverse itself.

What does that have to do with today? Well, everything. Currently China may be looking to slow the growth of its money supply and tighten credit.

Investors have been worried about China's credit growth this year. A tight credit market could choke off the economic growth in the world's second largest economy. Continuing with loose credit, especially in the little-regulated shadow banking sector, on the other hand, is just rolling over the snowball for a landslide in the future.

China reported January new credit lending that exceeded expectations today. Total social financing, a broader measurement of credit in the economy, rose to 2.58 trillion yuan in January from 1.23 trillion yuan in December. That was also higher than 2.54 trillion yuan recorded in January 2013.

While China currently appears to be in a "neutral" position, sooner or later, China will have to slow its economy, and when it does, it may be forced to sell gold.

The consensus seems to be: China's central bank does not seem to be really tightening. "The January money/credit data, plus the PBoC's proactive open market operations, tell us that the PBoC's policy stance remains neutral," wrote Bank of America Merrill Lynch economists Ting Lu and Xiaojia Zhi in a research note published today.

One additional note is that there is speculation that China wants to replace the US dollar as the reserve currency, and establish a new global gold standard. While I have no doubt that China wants the yuan to be the world's new reserve currency, and it most likely one day may be, the talk of a new global gold standard is nonsense. The last thing China wants is an inflexible inelastic currency system. A global gold standard in a dynamic global economy would be a disaster. To maintain stable prices, the money supply must grow at the same rate as the economy. Each country has its own fiscal policy and growth and inflation rate. A gold standard would result in imbalances all over the world, and make China, Canada, Australia, Russia and South Africa the countries that control the mint.

In the last few weeks several blogs and news articles have highlighted rumors that the Chinese government and The People's Bank of China have been quietly buying gold with plans of creating a new Bretton Woods gold standard; however, both Jeffrey Christian, managing director at New York-based research firm CPM Group and Jim Rickards, author of the bestselling book, "Currency Wars: The Making of the Next Global Crisis," said the last thing China wants is its currency to be tied to a gold standard.

Additionally, this quote of Jeffrey Christian, managing director at New York-based research firm CPM Group, demonstrates how central bank buying of gold allows a speculative premium to be built into its price without any real basis. All the PBOC has to do is allow rumors to persist and the speculators will drive up the value of their gold for them. Why buy more when a simple rumor can make you richer?

On the contrary, Christian said that he suspects that one of the reasons why the bank hasn't updated its reserves is because it's not buying that much gold or as much gold as people expect. He added that he suspects the gold that is being bought is for the Chinese sovereign wealth fund, China Investment Corporation, which is buying the yellow metal to diversify and protect its investments.

In conclusion: central bank buying of gold is a double edged sword. Gold is a rather volatile holding on a central bank's balance sheet, and that volatility creates problems, especially when a contractionary policy is being implemented. While central bank buying may be driving gold higher today, it will also likely drive it lower tomorrow. As economies rebound around the globe, they will shift from a stimulative monetary policy to "neutral" and even contractionary policies. When that happens, the dynamics driving gold today will be reversed. Because the US remains on a dollar standard and the world prices gold in US dollars, as inflation develops in nations with gold on the balance sheets of their central bank it will trigger gold selling, not buying. Inflation may actually trigger lower gold prices if the inflation develops in nations outside the US. That is the whole irony of this situation.

Disclaimer: This article is not an investment recommendation or solicitation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice. Past performance is no guarantee of future results. For my full disclaimer and disclosure, click here.

Disclosure: I am long GLL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I also own GLL calls.

Source: Why China Buying Gold May Be Bad For Gold's Price