China's Gold-Backed, Reserve Currency

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Includes: GLD, PHYS
by: Sprott Money

Summary

Does China plan on making the renminbi the world’s reserve currency?

Does China plan on backing the renminbi with gold?

Under international laws governing the transfer of currencies (and gold is always considered to be a “currency”), nations are not required to report additions to their reserves from domestic sources.

Over the years, two questions have surfaced from readers on multiple occasions. "Does China plan on making the renminbi the world's reserve currency?" and "Does China plan on backing the renminbi with gold" (PHYS, GLD)?

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Clearly the two questions are related. Yet, somewhat strangely, the questions seem to always be asked in isolation of each other. Thus the purpose of this article is to consider these two questions (and their answers) together.

Of course, by this point in time, there is little drama in the minds of most readers when these questions are asked. Events have already progressed to where the answers are now self-evident. One half of this was laid out in a recent commentary, which focused on the transition away from the U.S. dollar - the current reserve currency.

That previous piece reviewed the considerable progress which China has already made in "internationalizing" the renminbi. Indeed, for seven of Asia's most-dynamic economies, the renminbi is already their reserve currency. All that was required to make this a reality was for China to engage in "currency swaps" with these nations.

It takes the supply of dollars currently held by some nation, which it previously used as its instrument for international trade. Then China replaces those dollars with renminbi, and then that other nation uses renminbi as its international currency from that point onward.

More importantly, however, we have finally seen a clear indication that the Western bloc itself has bowed to the inevitability that China's currency will soon be the world's currency. This was demonstrated through an announcement by the UK government, the heart of Western banking, and thus the heart of the Western (U.S.) monetary system.

That government announced that it would start denominating some of its own bonds not in dollars or pounds, but in renminbi. Merely holding renminbi as part of its foreign currency "reserves" (as Western governments already do) is an ambiguous gesture. It indicates that the renminbi is an important currency, but nothing more.

However, when a government begins denominating its own debt instruments in a foreign currency, this is an unequivocal indication that the foreign currency is regarded as a superior currency - i.e. the "reserve currency". That announcement was, effectively, the official beginning (in the West) of the transition from dollar to renminbi.

Equally, China's intent to (some day) back the renminbi with gold also appears to be carved in stone. Not only has China's government been officially raising its reserves, with acknowledged reserves of over 1,000 tonnes, but we have every reason to believe that it has been covertly adding to its gold reserves at a much greater rate.

This is indicated through the extreme, determined effort made by the Chinese government to ramp-up its domestic gold-mining industry. In a span of only four years (2002-06), China more than doubled its domestic output, from roughly 175 tonnes per year to 360 tonnes. In an industry where the time-span from planning a mine to commencing production typically ranges close to a decade, such a dramatic increase in gold output can only point to some specific, greater (national) purpose.

Here readers need to understand that under international laws governing the transfer of currencies (and gold is always considered to be a "currency"), nations are not required to report additions to their reserves from domestic sources (their domestic mining industry, for example). Thus when China moved itself from being the world's 4th largest gold-producer (2002) to being the world's largest producer (2006), it provided itself with a much larger stream of gold which could be secretly (but legitimately) added to its own reserves.

Given that none of this mined gold ever leaves the country, and accounting for what China has added to its reserves in official (international) purchases, the actual total of China's current gold reserves has been estimated by some commentators (myself included) at roughly 4,000 tonnes. Of course if China has been secretly increasing its reserves in a less-than-legitimate manner, that number could be even higher.

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Here it is worth noting a report which originally appeared in China Youth Daily, back in 2009. The report quoted Ji Xiaonan, chairman of the supervisory board for the China State Council, which manages the nation's largest state-owned companies. Thus this is someone familiar with (and likely deeply involved in) China's strategic economic planning.

Ji stated (in 2009) that China should seek to:

i) Increase its total gold reserves to 6,000 tonnes in 3 - 5 years

ii) Increase its total gold reserves to 10,000 tonnes in 8 - 10 years

If that statement represents the actual schedule which China has followed in raising its reserves, this would mean that China's actual, current gold reserves would already be at least 6,000 tonnes. In comparison, the creator/issuer of the current reserve currency, the U.S. government, claims to have total gold reserves of roughly 8,000 tons, although no serious commentator actually believes that number, given that no outside individual has seen any of this gold in roughly 60 years.

However, demonstrating China's intent (and considerable actions) in making the renminbi the world's reserve currency and backing it with gold - thus answering our questions in the affirmative - is only the beginning of our examination of this topic, not the end. We see the real issue(s) emerge when we consider that there are only three possible strategies which China can pursue in attaining these objectives:

1) First back the renminbi with gold, then complete the transition to reserve currency.

2) Simultaneously back the renminbi with gold as it completes the transition to reserve currency.

3) First complete the transition to reserve currency, then back the renminbi with gold.

In fact, only one of these three options is practically/economically viable. A strong hint as to which of the three meets that criterion was provided in the commentary which immediately preceded this, when it was observed that China is clearly intent on making "this global transfer of economic power/control as orderly as possible."

Once we focus on that underlying principle, it quickly becomes apparent that neither of the first two options is feasible, if China has any hope of making these enormous, twin transitions anything close to "orderly". We can comprehend the implied economic chaos of either (1) or (2) by asking one, simple question. If people had a choice between holding a paper U.S. dollar or a gold-backed renminbi; which would they choose?

For roughly 90% of the world's population, the economic stampede away from dollars and into renminbi would begin even before one could finish articulating that question. Gold is (and always has been) "money". Thus a gold-backed currency is also money.

Even in the Western bloc, subjected to an entire generation of talk that gold (rather than their own paper) was "a barbarous relic", one must suspect that the attraction of currency (money) with tangible, legitimate value would exert a tremendous attraction.

Immediately, we see that only the third option is viable: first completing the transition from a (paper) U.S. dollar to a (paper) renminbi as reserve currency. Then, only after most of the world has transferred their holdings of dollars to holdings in renminbi, in (hopefully) some quasi-orderly fashion, would/will it be safe for China to openly back its currency with gold - and restore a gold standard (i.e. legitimacy) to the international monetary system.

stampede

The irony here is that China cannot openly announce or confirm this specific strategy, since if it officially provided affirmative answers to our original two questions, this could very easily trigger precisely the sort of economic stampede it hopes to prevent. It is thus left to individuals to deduce these answers for themselves, and then position themselves (financially) before any potential "stampede".

Jeff Nielson for Sprott Money

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Sprott Money is a bullion dealer located in Toronto, Ontario. To the extent that this content includes references to securities, those references do not constitute an offer or solicitation to buy, sell or hold such security. This document should not be considered investment advice and the information contain within should not be relied upon in assessing whether or not to invest in any products mentioned.