Does China’s Buying Gold Signal a Shift in Forex Policy?

China recently released an update on the breakdown of its foreign reserves and this rare disclosure confirmed that China has been quietly adding to its gold reserves. In fact, over the past six years, China has almost doubled its holdings in gold to 1,054 tons, making China the sixth largest holder of gold bullion.¹ As news of China’s gold-buying reached the markets last Friday, gold futures jumped $7.70 to a three-week high of $913 an ounce as investors speculated that China will continue to buy gold as part of its overall foreign exchange reserves.

At an estimated $1.95 trillion, China manages the world’s largest foreign currency reserves, but even taking the latest buying spree into account, gold accounts for only 1.6 percent of China’s overall reserves. The lion’s share – a full $744 billion – is held in the form of US government bonds, and it is this massive exposure to the US dollar that is raising alarm bells at the People’s Bank of China.

Earlier this month – just prior to the London G20 summit meeting, in fact – Zhou Xiaochuan, Governor of the People’s Bank of China, called for a discussion aimed at replacing the US dollar as the world’s de facto reserve currency with a new currency issued by international financial institutions. The topic did not make the official G20 agenda of course, but China did manage to make its point that as the world’s preeminent holder of foreign currencies, it would not be ignored – nor would it quietly accept US economic policy that further weakens the dollar thereby reducing the value of its cash reserves.

As America continues to flounder in a devastating recession while simultaneously adding to an already out-of-control national debt, China has watched the value of its US reserves wither. Nevertheless, China remains the principle buyer of US government bonds so critical to President Obama’s recovery plans, but you do have to wonder if China will soon reach the point where it will simply decide that it is too risky to continue serving as America’s personal banker.

The problem with this of course, is that China can ill-afford to do anything that will delay an eventual recovery in the US – it simply has too much to lose. Should China deny further credit to the US – or even less likely, flood the forex market with some of its own greenbacks – the resulting loss in the dollar would hurt China almost as much as the United States itself. Not only would the value of China’s reserves be slashed, but China’s number one customer would be in an even weaker position to buy the exports China desperately needs to sell to maintain its own economy.

No, China understands that there is little that it can do directly – oh sure, government officials can rail against American fiscal policy and threaten to sell off its American dollars, but everyone knows this is just so much nationalist posturing. It may sound trite, but the reality is that the US and China are in this thing together and both countries are dependant upon each other. China may continue to buy gold to help hedge its US dollar exposure but there is little question that China will also use its reserves to buy even more dollars to ensure the US has the liquidity it needs to keep its financial system functioning.

1. As of April 2009, the top five gold holders were: the United States (8,134 tons), Germany (3,413 tons), the International Monetary Fund (3,217 tons), France (2,487 tons), and Italy (2,452 tons)

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