China is wise to boost its gold reserves as a weaker US dollar looms and currency wars beckon

China’s central bank is piling into gold, the traditional safe haven, as bond yields go negative and the US considers ditching its ‘strong dollar’ mantra, potentially igniting currency wars

Neal Kimberley

Published: 5:00am, 24 Jul, 2019

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China added more gold to its foreign reserves in June, for the seventh month in succession.

China’s activity may be shrewd as circumstances favour gold – international tensions, interest rates at derisory or negative levels, and the real possibility that currency wars may break out.

Nor is China the only sovereign buyer of gold.

“In 2018 alone, central banks bought 651 tonnes of gold, up 74 per cent compared to 2017 and the highest level since 1971,” wrote Isabelle Strauss-Kahn, a member of the World Gold Council’s advisory board, last Friday.

If markets decide that the Trump administration’s commitment to the strong dollar is under review, investors are likely to sell the US dollar hard, including versus gold

“Over the past decade, central banks have purchased more than 4,300 tonnes of gold, taking their total holdings to around 34,000 tonnes today,” Strauss-Kahn added.

“The trend has continued in 2019, with net purchases reaching 90 tonnes before the end of the first quarter.”

Admittedly, for central banks to diversify their reserves to include more gold has its own merits and is not necessarily a judgment on immediate gold price prospects.

Equally, the percentage of gold held in such reserves remains small compared to fiat currencies. China, for example, has total reserves of US$3.119 trillion in June, of which US$87.27 billion was in gold.

Central bank purchases of gold are no guarantee that gold prices will rise but they indicate to the wider investing community the underlying and potentially price-supportive demand for the precious metal.

Also, historically, a rise in international tensions has proven somewhat supportive of the gold price, and there is certainly no shortage of that at the moment.

“Whether it be ongoing tensions in the [Persian] Gulf or the protracted uncertainty stemming from various trade disputes, there is certainly fuel on this front to keep gold supported at least,” Neil Mellor, senior currency strategist at US bank BNY Mellon, wrote last week.

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As gold generates no interest, any decision to add more gold to an investment portfolio should factor in both the costs of holding such a position and the opportunity cost of returns that could be earned elsewhere, for example from government bonds.

But years of ultra-accommodative monetary policy around the world after the global financial crisis have suppressed yields to such an extent that holding gold is now a less unpalatable option.

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In a number of jurisdictions, benchmark interest rates are negative. Yields on government bonds have fallen along the curve. In Japan and Switzerland, 10-year government bonds carry a negative yield.

The situation is the same for German government bonds, with the euro zone also having a sub-zero benchmark interest rate. Indeed, the reservoir of negative-yielding bonds globally is now more than US$13 trillion and deepening.

In the United States, the central bank is poised to cut interest rates on July 31 even though US economic data remains broadly robust.

“You don’t have to wait until things get so bad to have a dramatic series of rate cuts,” US Federal Reserve vice-chairman Richard Clarida said on the Fox Business Network last Thursday.

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The prospect of lower US interest rates might itself enhance the attraction of gold compared to the US dollar, the world’s predominant reserve currency.

But there is also something of a question mark over the continued adherence of the Trump administration to the “strong dollar” mantra that has been a keystone of US government policy since it was first enunciated by the US Treasury secretary Robert Rubin in 1995.

Alluding to the possibility of an alteration to that long-held currency stance, US Treasury Secretary Steven Mnuchin told Bloomberg last Thursday that “this is something we could consider in the future but as of now there’s no change to the dollar policy”.

US Treasury secretary Steven Mnuchin and his wife Louise Linton hold a sheet of US$1 notes bearing Mnuchin's name in this 2017 file photo. Photo: Bloomberg

The “as of now” caveat caught the market’s eye, as it indicated that the Trump administration could yet choose to move away from the currency position Rubin crafted in 1995. To do so would be risky business, and, some might say, playing with fire.

If markets decide that the Trump administration’s commitment to the strong dollar is under review, investors are likely to sell the US dollar hard, including versus gold.

Currency traders poised to pounce on weaker yuan

This could ignite currency wars, and a punishing race to the bottom, as nations seek to weaken their currencies to safeguard their competitive positions. Gold might well benefit as a result.

China has been buying gold for seven months in succession. That makes a lot of sense.

Neal Kimberley is a commentator on macroeconomics and financial markets

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