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Ronald Stoeferle

Ronald Stoeferle

Ronald is a metals analyst at Erste Group. Erste Group is the leading financial provider in the Eastern EU. More than 50,000 employees serve 17.4…

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China on its Way to the Leading Global Currency?

The open criticism of the US policy is getting more vociferous by the day. For example, a former central bank advisor pointed out that in the medium to long term US Treasuries were “not safe”  . In order to further diversify China has now stepped up its bond purchases from the European stabilisation fund EFSF. China will also launch a new investment fund, which will invest a part of the almost USD 3bn worth of foreign exchange reserves in energy and precious metals. PBoC advisor Xia  recommended holding only USD 1bn worth of foreign exchange reserves, while the rest should be employed for strategic investments . He also suggested a gradual increase in gold reserves and recommended following a “buy the dip” strategy over an extended period of time. He proceeded to advise the PBoC to add silver to the official reserves  while advising the US government to sell some of its gold reserves. An official of the Chinese Chamber of Commerce said China should step up its gold reserves to as much as 8,000 tonnes. We therefore expect China to gradually accumulate gold, and we also believe that the country holds substantially larger reserves than the official record of 1,054 tonnes suggests.

Plans are to further liberalise the gold market. The Hong Kong Mercantile Exchange wants to gradually set itself up as alternative to the Comex. Since 18 May the exchange has had a 1kg future on offer with the physical delivery taking place in Hong Kong. At the moment only five banks have permission to import and export gold. This is going to change now, with numerous banks being granted access to the Shanghai Gold Exchange. This could facilitate the purchase of gold for millions of Chinese bank customers.

In the new five-year plan the targeted share of consumption is 55% (up from currently 40%). The transition from an export-oriented economy to internal growth will entail extensive implications for the global economy. This should further stimulate gold consumption. While the gold affinity in China is substantial, annual consumption per capita is still only 0.4 grammes. Given the savings ratio of almost 35% and the rising wealth, gold consumption has to increase by default. We believe that the growing relevance of the Chinese middle class for the gold market is not fully appreciated.

The IMF has recently also confirmed the fact that the USA will have to gradually cede its leading status to China. The fund expects China to overtake the USA in 2016 in terms of purchase power parities, and it envisages growth from USD 11.2 trillion in 2011 to USD 19 trillion in 2016, whereas the USA should grow from USD 15.2 trillion to USD 18.8 trillion Roughly ten years ago the US purchase power parities still exceeded the Chinese ones by a factor of 3x.

Yuan as leading currency?

The fact that China wants to achieve full convertibility for the yuan in the long run is becoming clearer by the day. This would be a big step towards a new global leading currency. China is preparing for the post-USD era at full speed. The yuan should outrank the US dollar in terms of global relevance within a few years. Yi Gang, the co-chairman of PBoC has recently made reference to a liberalisation within the next five years. Li Xiaojing, Managing Director of Bank of China in New York, has already mentioned the preparation work for the day that the Chinese currency will be fully convertible. He regards this as one of the highest priorities . The plans are more than just ambitious, but China has a track record of achieving ambitious goals.

At the moment only 0.4% of all foreign exchange transactions are settled in Chinese currency. The US dollar has recently accounted for 43% of total transaction, the euro for close to 20%, and the Japanese yen for 10%. This means that the yuan is clearly underrepresented in view of the already central relevance of China for the world’s economy.

Currently numerous smaller agreements are being signed that reveal the overall long-term strategy. We assume that this is how China wants to gradually boost demand without achieving outright convertibility right away. Within the framework of the new five-year plan, China wants to settle almost 50% of foreign trade in yuan by 2016. It wants to invoice in yuan in the bilateral trade transactions with African or Latin American countries that are rich in resources. Iran for example is said to supply oil for yuan. In addition, the PBoC has allowed almost 70,000 companies to invoice its foreign business worth almost USD 70bn in yuan.

China is currently inflating its money supply by a larger degree than most other nations. M2 increased by more than 17% in the first quarter in comparison with the referential period of 2010. In the past decade M2 has increased by an average of 18.8% (while the GDP increased by 10.9%). China currently runs the highest M2/GDP ratio in the world. In 1996 M2 amounted to USD 700bn, meanwhile it has increased to more than USD 11 trillion. If we assume that the money supply will continue to rise by 15% per year, the increase in absolute terms would be USD 1.7 trillion annually. If one wanted to cover only 10% of the annual increase in money supply (i.e. USD 170bn) with gold, it would require almost 3,600 tonnes at current prices.

M2 money supply USA vs. M2 China (in USD)

M2 money supply USA vs. M2 China
Sources: Datastream, Erste Group Research

If China wanted to cover 40% of its M1 money supply with gold, it would have to buy more than 35,000 tonnes of gold. If the USA appreciated its gold reserves to USD 6,000/ounce, it would cover 40% of M1 without a problem. At USD 6,000/ounce, China would still have to buy 9,000 tonnes in order to be able to cover 40% of its own money supply . The consensus expects China to aggregate at least USD 2.6 trillion worth of foreign exchange reserves in the next years. If China wanted to maintain its 1.5% ratio of gold in terms of total reserves, it would have to buy at least 200 tonnes per year.

“Anyone who thinks that exponential growth can go on indefinitely in a finite world is either mad or an economist.”  Kenneth Ewart Boulding

We are therefore sceptical with regard to the – generally accepted – belief in the Chinese economic miracle. The Chinese economy has grown by almost 10% p.a. in the past decades. The consensus (according to Bloomberg) expects real growth of 7.7% p.a. in the next 20 years, which from our point of view seems by far too optimistic. A mere extrapolation of the past is dangerous, as a look back into history shows. The boundless optimism sometimes reminds us of Japan in the late 1980s.

The Chinese leaders are faced with a predicament. On the one hand almost 25 million new jobs have to be created every year, and on the other hand the negative real interest rates are fuelling numerous asset bubbles. While we do not expect the Chinese economy to collapse, a solid shakeout seems overdue. For an economy that has grown by double-digit rates for years, GDP growth of only 5% feels like a severe recession. The sooner China allows the cut to be made, the less painful it will be.


History has often shown that a planned “soft landing” tends to end in an abrupt crash. Following the teachings of Ludwig von Mises, we conclude that a laissez-faire policy would be the only right approach. The massive market interventions delay the shakeout in China and will only make things worse when it does eventually strike. We believe that such a collapse, which has to be expected, represents one of the biggest negative factors for the gold price.

By. Ronald Stoeferle of Erste Group

Erste Group is the leading financial provider in the Eastern EU. More than 50,000 employees serve 17.4 million clients in 3,200 branches in 8 countries (Austria, Czech Republic, Slovakia, Romania, Hungary, Croatia, Serbia, Ukraine). As of 31 December 2010 Erste Group has reached EUR 205.9 billion in total assets, a net profit of EUR 1,015.4 million and cost-income-ratio of 48.9%.

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