China's gold buy raises eyebrows for all the right reasons

By Myra P. Saefong
MarketWatch.com
Friday, May 1, 2009

http://www.marketwatch.com/news/story/Chinas-gold-buy-raises-eyebrows/st...

TOKYO -- The precious-metals market took notice for all the right -- but not-so-obvious -- reasons when China announced last week that it ramped up its gold reserves by 76% in the last six years.

After all, the world's largest producer of gold, which also happens to be the world's most populous nation and third-largest economy, must have a good reason for its purchases -- and quite a few experts said the move solidifies gold's place as a monetary asset, and shows that it's destined for a brighter future.

"The important take-away is that China itself is absorbing the bulk (if not all) of the production of the world's largest producer of gold (also China) with the now confirmed intent of building reserve holdings," said Peter Grant, a senior metals analyst at USAGold-Centennial Precious Metals in Denver. "That is very favorable for the longer-term outlook for gold," he said.

Last week, China announced that the amount of gold in its reserves has climbed to 1,054 tons from 600 tons in 2003.

"China, true to its reputation for patience and steady, long-term progress toward its goals, has taken the golden path and now they want the world to know about it," said Michael Kosares, president of Centennial Precious Metals.
The nation has become the fifth-largest individual-country holder of the precious metal.

And it didn't just announce its gold accumulation last week. It also asked the International Monetary Fund to sell its entire 3,217 tons reserve, Kosares points out.

And why would China encourage sales that could potentially depress the price of the gold it just bought a lot of? So it can buy more, said Peter Grandich, a metals writer at Agoracom, an online marketplace for small-cap investors.

The request, combined with the announcement on reserves, "is intended to deliver a message to the financial markets [that China] sees gold as an important part of the overall international monetary scheme -- a scheme that may evolve to a system in time," said Kosares.

On a stand-alone basis, the value of China's gold reserves is impressive, but not really so given the size of the nation's foreign-exchange reserve.

China's gold reserves are worth almost $31 billion -- about 1.6% of its total foreign-exchange reserve holdings, and gold as a percent of the country's total reserves has actually declined since 2003, according to Sam Subramanian, editor of AlphaProfit Sector Investors' Newsletter.

To put that into better perspective, if China was to purchase the IMF's reserves of 3,217 tons at a price of $1,000 per ounce, the price would be $103 billion, according to Kosares.

China's current foreign reserves stand at about $1.95 trillion, so the purchase price of all the IMF gold would amount to a "paltry" 5.25% of China's total reserves, he said.

So the total figures aren't so impressive and the gold market overall probably saw the purchase as a really small amount compared to China's resources, said Mark Leibovit, chief market strategist for VRTrader.com.

"If China was serious, their demand could drive gold through the highs and keep it there," he said.

Gold futures prices touched a record level above $1,030 an ounce in mid-March of 2008. They've pulled back from the all-time high to currently trade above $900.

But consider this: Even after the large increase in gold holdings, China's holdings of gold as a share of total foreign-exchange reserves are well below the world average of over 10%, according to Mark O'Byrne, executive director at Gold and Silver Investments Ltd. Given that, "it seems very likely that China will continue buying gold, which would in large measure offset sales by European central banks and expected IMF disposal," he said.

He also pointed out that Hou Huimin of the China Gold Association said China may want to hold a total of 5,000 tons of gold so "it seems likely that they will at least seek to replicate the average international gold holding of some 10% [and] even longer term, there is no reason to doubt that they may hope to join the U.S. as one of the largest holders of gold in the world," said O'Byrne.

All in all, China's moves reveal the government's assessment of the metal's worth as a currency, analysts said.

"The fact that China is a buyer for reserves is far more important than how much it currently holds," Julian Phillips, a South-Africa-based editor, wrote in a newsletter published on GoldForecaster.com. "There is no other conclusion we can reach other than China recognizes its worth as a reserve asset," he said.

That comes on the heels of expectations that the U.S. dollar is "virtually guaranteed to, eventually, lose its status as the international reserve currency," said David Beahm, a vice president at precious metals retailer Blanchard & Co. "As the world deals with the global economic crisis, the value of gold as the only true 'hard currency' is coming to the fore," he said.

But governments don't want to lose control of the printing press and don't want a gold standard either, said VRTrader.com's Leibovit. That is, "unless a plan is under way to peg gold to their currency at a substantially higher price, which would create a huge asset that would act as a counterbalance to their huge national debt," he said.

Still, it's possible that gold can return to a monetary role of backing up the value of currencies. "The implications for gold returning to a monetary role are tremendous and gold-price positive," said Phillips.

Really, "there is no alternative, but the question is when," said Leibovit. "Another financial shock could do it, causing distrust of any paper investment."

But Jon Nadler, a senior analyst at Kitco Bullion Dealers, points out that all of the world's above-ground gold amounts to around 0.6% of total global wealth, so even if gold were at $10,000 per ounce, the metal would only amount to 6% of total global wealth.

"That does not begin to make for a panacea for what ails the world," he said.

Even so, an important country such as China should continue to seek to diversify its massive holdings, and so should the average investor, he said. Just don't diversify with the "disingenuous idea" that this is a "sign of [a] fuse being lit under gold," Nadler said. "It's just insurance being bought ... a little bit at a time."

For now, others appear to be taking China's lead. Russia has made slow but steady increases in its gold reserve over the past few months, according to James Moore, an analyst at TheBullionDesk.com in London.

Singapore, Norway, Saudi Arabia and other member nations of the Organization of the Petroleum Exporting Countries are likely already increasing their allocation to gold, or likely to do so in the coming months, said O'Byrne. "They would be somewhat ignorant and financially and economically illiterate not to do so."

India and Taiwan are other large creditor nations which have "paltry" official gold holdings at some 3% and 3.6%, respectively, he said. "They are likely to increase their gold holdings to protect from currency depreciation in the coming months."

Gold demand is rising at time when global gold production is falling, said Blanchard's Beahm. "With most of the low-hanging fruit already plucked, gold producers are increasingly moving into remote and risky regions in order to keep up with demand."

Against that backdrop, Beahm expects gold prices to top $1,500 before the end of the year and notes that some analysts believe that level will become a floor, not a ceiling.

Leibovit said the precious metal will probably "follow the rule of 10" -- increase in value by at least the power of 10 in the next one to five years.

"The first step toward stability for both individuals and nation states is a step in the direction of gold, and China has taken it," said Kosares.

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Myra P. Saefong is MarketWatch's assistant global markets editor, based in Tokyo.

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