Why (and How) China is Boosting the Price of Gold

The History of Gold Prices (and How We Got Here)

To get the full picture of the current price of gold we have to look back nearly 100 years. In the 1800’s and early 1900’s gold played a key role in international monetary transactions. The gold standard was used to back currencies. Each country determined a fixed exchange rates for its currency, i.e. how many ounces of gold each unit of currency was worth.

Trade imbalances (importing more than they exported or vice versa) could rectified via the exchange of gold reserves. A country with a deficit would have to ship gold to the country with an excess. Any country experiencing inflation would lose gold and therefore would have a decrease in the amount of money available to spend.

Chinese gold coins

old Chinese gold coins—epSos.de (Flickr.com)

However, during WWI and WWII economic warfare was employed in an effort to combat poverty in ones own country by employing a policy called “Beggar Thy Neighbor”. This involved shifting demand away from imports onto domestically produced goods, either through government policy, rather than free markets. The primary vehicles were tariffs (or import taxes), import quotas, or by devaluation of the currency (i.e. changing it’s value in relation to gold). For example, During the 1930s, the British created their own economic bloc to shut out U.S. goods because they felt they couldn’t compete with cheap U.S. goods.

In July 1944, towards the end of the war 730 delegates from all 44 Allied nations gathered in Bretton Woods, New Hampshire. During this conference the U.S. held most of the cards because it was the least financially damaged by the War. The original plan presented by John Maynard Keynes was to establish a world-wide currency called the “Bancor”. Each nation’s individual currency would be pegged to the Bancor (rather than Gold) at a fixed rate. Governments would then be required to buy or sell Bancors in order to maintain the value of their currency at the pegged rate.

However, at Bretton Woods…

The Golden Link- Price Advantage U.S.

During World War II, European nations were highly in debt and had transferred large amounts of gold into the United States both for safe keeping and in payment of debts. In addition, the two wars had devastated Brittain and it was requesting aid from the U.S. So when the United States signed an agreement on December 6, 1945 to grant Britain aid of $4.4 billion the British Parliament finally agreed to ratify the Bretton Woods Agreement.

French President Charles de Gaulle, bitterly fought U.S. officials but in 1945 de Gaulle was forced to grudgingly ask the U.S. for a billion-dollar loan. And thus he too agreed to the Bretton Woods Agreement. This meant that other countries would peg their currencies to the U.S. dollar, and would buy and sell U.S. dollars to keep market exchange rates within plus or minus 1% of parity. Thus, the U.S. dollar took over the role that gold had played under the gold standard in the international financial system. In order to bolster the other country’s faith in the dollar, the U.S. agreed to link the dollar to gold at the rate of $35 per ounce of gold. So, theoretically, foreign governments could still exchange dollars for gold. For instance, if France had a trade surplus with England, England would pay France in Dollars and then France could exchange them for Gold.

But this gave the U.S. an ability that no other country had, i.e. the ability to inflate their currency. The U.S. inflated their dollars and because of the peg to the dollar basically the other countries got the inflation. Obviously, the other countries didn’t appreciate this. By 1965 this became apparent as the free market value of gold was worth more than $35 an ounce. So De Gaulle decided to take his surplus out of the U.S. and made a profit at the same time. He basically bought $150 million worth of Gold from the U.S. Government at the fixed price of $35 an ounce and took it home to France. By 1969 it was worth $39 an ounce on the free market.

By 1971, the U.S could no longer maintain the illusion that gold was still worth $35/oz and could no longer afford to keep selling it at below market prices, so Nixon was forced to “close the Gold Window” and terminated our agreement to sell gold at the fixed price and reveal the dollar to be the fiat currency that it was. Not long afterwards fixed pegs to the dollar were also abolished and currencies began to “float” against each other once again.

This should have been the end of the Dollar’s reign but Nixon had one more ace up his sleeve. In the early seventies the US still was basically oil independent, i.e. it produced enough oil for its own consumption. In an effort to protect U.S. oil companies against foreign competition, it created imports restrictions. So, in exchange for the lift of import restrictions, the OPEC countries promised they would only accept dollars for their oil. This gave the dollar back the control it lost when it gave up gold convertibility.

Basically every country that imported oil had to have dollars to buy it. This artificially increased demand for dollars and once again put the U.S. in an enviable position.

Along Comes China

In 1978, China began exporting more than it imported (i.e. it had a trade surplus). This started slowly but has grown exponentially. By 1980 China’s foreign currency reserves stood at approximately $2.5 billion. Being a “Communist” country with a “command economy” rather than a free market, China was able to create a unique environment. The Chinese currency (called either the ‘yuan’ or the ‘renminbi’) doesn’t float freely on the open market. The government sets a fixed exchange rate (similar to Bretton Woods) .  So when a business earns dollars by selling overseas, it has no choice but to hand that money over to the People’s Bank of China (or PBOC, the country’s central bank), in exchange for local currency. And so the PBOC began accumulating more and more foreign reserves.

China's Foreign Reserves

Thus the PBOC makes a profit on the exchange rate and collects valuable foreign currency in exchange for worthless local currency. At least that is the way it started. But recently, as the dollar has inflated… the dollar has become worth less… while the Yuan has become theoretically more valuable (except for the ‘peg”).

So now the Chinese are stuck with depreciating currency that they can’t dump (or else the value would be driven down on the remainder of their holdings). So they’ve been looking for options. Initially they bought U.S. Treasuries and at least earned interest on their money. But the FED has driven interest rates to near zero. So the Chinese diversified into the stock market buying things like the Blackstone Group (an investment firm) and Morgan Stanley.  But we know what happened to the financials in 2008. So like everyone else, the Chinese got burned big time by the U.S. equities markets.

But they still need somehow to diversify their assets and reduce their currency risk. And where to park all those Dollars? So they started buying up gold and gold resource companies. They began buying gold in the early 2000’s.  Up until this point most governments had been net sellers of gold in an effort to keep the price low and discredit it, so that they could keep up the demand for their currencies. But China realized that eventually paper currency would become worthless and Gold would always be valuable so they slowly began accumulating. Thus the beginning of Gold’s dramatic rise.

By 2011, China had become the world’s biggest buyer of gold. Overtaking even India.  Historically, India has always been the world’s leading gold buyer. In India, people traditionally save and display their wealth in gold… wearing it around their necks rather than trusting banks.

In addition to being the biggest importer of gold it is also the biggest producer of gold. Yes, they produce more gold than Australia or South Africa or Canada etc. But they don’t export it! China actually produces more than 300 tons of gold a year–that’s almost 50% more gold than Australia, the world’s 2nd largest producer.

So where is all that gold going?

According to Richard Russell creator of “The Dow Theory”

“China wants the renminbi to be backed with a huge percentage of gold, thereby making the renminbi the world’s best and most trusted currency.”

So it is stockpiling all the gold produced within China and even buying more on the open market. In addition, it is encouraging its citizens to buy even more gold.  In 2002, China lifted its ban on individual ownership of Gold, twenty-eight years after restrictions on holding private gold within the United States were removed. Then, in September 2009, China began to actively promote gold ownership to its citizens.  The government actually started a major campaign to encourage all citizens to buy gold making it available at  any Chinese bank in the country and at government “gold stores” which look a lot like jewelry stores but inside the cases, instead of jewelry, are various sizes of .9999 pure gold bars.

Why would the Chinese government actually encourage its citizens to buy gold?

  1. They are planning on confiscating it at some time in the future like they (and the U.S.) have in the past…                                  or more likely
  2. They are preparing their citizens for a major shift in the world economy.

China has announced plans to open something called the Pan Asia Gold Exchange (PAGE), In June of 2012. This is designed to be a direct competitor to COMEX in New York and the London Metals Exchange in the U.K. and they promised that it would “level the playing field and allow for a fair global price discovery of precious metals.” But according to SGT Report, it “posed an enormous threat to the existing fractional reserve bullion banks.” And has been derailed. But that won’t stop China and there is another “fully regulated” exchange in the works.

China has also recently inked agreements with Iran to bypass the U.S. Dollar and trade Gold for Oil.

Will China “Corner” the World Market in Gold?

Many experts believe that the Chinese Government  wants to establish a world-class currency, being the only one capable of being backed by gold. In this way they could supplant the U.S. just as we did to Great Brittain with the Bretton Woods agreement. This would give them tremendous economic leverage just as we had in 1944. In addition, to piling up government reserves, putting the massive population to work buying Gold reserves, producing gold from Chinese gold mines, and opening the Pan Asia Gold Exchange, China has also embarked on an ambitious accumulation program, buying world class gold mining companies outside of China.

They have bought significant portions of:

  • Anglogold Ashanti with mines in South Africa, Brazil, Tanzania, Ghana, Guinea and Australia : 100,000 shares
  • Goldfields Ltd with mines in Australia, Ghana, Peru and South Africa: 350,000 shares
  • Kinross Gold Corp. with mines in the U.S., Russia, Mauritania, and Ghana: 250,000 shares
  • Teck Resources: Canada, Mexico and Peru 101 million shares (17% ownership)
  • China also holds US$145 million or 155,600 shares of gold-backed ETF SPDR Gold Trust shares.

So it appears that China is getting serious about Gold and so previous spikes in the price of gold (See: Inflation Adjusted Gold Prices) may not be comparable when it comes to estimating how high Gold will go this time around. But China isn’t stupid and so it is probably timing its purchases and perhaps even selling at some points to mask its accumulation in an effort to get the best prices and not drive up the market as it continues to increase its holdings.

What Can We Do?

The question is how do we protect ourselves? What would happen if the U.S. dollar is no longer the preferred Oil currency? What if the Yuan or “Renminbi” becomes the reserve currency of the world?

None of this will happen overnight. The one advantage the Chinese have is that they take the long view. They don’t have to worry about 4 year presidential terms, or annual reports. Instead they think in terms of decades (or longer).

I think at this point the best way to play it is right alongside the Chinese. Accumulate Gold and Gold mining stocks, and ETF SPDR Gold Trust shares for the long term. In the long run they will retain their value and appreciate due to increased Chinese demand.

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