Should we be worried with China boosting its stockpile of gold?

The market was abuzz with rumors recently; rumors that China might start backing yuan directly with
gold. It means the Peoples Bank of China will ensure direct convertibility of gold into yuan. For e.g. if the
Chinese central bank announces that they will be ready to transact one ounce of gold at 1500 yuan
anytime, it means you can swap your yuan for gold or vice versa at that specified exchange rate. U.S.
stopped backing its dollar with gold since 1971. However, this is unlikely because in order to back all the
yuan currency in circulation today, either the price of gold should rise to $48,000 (conservative estimate)
or China would need almost 4 lakh tons of gold at current market rates. China currently has about 1800
tons of gold (official estimate). China is unofficially believed to have 3,000 tons of gold and it is unlikely
for China to hoard 4 lakh tons of gold in near future. It is even unlikely for the gold price/oz to reach
$48,000 anytime soon.

Out of its massive $3.2 trillion forex reserves, analysts believe, $2 million are dollar denominated. This is
because China has grown by pegging the yuan to dollar and has been able to keep the volatility under
check, boosting exports. Pegging the currency means the Peoples Bank of China will always stand to
defend the peg ratio (i.e. lets say $1 for 6 yuan by selling or buying dollars. The investors tend to feel
hedged against foreign currency risks and the Chinese exports stay competitive as long as other currencies
appreciate against the U.S. dollars)

So, then why is China hoarding gold? I did a bit of digging in order to find out the percentage of gold in
various countries foreign exchange reserves. As you can see in the graph that I have prepared below,
China has only 2.2% of its foreign exchange reserves in gold.

Percentage of Gold in Foreign

Exchange Reserves
100
80
60
40 89 74.3 68.9 68 62.9 59
20
0 15.3 6.3 2.4 3.6 2.2

Percentage of Gold in Foreign Exchange Reserves

CHART CREATED BY AKASH MEHTA

DATA COURTESY: WWW.GOLD.ORG
When compared to other countries like U.S., Russia, and Germany among others, China has dismal
diversification through gold. Even if the unofficial figures are to be believed, Chinas gold reserves
constitute a minuscule 3.6% of its huge forex reserve.

So, my assumption is that China is trying to diversify its forex reserves by adding healthy amount of gold
to it. Academic economists have long held the view that a country should hold close to 10% of gold in its
forex reserves in order to hedge against financial risks. It becomes all the more important for China to
diversify now as the U.S. continues to inflate its way out of debt simultaneously hurting the value of dollar.
China can no more rely on dollar.