Towards a new Gold Standard?
The value of the yuan against the US dollar is not making the headlines it should at the moment. Between the 17th and 20th March it appreciated by nearly 1%. Much of this volatility was arguably a response to the Federal Open Market Committee’s (FOMC’s) removal of the word “patient” from its statement on US interest rates. However, between the same dates, gold prices increased by nearly 3% prompting China to announce that the value of its currency against the US dollar was “appropriate”.
The occurrence of these three things within a week does not look like a coincidence, especially given that the Asian Infrastructure Investment Bank, first conceptualised in October 2013, acquired the support of the UK government, some European governments, the IMF and the Asia Development Bank during March 2015.
As China’s economy rebalances and becomes demand-led rather than export and infrastructure driven, it is in China’s interests to support trade in its neighbouring countries. This allows the region as a whole to develop by picking up some of the intermediate manufactured goods production that China can re-distribute through its own supply networks as it moves further up the manufacturing value chain.
Markets are markets and it is a mistake to conclude much from a few weeks of data. Yet it has shown how the re-focusing of China’s currency policy could have global market consequences. Currency policy is currently hidden within a multitude of different signals which appear to have converged during early March. China’s policy makers may be showing that they want to expose the yuan to international markets as they prepare for capital account convertibility. But they have also shown that they are preparing the yuan to establish itself in trade finance and indeed international markets as the second global currency.
There are three reasons for stating that the yuan is strengthening as a global currency: the first is trade, the second is the link between trade and the value of the yuan and the third is the link between gold and the value of the currency.
First, the link between trade and gold in China’s case is clear. Figure 1 shows how gold prices and China’s trade have moved together since June 2001 with a correlation of above 90%. The movements were almost identical up to the end of Q3 2013 when China’s trade starting slowing, de-coupled for 12 months to the start of Q4 2014 and have been similar for the last four months. February’s drop in gold prices mirrors China’s drop in trade and while this is clearly not causality, the closeness of the correlation is important.
Second, the correlation between Chinese trade and the value of the currency is similarly high at nearly 95%. However, interestingly, against the USDCNY spot (where strengthening of the yuan is shown by a downward trend) the correlation with Chinese trade is negative. In other words, despite a perception that the yuan’s value is artificial because of its 2% peg against the US dollar, the mild appreciation of the yuan since 2005 has not had a detrimental effect on trade (Figure 2). What this suggests is that the peg is helping to shore up the currency’s strength as trade develops rather than being managed to shore up trade.
Further evidence of this is shown in the third link: between the value of the yuan and China’s trade in gold. The correlation is nearly 80%: that is to say that as the exchange rate has moved, so gold trade has increased (Figure 3).
Three things are immediately striking about Figure 3: first, gold trade only really started when the currency first appreciated against the US dollar; second, gold trade spiked when the initial 1% peg against the dollar was introduced in 2012; third, imports of gold started to increase sharply again from Q2 2013 as pressures for reform grew and the country prepared for its 18th CPC Central Committee Meeting in November 2013.
What all this suggests is that China’s currency policy is apparently a great deal more coordinated than it might appear at first. It is impossible to know exactly how much gold the country has and the values of trade in physical gold also underestimate total trade in gold which may come from barter or alternative forms (such as jewellery). However, alongside the increase in recorded trade in gold, China has been reducing its foreign currency reserves. This suggests that there is the potential for a large currency shift away from the dollar towards the yuan. The fact that gold reserves are increasing while foreign exchange reserves are falling suggests that policy makers are less concerned about weak Chinese growth and exports as they are about ensuring that, when the time is right, the yuan can enter a free-float against the dollar with impunity.
The links between trade, the yuan and gold all point in one direction: expect the gold price to increase, the yuan to strengthen and China’s exports to increase. China’s economy does not look like it is slowing – but it could just be setting a new Gold Standard.
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