China’s gold-buying spree could be final straw

Some commentators have spent decades predicting the imminent demise of the US dollar’s special status as the world’s international reserve currency.

Eventually, they will be right, and that day may be drawing much closer. As usual, China could hold the key.

Historically, the dollar has been the reserve currency of choice because of some clear advantages over potential alternatives.

For a start, the US has a strong institutional framework, with well-established rules, and many constitutional checks and balances. This makes it a relatively predictable and safe place to invest. Moreover, the sheer size of the US economy and the depth of its financial markets have created a large pool of relatively liquid assets, ideally suited as a global store of value.

Indeed, many countries around the world still try to keep their own currencies stable against the US dollar, either with fixed pegs or some sort of managed exchange rate. The so-called dollar zone is therefore even bigger than the US itself.

It helps, too, that so much of global trade still takes place in dollars. The prices of key commodities are priced in the US currency, including oil, metals and grains, and the dollar is welcomed as a means of payment almost anywhere in the world.

And yet, cracks are starting to appear. One that has been growing for some time is the gradual diversification by central banks, which have been reducing the share of foreign currency reserves they hold in US assets (mainly Treasury bonds).

IMF data suggest that this proportion fell to a 25-year low of 59% at the end of 2020, compared to 71% in 1999.

The downward trend has since paused, but recent data has been flattered by the strength of the dollar, as the US economy has outperformed and the Fed has kept interest rates high.

In turn, this has depressed the dollar value of reserves held in other currencies. Beneath the surface, though, the diversification out of US assets has continued.

As part of this trend, central banks have been adding to their holdings of gold. The People’s Bank of China (PBOC) has been at the forefront here, with official data showing that March was the 17th successive month of net purchases. Industry insiders suspect there has been a large amount of covert buying by the authorities, too.

This is not necessarily anything sinister. It could simply be that the PBOC is a shrewd investor, capitalising on gold’s traditional appeal as a safe haven, a hedge against inflation and a means to diversify risk.

But there may be a lot more to this story. There are clear strategic advantages to China diversifying out of US assets, largely given rising geopolitical tensions over Taiwan and Beijing’s growing assertiveness in the South China Sea.

China’s stockpiling of gold could also be a warning that the country could use its large holdings of US government bonds as a weapon. Any threat to dump these bonds could drive up the cost of borrowing, not just in the US but also in the rest of the Western world. Investors therefore need to stay alert to geopolitical risks – and keep watching the signals from Beijing.

Julian Jessop is an independent economist.