China's Gold Investment - 11 March 2010

How can China build its gold reserves if it doesn't Buy Gold...?

"A FEW FACTORS limit our ability to increase [our] Gold Investment," said China's chief foreign exchange manager, Yi Gang, in a speech this week, notes Steve Sjuggerud in his Daily Wealth email.

Western investors have long speculated China will start Buying Gold and selling its hoard of US Dollars at some point. (China's hoard could be literally trillions of US Dollars.) It would be the first step in a "Doomsday" scenario for the greenback.

Just imagine – China trades in its Dollar reserves for Gold Bullion. The value of the Dollar crashes...and US interest rates soar, as China is no longer willing to buy US government Treasury bonds.

Some investors have said China has a perfect way to do it, available right now. The International Monetary Fund (the IMF) has a near-200-tonne hoard of gold that it wants to unload.

But if China actually used all its Dollar reserves to Buy Physical Gold, it would completely overwhelm the market. It would end up trying to buy about a third of all the gold ever mined in the history of the world. There's no way it could get all that gold without sending the price to outrageous levels.

It seems Mr. Yi recognizes that. He essentially said gold is too volatile, the historic returns aren't that great, and any gold buying by China would "certainly" increase Gold Prices.

If Mr. Yi is to be taken at his word, in short, China doesn't have plans to Buy Gold in the open market. And Mr. Yi's comments are in line with recent comments from the China Gold Association, who told the China Daily newspaper that it is "not feasible for China to buy the IMF bullion, as any purchase or even intent to do so would trigger market speculation and volatility."

So how would China acquire gold if it doesn't buy it? This is where it gets interesting...

An official from the China Gold Association told the China Daily that rather than acquiring Gold from the IMF, China would Buy Gold directly by buying gold mines "abroad". Rather than buying physical gold in the open market (where China would be the 800-pound gorilla in the room), China plans to buy future production instead.

If that's true (and there is some sense to it), then how should you play it? Dennis Gartman reported on this yesterday, in his Gartman Letter:

Perhaps we are to begin owning gold mines rather than Gold Futures or Gold ETFs. We have avoided owning mines for years, preferring the "purer" play of owning gold rather than the mines, for we fear being exposed to poor mine management, or accidents in a mine that might do damage to the equity while gold itself moves higher. But if the Chinese authorities want to own mines, perhaps we have to consider doing so also...

I've done more than consider buying Gold Mining companies. In the latest issue of True Wealth, my subscription newsletter, I recommended Buying Gold mines as the best way to have exposure to gold right now.

The reason is simple. This chart sums it up...



Gold is up 70% since the summer of 2006. Meanwhile, gold stocks (as measured by the Gold BUGS Index) have done nothing.

Usually, a 10% move in gold would mean a 20% move in gold stocks. But this relationship broke down in the financial crisis. Now, either the price of gold needs to crash... or the price of gold stocks needs to soar to correct this anomaly.

The timing might be just right. Gold mining stocks are down, and it's just coming to light that the Chinese authorities could prefer acquiring gold mines – which give the country a permanent supply – over Buying Gold in the open market.

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