Sunday, June 13, 2010

China's Take on Gold

Late last week, China's central bank announced that it would not buy gold as part of its asset allocation strategies. It cited the gold market's small size, illiquidity and volatility as reasons.

This decision should serve as a warning to gold bugs. The Chinese have issued currencies (first metal and then paper) for thousands of years. They also possess the accumulated wisdom and experience of a civilization that continually existed those thousands of years. China suffered from inflation and financial speculation before Columbus, the Vikings, or whoever discovered America. They know a bag of . . . well, can of worms when they see one.

China has an enormous investment problem. It probably holds more of the world's financial assets than any other single investor, and is engaged in a uniquely difficult search for value. American financial advisers and money managers look for and promise (morally, if not legally, speaking) positive gains, perhaps a tacit reflection of America's singular success in growing geographically and economically during its short existence. The Chinese understand from long experience that, at times, survival is the priority and positive returns may require more risk than is prudent. They largely avoid stocks, and mostly stick with government bonds and other high quality fixed income investments. They didn't abandon the dollar when it sank in relation to other currencies, and haven't abandoned the Euro even though it's sunk in relation to other currencies. They aren't trying to avoid all losses, but seek stability until they can re-focus their economy toward growth based on domestic consumption.

Why would they be uninterested in gold, even though Chinese emperors first coined gold thousands of years ago? Their announced reasons tell the story. Gold can't serve the needs of large-scale modern investment. There isn't enough of it. Most of the value in today's world economy is embodied in securities (like stocks and bonds), bank accounts and other cash equivalents, real estate, and private ownership of businesses. Gold is a fringe investment, whose aficionados sometimes include members of one lunatic fringe or another. It can skyrocket in value, and just as easily nosedive.

Some central banks have increased their holdings of gold in the last few years. But China's decision to avoid investing in the gold market takes a potentially huge buyer out of the picture. Buy gold if you like. Just remember that your sharing the gold market with some semi- or fully whacked out people, and anything can happen. Gold tends to rise in price during times of stress; hence its popularity in recent years. But it won't hold its value after the crisis passes. That was the case in the early 1980s. Your holdings of gold will attain lasting value only if civilization collapses. Give our regards to the Mad Hatter if you think that's going to happen.

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