With foreign exchange reserves already the largest in the world, why does China continue to increase its holdings of gold?

First, China's foreign reserves have rebounded, and its gold holdings have increased

According to the data of the State Administration of Foreign Exchange, affected by factors such as exchange rate conversion and asset price changes, as of the end of January 2023, the scale of our country's foreign exchange reserves was 3.1845 trillion US dollars, an increase of 1.82% from the end of 2022, which is the fourth consecutive month of foreign reserves rising.

In addition to the recovery of foreign reserves, China's official reserve assets, gold holdings have also increased month by month. According to SAFE data, our country began to increase its gold holdings in November 2022, with a cumulative increase of 2.48 million ounces in three months. In January, our country's gold reserves reached 65.12 million ounces.

This is the first time in three years that China has increased its gold holdings. Since September 2019, China's gold reserves have remained at the level of 62.64 million ounces for three consecutive years.

China is the world's largest foreign exchange reserve country, ranking first in the world for 17 consecutive years, nearly three times that of Japan, the second largest in the world. Its huge foreign reserves are sufficient to meet the needs of crisis situations. So why has China suddenly attached importance to gold reserves that do not directly generate income after three years?

Second, the gold allocation ratio is too low

Among the official reserve assets of our country 3.40 trillion, foreign reserves are the majority, while gold holdings are small. As of the end of January, the central bank's pure foreign exchange reserves 3.18 trillion US dollars, accounting for 94.4%, while gold reserves 65.12 million ounces equivalent to about 125.20 billion dollars, accounting for less than 4%. In addition, there are IMF reserve positions and SDR reserves equivalent to about 63 billion dollars.

Compared with the international comparison, China's official reserve assets account for a large proportion of foreign reserves, while the share of gold holdings is relatively small.

According to IMF data, by the end of 2021, global foreign exchange reserves accounted for only 81% of total reserves, while gold's share reached 13%. In particular, developed economies hold about two-thirds of gold stocks. Gold accounts for 17.4% of developed economy reserves and 6.9% of emerging economy reserves. Basically, converting a part of foreign exchange into gold is a monetary reserve policy adopted by all countries in the world.

From the perspective of holdings, China's gold reserves of more than 2,000 tons rank behind those of the United States, Germany, Italy, France, and Russia. There is also a big gap with the United States' more than 8,000 tons. As China's economic strength grows, there is indeed a need to increase its gold holdings.

III. Excessive foreign reserves are vulnerable to depreciation pressure

Foreign exchange reserves, including cash, foreign bank deposits, foreign securities, etc., have the advantage of being flexible in the balance of payments and generating interest income, but the disadvantage is that it is easy to cause losses in foreign exchange depreciation.

Although Safe does not disclose the asset structure of China's foreign exchange reserves, according to the US think tank the Council on Foreign Relations, China's foreign exchange reserves are mainly in US dollar assets, and most of them are held in the form of securities, including US Treasury bonds, agency bonds, corporate securities and stocks.

After the Federal Reserve started the most aggressive interest rate hike since the 1980s in 2022, China's foreign reserve assets are facing great pressure on ROI losses. Take US bonds as an example, our country is the second largest holder of US bonds after Japan. The yield of 10-year US bonds in 2020 is only about 0.5%, which has risen to nearly 3.9%. It is the historical high since the financial crisis. The yield of US bonds is inversely proportional to the price. The higher the yield, the greater the decline. Early purchases of US bond positions will suffer huge capital gains.

The valuation loss is the culprit behind the continuous decline of China's foreign reserves last year. Driven by the record trade surplus, our country's current account surplus in 2022 was 417.50 billion US dollars, the second highest in history after 2008; capital account outflows were also controllable, reflecting the non-reserve financial accounts of cross-border capital flows in the private sector. In 2022, the net outflow was 276.80 billion US dollars, but the stock of foreign exchange reserves under the central bank's balance sheet fell by 122.50 billion US dollars. According to Zhang Ming, deputy director of the Institute of Finance of the Chinese Academy of Social Sciences, the valuation loss of foreign reserves in 2022 was as high as 220.70 billion US dollars.

From a historical perspective, the impact of the depreciation of foreign reserves may be even greater. In September 1931, the United Kingdom announced that it would abandon the gold standard, the pound fell sharply, the foreign exchange reserves of the Bank of France immediately plummeted by 35%, and the Netherlands and Belgium also suffered huge losses. China's foreign reserves are mainly in US dollar assets. If the dollar depreciates rapidly, the losses will be greater.

And gold has a natural anti-inflation and depreciation risk. World gold production rose from 2,299 tons in 1995 to 3,556 tons in 2018, a total increase of 55% in more than a decade. In contrast, under the stimulus of the Federal Reserve and other major central banks, global foreign exchange reserves have increased by more than 7 times since 1999. The increase in gold holdings helps to hedge against the depreciation of foreign reserve currencies.

IV. Avoiding geopolitical risks

For example, after the conflict broke out between Russia and Ukraine in February last year, the United States and its allies announced the freezing of the Russian Central Bank's $300 billion foreign exchange reserves, accounting for 60% of Russia's $498 billion foreign exchange reserves in January 2022. Foreign exchange reserves have become a weapon of sanctions, and their security has been greatly compromised.

In this context, China naturally needs to optimize the structure of foreign reserve assets to cope with possible political disputes. When the conflict between Russia and Ukraine broke out in February 2022, China still held about $1 trillion in US debt. By the end of the year, US debt holdings had fallen to $867.10 billion. Except for a small increase in holdings in July, the other 11 months maintained the state of selling US Treasury bonds. The year-on-year decline remained double-digit for nine consecutive months. In December, US bond holdings fell by 16.7% year-on-year.

Given that the dollars exchanged for US assets after selling US Treasuries are still US assets, the demand for gold to exchange dollars for "natural currency" comes into play at this time. In fact, not only China, but also other countries around the world are also increasing their holdings of gold due to geopolitical risks.

On January 31, the World Gold Council (World Gold Council) released the 2022 "Gold Demand Trend Report", which pointed out that the global central bank's annual gold purchase demand reached 1,136 tons in 2022, more than double the 450 tons from the previous year, setting a new high in 55 years. In the fourth quarter of 2022 alone, the global central bank purchased 417 tons of gold, and the total amount of gold purchased in the second half of the year also exceeded 800 tons.

Summarize:

1. Gold reserves account for less than 4% of the official reserve assets of our country 3.40 trillion, which is lower than the international level.

Excessive foreign reserves are vulnerable to depreciation losses, and the valuation loss of foreign reserves will be as high as 220.70 billion US dollars in 2022.

3. Foreign reserves may also be frozen by hostile countries, and converting some of them into gold is conducive to protecting against geopolitical risks.