In a move that provides a glimpse of the future of US dollar and gold, China has allowed its currency to be traded for the first time in the United States. This is a bullish sign for gold investors. It is an important step in the country’s plan to make the renminbi an international currency. The explicit move is an endorsement by Beijing since the state-controlled Bank of China Ltd is at the forefront of this development.

Although a floating currency allows price moves in both directions, it is general consensus that the renminbi will strengthen against the US dollar due to trade imbalances between the two countries. The impact on commodity markets, including gold, will depend on the extent and speed to which China allows its currency to rise.

The impact of a free floating yuan will affect commodities in three angles: economic strength and prospects of global recovery, direct impact on trade of commodities to and fro China, and the broader knock-on effect on commodity demand.

Bank of China Expectations

According to Li Xiaoping, the general manager of Bank of China’s New York brand, “we’re preparing for the day when renminbi becomes fully convertible.” He added that the bank’s goal is to become the “renminbi clearing center” in the United States. Right now, the yuan is still tightly controlled by the government. Until the middle part of last year, the buying and selling was confined to China and was under tight capital controls. It was in July last year that the government allowed the currency to be traded in Hong Kong. Its volume has since ballooned to $400 million from a base of zero.

The move by Bank of China comes at a time when the United States is pressuring to country to let its currency appreciate, blaming it for making US trade deficit worse. It should be noted, however, that Beijing’s preparation for convertibility also hints at the strength of China’s economy. It is the second-largest national economy in the world. To be recognized as a global power, it should also have a global currency.

Although individuals and businesses in the United States can trade yuan in Western banks like HSBC Holdings, this is the first time that China has allowed a Chinese-controlled bank to engage in similar activities. This is a stamp of approval on renminbi trading. However, the Bank of China puts a limit of $4,000 per day (and $20,000 per year) on the amount that a US-based person can convert. This restriction is basically in place to minimize currency speculation. There is no limit on the amount that businesses can convert as long as they are engaged in international trading. In addition, the Bank of China places no restriction on the amount of yuan that can be converted back to dollars.

Growing Openness in Beijing

The decision of allow open trading of the yuan can be traced back to Beijing’s growing openness to currency liberalization. In a previous article, we talked about China’s (together with Russia, France, and other countries) intension to create a basket of currencies to replace the dollar. But “China has a long way to go before it has a fully convertible currency, and this is an inching step forward,” according to Robert Sinche of RBS Securities in Stamford, Conn.

Some analysts expect that in a few years, 20-30% of the country’s transaction will be conducted in yuan instead of dollars (the figure is less than 1% today). Take note that as China becomes more proactive in pushing its currency, every one US dollar worth of contracts may be replaced by yuan. In addition, for every seven yuan that is purchased on the international foreign exchange, it is replacement one US dollar. There is also a perception that the renminbi is stronger than the dollar is growing.

If you look further down, the impact of using the yuan as an international currency won’t be positive for the US dollar since it will no longer be used as widely for international trade. The money will add to the home money supply. This will have a lot of ramifications in the global economy.

There are skeptics who doubt its growth potential, however. For example, some say that growth will be checked due to new regulations. Last month, the Hong Kong Monetary Authority placed restrictions on banks’ ability to provide yuan-related products in the territory. Analysts believe the regulations are designed to keep speculators from betting on the currency’s movement, which can potentially cause massive disruptions to the economy. A more immediate obstacle to growth is lack of demand among American businesses, majority of which still use the dollar for cross-border transactions. Some people also believe that China may back track if this proves to be the wrong move. What Beijing is interested in, at this point, is measured growth in yuan trading.

A lot of investors are looking into buying yuan as a form of investment, seeing it as a sure bet. Chinese officials have stated that they will allow the currency to appreciate. The only question here is the pace of appreciation. Another aspect to look into is bank fees as these tend to be high for yuan accounts.

The Chinese renminbi has appreciated by 3.3% against the US dollar last year. Beijing loosened the currency’s peg to the dollar during summer. But the gains stalled after the world’s major economies met in November for the Group of 20 summit.

Chinese Demand for Gold

In a previous article, we have talked about the increasing gold demand from China. This will impact global gold prices because most will be imported. Right now, the premiums for gold bars for spot delivery is skyrocketing and the end is not yet in sight. Some trends that can be observed in China include rising food inflation and the rising levels of general inflation. The phenomena may be the result of urbanization shifting productivity from the countryside to the cities.

While inflation may play some part in rising demand for gold in China, it is not the driving force behind it. As the country’s capacity continue to increase, its middle class investors are growing – many of them are turning to bank deposits and gold because it is perceived to be “safe”. The government itself also has a massive demand for the bullion.

Since we were just explaining how can events outside of the US impact the price of gold, let’s take a look at the long-term gold chart from the non-USD perspective (courtesy of http://stockcharts.com):

From a non-USD perspective, the support is provided by the 200-day moving average, which has been important in the past. Please note that even if this is a beginning of a bigger downswing, we are still likely to retrace about 50% of the decline first, as it was the case previously.

Future of the Fed

Another notable concern that’s worth mentioning this week is about the future of the Federal Reserve. Questions about the Fed’s ability to withdraw stimulus money worth trillions of dollars are valid. This day remains distant at this point but a number of economists are already thinking about the unthinkable: can the world’s most powerful central bank become insolvent? Almost immediately, the answer is no.

As the United State’s monetary authority, it can print money at will. It has already bought $2 trillion worth of mortgage-backed securities and the unorthodox steps it engaged in enabled it to generate record profits in 2010. It sent $78.4 billion to the Treasury Department. However, its swollen balance sheet leaves it exposed to credit losses at the time of political encroachment on its independence.

But some experts worry that this exposure may force it to “recapitalize” or basically ask for a bail-out. According to Varadarajan Chari, an economics professor from the University of Minnesota as well as a consultant to the Fed in Minneapolis, the Fed may go broke at some point during its exit from current monetary positions – but just on paper. He said that, “the most obvious exit strategy is, when the inflation starts to pick up, to stop and reverse asset purchases.” This might require to Fed to incur significant accounting loss.

If you are interested in knowing more on the market signals we analyze, we encourage you to subscribe to our Premium Updates to read the latest trading suggestions. We also have a free mailing list - if you sign up today, you'll get 7 days of full access (+unique Charts and Interactive Investment Tools) to our website absolutely free. In other words, there's no risk, and you can unsubscribe anytime.

Thank you for reading.

Rosanne Lim
Sunshine Profits Contributing Author

--
Desperate times call for desperate measures, and since the situation is developing quite fast on some of charts that we track, we have decided to provide you with a mid-week update. We suggest reading it right away, as it includes suggestions for both: speculative and investment capital.

Additionally, we have discussed recently observed silver backwardation phenomenon.

We encourage you to Subscribe to the Premium Service today and read the full version of this week's analysis right away.