Yuan Gold Contacts a Step toward Reserve Currency

   on October 24 2011 8:50 AM

On Monday, the first gold contracts denominated in the Chinese Renminbi (also known informally as “yuan”) came to the Hong Kong market. Analysts have been quick to note the implications of a yuan-denominated contract, realizing that the new contract could drive nearly three times as much demand as the dollar-denominated contract.

Looking at the yuan product from the macro-view, a move into gold is about more than just gold—it’s about reserve currency status.

Dollar’s Monopoly

The US Dollar has a monopoly as the world’s reserve currency. The size and scope of the US economy and financial markets, combined with the relative stability of the political climate, made the US dollar a preferred currency for international trade.

However, the reason most cite for dollar dominance isn’t the United States’ role in international commerce, but its monopoly on a single product—oil. In an agreement with Saudi Arabia, the United States effectively tied the global oil market to the US dollar. No other currencies could be used to purchase “black gold,” the driver of modern industry.

Signs of Defiance

As China grows, it naturally wants to extend its reach as an economic powerhouse. Recently, in a move that rattled those who see the dollar as the only reserve currency, China agreed to trade oil and energy products with Russia in their own currencies. This should have been seen as a warning sign, a move that would lead to new policies to make the Renminbi a global currency for commerce.

Relative to other commodities, gold is relatively unimportant to commerce. Most of us can keep our cars running and the factories on without gold.

Renminbi Goes Global

Gold is a very important commodity in the realm of modern finance, however. In allowing the markets to buy gold denominated in the Chinese currency, investors can essentially exchange yuan directly for other currencies, using gold as a proxy.

That is to say investors now have a binary trade to buy and sell Renminbi. Buying the Renminbi requires holding a short gold position in yuan and a long gold position denominated in another currency. Once the gold is netted out by equal short and long positions, investors have only foreign currency exposure.

Never before has it been so easy for investors to buy and sell Chinese Renminbi directly or indirectly. Investors have long sought to play the rising Renminbi, but Chinese capital controls kept the currency as a primarily local institution. Now it’s available to most everyone, and with two simple transactions, enough Renminbi can be purchased, provided there’s enough gold available to back each trade.

And so this is where the Chinese realize the importance of gold. Allowing the yuan-denominated contract to trade will only increase investor appetite for other yuan-denominated commodities. While oil contracts may be a few months or years away, the reality is that the Chinese are positioned to make the Renminbi a world reserve currency. It’s only a matter of a few new commodity contracts to get the world’s attention.

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