If bullion investors thought the recent move by China to free yuan from dollar will help gold in a big way, think again. China seems to be not much interested in dumping gold forever, even though Beijing is ready to give flexibility to yuan.

In a recent statement, China's State Administration of Foreign Exchange (SAFE), which administers China's $2.4 trillion in reserves, said it would not use its foreign exchange reserves as an atomic weapon against investment targets.

The statement is a declaration of confidence in the US dollar; it is also a grudging acceptance of the limits of its bluster last year, when it stoked fears of a dollar collapse by feeding ill-informed market speculation that it would dump its huge holdings of US government debt.

It is hard to construct a reassuring statement around the words atomic weapon, but that is exactly what China's SAFE did. SAFE also made its clearest articulations to date on why it would be difficult for China to diversify its foreign exchange reserves meaningfully by buying gold.

Gold is globally recognised as a store of value and can be used for urgent payment, but there are some limits to investing in gold, and it cannot become a main channel for investing our foreign exchange reserves, the statement noted.

It pointed out that the gold market was limited and gold prices were very volatile. Additionally, SAFE noted, gold investments don't generate returns, and in fact, investors have to bear costs -- on storage, transportation and insurance. Looking back at its performance over the past 30 years, the risk-return balance of gold is not very good... Gold can be a hedge against inflation, but quite a few other assets can too.

The SAFE said buying gold would not help very much in diversifying China's foreign exchange reserves. China had increased its gold reserve by more than 400 tonnes in the past few years, and its gold reserves now stood at 1,054 tonnes. Even if we double the amount, it can only diversify about $30-40 billion of China's foreign exchange reserves, it noted. Even then, the proportion of gold reserves in China's forex reserves would increase by only one or two percentage points, it observed.

China is in fact diversifying its foreign exchange reserves at the margin -- into a very surprising avenue. There has been a very clear pick-up in China's purchases of Japanese Government Bonds (JGBs) so far this year. China has bought net $5.8 billion of JGBs so far this year, including some $2.2 billion purchased in April alone.

This is an astounding turnaround from the net selling of $0.9 billion in 2009 and net purchases of $0.25 billion in 2008.

China Gold