Commodity Online
NEW DELHI: Central banks in countries like India and China may soon go for gold instead of dollar as their reserve.

China, the biggest foreign holder of dollar denominated treasury securities with some $681.9bn or about 12 per cent of treasury papers outstanding, may soon dump Uncle Sam’s currency for gold as it believes that dollar may nosedive following the bailout packages.

This is the new trend among the major emerging economies.

In India also, accumulation of foreign exchange reserves has been increasing in recent years. The country’s primary sources of foreign exchange reserves have been capital flows and portfolio inflows. While the share of gold in total foreign exchange reserves is very high in United States and European countries, the share is comparatively lower in Asian countries.

The question that arises is whether India should add more gold to its composition of foreign exchange reserves. In the present scenario, emerging market economies have started accumulating foreign exchange reserves on an unprecedented scale.

These economies have accumulated reserves at an annual rate of $250 billion during the period 2000-2005. High foreign exchange reserves are often seen as a strength indicating the backing a currency has.

On the other side of the coin, holding of huge foreign exchange reserves also indicates the lack of confidence on the global financial architecture. Gold does not earn any interest, other than the return that it fetches if lent. This is in fact the primary reason why central banks in many countries decided to reduce their gold holdings. The gold’s share of reserves was above 10 per cent in 2006. This is mainly because of the sharp rise in the price of gold.

For a country that follows a fixed exchange rate regime, foreign exchange reserve has an important function. In order to keep the currency exchange rate fixed, the central bank of the country has to trade in the currency market to balance demand and supply.

But for countries that follow floating exchange rate, the need for maintaining foreign exchange reserves is a question that has remained unanswered. If the foreign exchange reserves maintained by a country are not adequate, then investors may get speculative on the currency and affect its pricing.

The three components of India’s foreign exchange reserves are gold, special drawing rights and foreign currency assets. India is constantly accumulating its foreign exchange reserves to meet the requirements of its increasing current account deficit and to protect against volatile capital flows. In this process, it is felt that India seems to hold foreign exchange reserves very much in excess.

With the growth of the domestic industry and higher oil prices in international markets, the current account deficit is expected to widen in the coming years. This implies that the country would require more foreign exchange reserves to manage the foreign exchange demand that will arise from current account transactions.

Investors have been piling into gold as a safe haven as the world’s worst financial crisis since the 1930s depression sent global stock markets crashing.

China has $2 trillion of reserves, and only one per cent in gold and nearly all of the rest is in US dollars. European central banks, which hold about half of global gold reserves, saw gold sales fall to their lowest levels since 1999.

The dollar hit a three-year high against a basket of six major currencies this week, with news that the US government would pour a further $30bn into troubled insurer AIG hastening risk-averse flows. The dollar index hit 88.822 — its highest since April 2006.

Bit, that is a temporary phenomenon. Looking at the size of the bailout packages in North America the fact that the US economy may well enter a depression .

Such a decline would apply pressure on Gulf Arab states which have faced popular pressure to ditch their currencies link to the greenback and switch to fight imported inflation when the dollar was weak.

The US government will fund the bailout by printing new money or issuing huge amounts of new debt, either of which will put severe pressure on the value of the greenback and on government bond yields.

The United States holds 8,133.5 tonnes of gold reserves valued at $188.23 billion. China holds gold reserves of just 600 tonnes, worth only $13.89 billion.