U.S. Treasury Secretary John Snow visited Beijing recently to raise the Renminbi (RMB) re-valuation issue with China’s senior leadership. While the media focus was on currency values and unfair trade advantages, what is sometimes overlooked is the potential implications it has for gold.

Firstly, let’s us consider the background behind the pressure for RMB revaluation, and why for the foreseeable future, both U.S. and China's interest are interlinked. At the root of the international unhappiness with China’s currency level is the country’s rapidly growing trade surplus created by its “rented economy”. The term “rented economy” applies since foreign investment controls much of China’s low cost production. China is becoming the “workshop/factory” of the world and is holding down global inflation.

China’s senior leadership might still call themselves “Communists”, however, in reality the country is run the like a holding company along strict reporting lines with one clear objective, namely 7 to 8 % annual growth. The currency peg between the RMB and the U.S. dollar is facilitating this growth objective while at the same time it results in lower interest rates in the United States. This is because, in order to keep the RMB at the 8.3 % level, China needs to buy up surplus dollars and re-invest them abroad, foremost in U.S. Treasury bonds. The peg is mutually beneficial to both China’s growth target and Alan Greenspan’s need to keep long-term interest rates and inflation low.

As of last month China’s holdings of U.S. Treasury bonds rose to a record $122.5 billion, less then Japan’s but far more than any other country. Together Japan and China hold 41.9% of the $1347.2 billion debt the U.S. government owes the world.

Even though hot money is not allowed in, an unprecedented amount of foreign currency is flowing into China, to buy land, construction material and to pay workers to build new factories. These factories start producing, much of their production is exported and sold for U.S. dollars, while the raw materials used and the workers’ wages are priced in RMB. As more foreign exchange flows into the current account, the People’s Bank of China (PBC), buys up these dollars because the government is committed to keeping the exchange rate stable.

If it were to stop buying the dollars, the value of the RMB would quickly appreciate. But the PBC has a problem. If it simply uses new RMB – creating a liability on its balance sheet against the dollar assets – the extra money in circulation within China would soon cause inflation, as indeed happened in the mid 1990s. That would damage the economy and eventually hurt China’s export industries, since the prices of Chinese goods would rise.

So instead of causing inflation inside the country, China is exporting deflation.

This in turn allowed the Fed to spark an economic revival by lowering interest rates to 45 year lows without risking inflation.

One weak spot of the recovery, however is the stubbornly high U.S. unemployment rate. And this is where Mr. Snow comes in. President Bush has already seen 2.7 million factory jobs disappear on his watch and he needs to be seen to be doing something about it in order to be re-elected. Viewed from this perspective, Mr. Snow’s visit to Beijing is more about U.S. domestic political issues rather than seriously forcing China to un-peg the currency.

All of the above leads us to the question what full RMB convertibility eventually means for gold prices.

China can press onward toward convertibility on the capital account, which would allow Chinese people more freedom to move their savings abroad, counterbalancing the inflow of U.S. dollars. In many ways that is the best option and it is already being implemented, but it would threaten the steady increase of savings put in low interest accounts at the state banks. This is the one thing that keeps China’s financial system stable at the moment. Historically, the less trust there is in the financial system the more demand there is for gold.

In addition, strong capital inflows and rising Forex reserves are already sharply boosting official demand for gold in China. This is because if the PBC is to retain its proportion of gold holdings at the current 2.4% of total reserves (European Central Bank standard: 15%), it would need to increase its gold holdings by an estimated 120 tons or 60% of gold consumption in China in 2002.

China already enjoys with 40% one of the highest savings rates in the world. The closer we get to revaluation, the more USD dollar savings will be converted into gold.

In order to pave the way, the PBC last year relinquished its monopoly on imports and exports of gold, the Shanghai Gold Exchange was established and many Chinese commercial banks are planning to launch personal gold investment businesses.

The way forward for China’s central bank and savers in the coming years is, surely, to diversify out of their huge dollar holdings and move to back its currency by gold as it heads slowly but surely towards convertibility on the capital account.

After the Beijing Olympics when the snow falls in the winter of 2008, gold might truly glitter.

Michael R. Preiss serves as Chief Investment Strategist at CFC Securities.