Editor's Note: This issue of Review & Outlook is based on a
series of posts I made at the USAGOLD blog over the course of the past month. China has
imported an unprecedented amount of gold bullion in 2013. So much so, that if
it were to maintain the current pace, it would
import nearly the equivalent of global production for the year. When the news
first filtered out of China on the amounts of gold being mobilized through
its Shanghai Gold Exchange, the numbers seemed too large to be believed. The
obvious question became "What is the source of this extraordinary amount
of gold bullion?" It was only in October when Reuters reported that much
of that gold had been shipped from London-based exchange traded funds to
Switzerland for refining into smaller Asia-friendly bars and then on to Hong
Kong and Shanghai that the full picture came into focus and the extraordinary
numbers gained credibility.
Below I detail how the
China gold trade mechanism works, the reasons for it, and why China's
interest in gold is likely to remain of paramount importance to the global
market for many years to come. I have updated the original statistics from
recently posted reports at the Koos Jansen website based in the Netherlands -- a research source specializing in the
China gold trade. To stay abreast of the China situation as well as other
developments in the gold market on a daily basis, I invite you to visit our
blog page linked above.
Part One - The London-Zurich-Hong Kong-Shanghai gold conduit
According to a recent
Reuters report, the United Kingdom's gold exports to Switzerland jumped from
85 tonnes to 1,016 tonnes
in the first eight months of 2013 — a twelve times increase. Some
bullion market watchers attribute the huge increase to withdrawals or sales
from exchange traded funds (ETFs) — an explanation that covers only
half the story…….if that. When one learns where this gold ended
up and why it went there, the true importance of this unusually large
deployment begins to take shape.
Switzerland, according to
the Koos Jansen website, has exported over 600 tonnes of gold to Hong Kong through August, 2013. Hong
Kong, in turn, has exported over 700 tonnes of gold
to the Chinese mainland over the same period through the Shanghai Gold
Exchange. Through August, 2013 Koos Jansen puts the
total Chinese gold mobilization through the SGE at a stunning 1672 tonnes. Now, with this report of ramped-up
exports from the United Kingdom, another piece of the puzzle falls into place
and we begin to get a fairly clear picture what these gold mobilizations
entail. Switzerland and Hong Kong are acting as a conduit of western gold on
its way to China — and probably, at least in part, to Chinese central
bank reserves.
To what extent this gold
mobilization is the result of some yet-to-be-identified external pressure on
London's bullion banks, or simply business as usual, remains to be
determined, but gold movements of this size usually do not occur in a vacuum.
Hedge funds have been in the gold ETF liquidation mode since April, at the
behest, it seems, of certain bullion banks that have issued generalized ETF
sell recommendations to their clientele (which includes the funds). The ETF
selling has been blamed repeatedly for the rapid drop in the price. If all of
this has been a ploy to drive down the price on paper and channel substantial
amounts of physical gold to China, who is the winner in this game and who is
the loser? And why is it being done?
The gold market is
incurably opaque (no matter how diligent or persistent the arguments to the
contrary that it isn't or that it should not be), and that is probably why so
many are intrigued by it. Yet, at the same time, those who innocently own
gold for asset preservation purposes can rest assured that they will never
become collateral damage in these affairs as long as they do not allow
themselves to lose patience or forget the reasons why they purchased gold in
the first place.
Commencing to have doubts
about the currency
Gold is never sought by
those who think all is well with the world. It is sought by those who believe
that things could go wrong, or indeed, that things have already gone very
badly. That true believer might be someone of incredible private wealth, as
was the case with Bernard Baruch in the 1930s, or it might be a great
nation-state like Germany or China today. When the sitting Secretary of the
Treasury asked Bernard Baruch why he was buying so much gold, the reply came
quickly that he "was commencing to have doubts about the currency."
China and Germany -- the former by buying gold on the open market and the
latter through its gold repatriation program -- no doubt, are acting on
doubts of their own. Up until today, we were unaware of the degree to which
those doubts had manifested themselves in the hidden corridors of the world
gold market. . . .Now we know. In the first eight months of 2013 China
produced 270 tonnes of gold from its mines, and
theoretically almost four times that amount through its London – Zurich
– Hong Kong - Shanghai gold conduit. In future years, China's gold
import operations likely will be considered a major financial coup d'etat.
The Telegraph's Andrew Critchlow explains that China's consumption of raw
materials makes it "only a matter of time before the renminbi
replaces the dollar as the primary currency for trading commodities and
resources such as crude oil and iron ore." He comes to an ominous
conclusion: "The debt ceiling farce in Washington and China's growing
reluctance to continue underwriting the US economy by buying up its bonds and
adding to America's near $17 trillion (£10.5 trillion) debt mountain
suggests that this tectonic shift in the global trade system could be just
around the corner."
While financial markets'
attention was riveted on Washington's budget theatrics, the United Kingdom
and China quietly entered into a game-changing currency swap arrangement that
will allow the two countries to trade for goods and services directly in
their own currencies, thus cutting out the dollar middle man. "All of a
sudden," says Kathleen Brooks, research director at Forex.com,
"there's potentially no dollar risk." The two countries quickly
followed the swap arrangement with easier access to Chinese financial markets
for British investors, including we might assume London financial firms, and
the same for Chinese banks in the United Kingdom. By circumventing the
dollar, the UK and China are sending a strong message on the greenback's
future as the the world's sole reserve currency --
all toward a "de-Americanized world' as China's state -owned Xinhua news
agency put it.
Zhu Baoliang,
an economist in China's State Information Center, a research unit of the
National Development and Reform Commission, a powerful planning agency, told
Financial Times, "We need to continue to diversify. Even without this
latest debt debate, it would still be necessary to diversify." With this
endeavor, it seems China and Europe have crossed a Rubicon of sorts and
shifted the playing field in financial markets. It's one thing for Iran or
Libya to challenge the pre-eminence of the dollar, but another thing entirely
when China and Europe do it.
Part 2 - Screen-traded
fiat gold could get very violent wake-up call
"This could turn
into a very violent wake-up call for [screen-traded gold]. People talk about
'fiat currencies', but we also have 'fiat gold.' Volatility is too cheap
right now." — Gold refiner quoted by John Dizard
in his Financial Times column this weekend
In Reuters' initial
report on the London-Zurich-Hong Kong-Shanghai gold pipeline, Macquarie gold
analyst Matthew Turner speculated that the 1016 metric tonne
United Kingdom export was shipped to Switzerland for refining into
"smaller bars more attractive to Asian consumers or to be vaulted there
instead." Though vaulting cannot be ruled out, the recasting explanation
makes considerably more sense given the times and the extraordinary amount of
gold being imported by China – over 1500 tonnes
so far this year as mentioned above. It is difficult to imagine a scenario in
which China would be interested in vaulting gold in the West –
particularly at a time when the West is experiencing difficult financial and
economic circumstances.
On the other hand, we
know that four of the world's top gold refineries are located in Switzerland
— Valcambi, Pamp, Argor-Heraeus and Metalor.
Roughly 70% of the world's annual gold production is refined in Switzerland
and it is considered the center of the world's gold refinery business. Its
bars are trusted on the world's gold exchanges by the top banks, bullion
dealers, jewelry manufacturers, and nation states alike. If Turner is right
about recasting the bars into Asia-friendly units, and I think he is,
Switzerland would be the place to do it, particularly in light of the volume
reportedly being re-refined. In my view, China intends for this gold to be
transported to and remain in the East otherwise it would not
have gone to the trouble of having it recast into Asa-friendly
bars.
Bar recasting fits Asian
exchange trading units
To gain a deeper
understanding of what China might be up to, some background is essential.
Let's start with the trading units at the two major Chinese exchanges
involved in the gold trade – the Hong Kong Gold and Silver Exchange and
the Shanghai Gold Exchange (SGE) – because that goes a long toward
explaining why the 1016 tonne export made an
initial stop in Switzerland before moving on to China.
The tael
is the standard unit of weight on the Hong Kong exchange. It equals 1.20337
troy ounces, or 37.4290 grams, fineness in the past
has been 99% but this standard has been upgraded to 99.99% to conform to
international trading standards. According to gold expert Timothy Green's The Gold
Companion (1991), the standard trading sizes on the Hong Kong
exchange is five and ten taels. The basic contract
is 100 taels, or 120.377 troy ounces, as opposed to
the standard 100 troy ounce contract on U.S. futures' exchanges. The Hong
Kong Gold Exchange is an outlet for much of Asia and the tael
trading units, once again according to The Gold Companion are used in China,
Taiwan, South Korea, Thailand and Viet Nam.
Dragon's hoard includes
Chinese people, Peoples Bank of China
The SGE is the only gold
exchange in China and its contract-trading unit is the kilo bar (32.15 troy
ounces), once again a significant deviation from the western exchange
standard. SGE widely publicizes itself as a "delivery market" thus
the smaller and familiar kilo bar size as its chief trading unit makes a
great deal of sense. Most of the metal moving from London to Asia through
Switzerland will more than likely end up in the
hands of consumers in the form of jewelry and small bars (See stats below).
What few people realize is that all of this activity is fully sanctioned by
the Chinese government and the Peoples Bank of China (PBOC). In fact, the
Shanghai Gold Exchange is owned by the PBOC. As a result any unallocated gold
imported and stored at the exchange for future delivery is, indirectly at
least, gold inventory at China's central bank.
Drawing again from the Koos Jansen analysis, the China Gold Market Report
– compiled by the key players in China's gold market, including
analysts for the SGE – lists the following distribution of physical
metal through the Shanghai exchange in 2011:
456.66 tonnes – Jewelry manufacturing
53.22 tonnes – Industrial raw materials
21.55 tonnes – Gold coins
213.85 tonnes – Investment gold bars
13.52 tonnes – Other, unnamed industrial
purposes
284.88 tonnes – Net investment
"…[D]emand arising from the transfer
process of gold as an investment tool
Total = 1043.68 tonnes
To offer a measuring
stick that might give that total number additional meaning – it equals
roughly 40% of annual mine production, one-eighth the U.S. gold reserve, and
nearly one-third Germany's reserve. (Keep in mind, too, we are talking 2011
numbers not 2013 numbers after the latest massive imports outlined above.)
It is no secret that the
Chinese people have a traditional, transcending attachment to gold. That same
attitude, it should be kept in mind, permeates almost the whole of Asia, and
as more and more people partake in the fruits of Asia's rise economically the
demand for gold is likely to grow with it. As such, the demand we have seen
thus far could be just the tip of the iceberg, particularly when you take
into consideration China's ambition to build a significant central bank gold
reserve. China is likely to take advantage of any drop in the price to load
up as it did in the April-August, 2013 time period.
Fiat currency, fiat gold
In a recent Financial
Times opinion piece, John Dizard explored the burgeoning
tension building between the paper and physical gold markets. He pointed to
the very situation in the physical gold market we have just covered in depth.
He talks about the shortage of kilo bars globally, the recasting of 400 troy
ounce ETF bars for shipment to China, and the upside down forward rate on
physical gold, a strong indicator of short physical supply. Dizard poses the question, "Could the gold flow back
from those kilo bars to recasting as good delivery 400oz bars?" In other
words, does the London-Zurich-Hong Kong-Shanghai pipeline run in both
directions? An unidentified gold refiner answers: "Much of that has been
converted to jewelry. It would be a lengthy process. Those are pretty sticky
hands…This could turn into a very violent wake-up call for
[screen-traded gold]. People talk about 'fiat currencies', but we also have
'fiat gold.' Volatility is too cheap right now."
HSBC's role in the China
gold trade
One more point of
interest before I put this piece of the China analysis to rest: HSBC, the
multinational bank headquartered in London, is the chief storage facility for
the largest gold ETFs. As mentioned in my previous article, much of the gold
transferred to Switzerland by HSBC came out of the ETFs. In addition, HSBC is
an important trading member in the daily London Gold Market Fixings. Founded
by Sir Thomas Sutherland in the British colony of Hong Kong in 1865, HSBC
stands for the Hong Kong Shanghai Banking Corporation.
Part 3 - Insights on the
way China thinks about gold
As Chief Market
Strategist for Anglo Far East, the precious metals logistics and custodial
services company, Alex Stanczyk travels frequently
to China and has extensive knowledge and experience about its attitude
towards gold. In the following snippet from a longer interview at the Koos Jansen website, he discusses China's gold strategy
and what it might mean for the market in the months and years to come. The
interview took place in early September, 2013, and it is reprinted here with
permission.
I might have a small
advantage over some other gold commentators. I have been invited to China on
several occasions to speak. One of those occasions was to speak to the
Chinese government - it was a think tank on monetary policy. I know China is
ramping up its gold reserves massively during this period of time. I think
their likely importing way more than the figures you and I see show.
Our firm has got personal
experience dealing with the guys that transport the gold, the security
companies. One of our partners had lunch in the recent past with the head of
the largest global operations company in security transport. He said there is
a lot of gold that they're moving into China that's not going through
exchanges. If the gold is for the government they don't have to declare where
it's going. They don't have to declare where it's going in, or where it's
heading. If you look at the way the Chinese do things, why would they tell?
We talked to the head of
the largest refinery in Switzerland and he told us directly that all that
metal that's coming out of London (904 tons YTD) is being refined into kilo
bars and sent to China, as well as metal that's
coming in from other areas in the world, that's all going to China. It's way
more than is being reported or moved through the exchanges. All the kilo bars
go to the Chinese people but the PBOC is likely only buying good delivery.
The Chinese government is
encouraging the people to buy gold for three reasons:
Number one, it soaks up
capital that would otherwise flow into bubble markets like real estate and
equities.
Number two, gold provides
a strong base in case of inflation or other economic chaos. This provides
stability and lowers the chances for civil unrest if there are economic
problems.
Number three,
if the people would sell it back, it gives the PBOC [Peoples Bank of China,
its central bank] a way to increase its reserves by stealth. Remember the
PBOC is very secretive about their gold reserves. It buys a huge amount of
gold off books using proxies, so it can keep it reserve numbers hidden. This
is very Chinese if you understand the Chinese mindset. The next
time they will report on their reserves it will be 3000 tons, probably higher.
There is this game that
the Chinese play, it's called Weiqi (pronounced Way
Chee), and it's similar to chess. In Weiqi you have to surround your enemy slowly and lay a
trap, and than close the trap all at once. That's
the way the Chinese think, they don't really disclose what their plan is,
they just move tiny pieces around the board in a seemingly incoherent way,
but when all the pieces are lined up that's when the trap is sprung. All of
the government party leaders play this game, and the CEO's and chairman of
China's largest businesses are all part of the party.
I have spoken to a highly
placed member of CSRC [China Securities Regulatory Commission] and he told me
directly that the government's purpose over the next five year plan is to
curb real estate and equities investment and get more people investing in
gold.
If you see the massive
demand that's going over to Asia it's really staggering. Year to date 1800
tons was imported into India and China, out of an annual mine supply of 2700
tons. It's a massive imbalance, this never happened before.
I think we have passed
the [gold market] bottom. The fundamentals for the reasons it started going
up in the first place never changed; the sovereign debt and the amount of
money supply increase. Gold is only measuring the devaluation of paper
currencies. This trend is been going on for many years and I don't see it
changing because the governments of the world don't have solutions to the
problems that they've got.
[End quote]
Michael J. Kosares is
the founder of USAGOLD and the author of "The ABCs of Gold Investing -
How To Protect and Build Your Wealth With Gold." He has over forty years
experience in the physical gold business. He is also the editor of Review
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