This post is part of the Chinese Gold Market essentials series. Click here
to go to an overview of all Chinese Gold Market Essentials for
a comprehensive understanding the largest physical gold market
globally.
The main arguments presented by Western consultancy firms, such as GFMS
and the World Gold Council (WGC), to explain the difference between
SGE withdrawals and Chinese consumer gold demand relate to Chinese
Commodity Financing Deals (CCFDs). However, this analysis is incorrect
as I will demonstrate in this post.
CCFDs are used by Chinese speculators to acquire cheap funds using
commodities as collateral. When it comes to using gold as collateral for
CCFDs there are two options: round tripping and gold
leasing. First we’ll discuss round tripping.
Round Tripping
Goldman Sachs (GS) has properly described the round tripping
process in
a report dated March 2014. We’ll start by reading a few
segments from GS about financing deals [brackets added by me]:
While commodity financing [round tripping] deals are very complicated, the
general idea is that arbitrageurs borrow short-term FX loans from onshore
banks in the form of LC (letter of credit) to import commodities and then
re-export the warrants (a document issued by logistic companies which
represent the ownership of the underlying asset) to bring in the low cost foreign
capital (hot money) and then circulate the whole process several times per
year. As a result, the total outstanding FX loans associated with these
commodity financing deals is determined by:
- – the volume of physical inventories that is
involved
- – commodity prices
- – the number of circulations
Our understanding is that the commodities that are involved in the
financing deals include gold, copper, iron ore, and to a lesser extent,
nickel, zinc, aluminum, soybean, palm oil and rubber.
…Chinese gold financing deals are processed in a different way compared
with copper financing deals, though both are aimed at facilitating low cost
foreign capital inflow to China. Specifically, gold financing deals involve
the physical import of gold and export of gold semi-fabricated products to
bring the FX into China; as a result, China’s trade data does reflect, at
least partially, the scale of China gold financing deals. In contrast,
Chinese copper financing deals do not need to physically move the physical
copper in and out of China, so it is not shown in trade data published by
China customs. In detail, Chinese gold financing deals includes four
steps:
- Onshore gold manufacturers pay LCs to offshore
subsidiaries and import gold from Hong Kong to mainland China
– inflating import numbers
- offshore subsidiaries borrow USD from offshore banks via
collaterizing LCs received
- onshore manufacturers get paid by USD from offshore
subsidiaries and export the gold semi-fabricated products
– inflating export numbers
- repeat step 1-3
Important to understand is that gold in round tripping needs to be
physically imported into China and then exported, in contrast to copper. The
reason for this, which GS fails to mention, is that the cross-border
trade rules for gold in China are different than for all other commodities. Only through processing trade gold can be
imported into China mainland by enterprises that do not carry a PBOC gold
trade license. Round tripping by speculators can only be done
through processing trade, as it’s not possible through general trade to ship
gold into China without a PBOC license. Consequently, round tripping flows
are completely separated from the Chinese domestic gold market where the SGE
operates. And hence round tripping cannot inflate SGE withdrawals.
Only by bending the rules – set up a fake jewelry enterprise in a
CSSA – speculators can import gold to round trip. By using processing
trade in order to import gold into China speculators are required to
subsequently export the exact same amount of gold, because these speculators
pretend to be jewelry manufacturers importing gold for genuine production,
which upon completion must be exported. This is why the gold is round
tripped. The requirement for export in processing trade can be
read in the official PRC
Customs Supervision and Administration of Processing Trade Goods Procedures (2004):
“Processing trade” shall refer to the business activity of import of
operating enterprises of all or some raw and auxiliary materials, components,
parts, mechanical components and packing materials (Materials and Parts)
and the re-export thereof as finished products after processing or
assembling.
Now we can understand why GS wrote [brackets added by me]:
Specifically, gold financing deals [round tripping] involve the physical
import of gold and export of gold semi-fabricated products to bring the FX
into China…
The speculators export semi-fabricated gold products to keep up
the appearance they are genuine gold fabricators, for
which the gold imported must be processed and exported.
On a side note, the gold used in round tripping can be at most
the amount of gold yearly exported from China (to Hong Kong). Though
the total exported gold will also contain genuine processing
trade, so round tripping will be less than this amount. Round tripping does
not inflate net export from Hong Kong to China,
only gross trade. The net amount of gold imported into China is shipped
through general trade, via the SGE, into the Chinese domestic gold market and
is prohibited from being exported.
In the chart above we can see China exported 330 tonnes to Hong Kong in
2013. Let’s guess 200 tonnes of that was genuine processing trade (jewelry
manufactured in a Chinese CSSA).
330 – 200 = 130 tonnes
Possibly, there was 130 tonnes imported into China for round tripping and
subsequently exported back to Hong Kong. Or, 10 tonnes was imported into
China for round tripping and subsequently exported to be round tripped an
additional 12 cycles, making 13 rounds in total.
13 x 10 = 130 tonnes
In the latter scenario a lot less physical gold is involved (10
tonnes versus 130 tonnes). In reality it’s more likely a gold batch used in
round tripping is making multiple rounds than one round.
The Chinese Gold Lease Market
The other gold financing deal that can be conducted by Chinese
speculators is gold leasing (which is the same as gold lending).
In general gold leasing is a normal market practice.
I have categorized all potential gold lessees (borrowers) in three
groups for us to have a look at examples (with US dollars) of how gold
leasing is done in financial markets:
- A gold miner needs funds to invest in new production
goods. It can borrow dollars from a bank at a 7 % interest rate, or
borrow gold at 2 % – the gold lease rate is usuallylower than the
dollar interest rate. The miner chooses to borrow 10,000 ounces and
sells it spot at $1,500 an ounce. The proceeds are $15,000,000 that can
be used to invest in new production goods. In a years time the miner has
mined 10,200 ounces to repay the principal debt plus interest (the
interest on gold loans can be settled in gold or dollars, depending on
the contract). Through gold leasing the miner has acquired cheap funding
compared to a dollar loan.
- A jeweler needs funds to buy gold stock for production.
It can borrow dollars from a bank for 7 %, or borrow gold for 2 %. The
jeweler borrows 10,000 ounces of gold, with which it can start
fabricating jewelry. To hedge itself against price fluctuations the
jeweler can sell spot, for example, 10 % of the 10,000 ounces it has
borrowed (1,000 ounces at $1,500 makes $1,500,000) to buy gold futures
contracts in order to lock in a future price. After a year the jeweler
has sold the 9,000 ounces (as jewelry) for dollars and can take delivery
of the long futures contracts to repay the gold loan.
- A
speculator is looking for cheap funds. It can borrow dollars
from a bank for 7 %, or borrow gold for 2 %. He borrows 10,000 ounces
and sells it spot at $1,500 an ounce. The proceeds are $15,000,000 and
subsequently these newly acquired funds can be used to invest in higher
yielding products (> 2 %). If the trader chooses to hedge itself in
the futures market is up to him. After a year the 10,000 ounces plus
interest need to be repaid, either the trader can purchase gold with the
profits made on the higher yielding investment or from delivery of
futures contracts.
In China gold leases are settled and transferred through the SGE. The
mechanics of the lease market in China was best described in
an essay by the PBOC from 2011:
…the SGE provides a crucial role in gold leasing. The SGE’s
block trading system is the trading platform used by gold leasing
participants; the SGE also provides transfer and settlement services.
…
China’s gold leasing does not involve the central bank. Gold leasing
takes place between commercial banks and enterprises as well as between
commercial banks, the former being key.…
- An enterprise that intends to be a lessee approaches a
branch office of a commercial bank with a rate request and application.
- The commercial bank carries out due diligence and then
submits a review to their head office for approval.
- Upon approval the head office quotes a lease rate with
the international gold lease rate as a benchmark plus additional basis
points taking into account the potential lessee’s credit, physical gold
management costs and other factors.
- If the potential lessee accepts the offer, a commercial
bank branch manager will sign a lease contract with the customer
including the terms and conditions clearly laid out.
- According to the “Shanghai Gold Exchange Lease Transfer
Procedure”, after signing the lease, the head office of the commercial
bank and lessee, or his agent, shall make a lease application through
the exchange’s membership system. After verification, the SGE shall
transfer the commercial bank’s gold from its SGE bullion account to the
lessee’s SGE bullion account. The lessee can now trade the physical gold
that it has leased or withdrawal the gold from the vaults.
- Upon expiration of the lease the lessee shall deposit or
purchase physical gold through the SGE to repay the gold. Corresponding
physical gold will be transferred from the lessee’s SGE bullion account
to the commercial bank’s bullion account. Leasing fees involved
will be settled in currency. At this point, the lease is completed.
First, I would like to insert a comment supplementing the PBOC’s
description of gold leasing in the Chinese domestic gold market. In the paper
it says:
“After verification, the SGE shall transfer the commercial bank’s gold
from its SGE bullion account to the lessee’s SGE bullion account. The lessee
can now trade the physical gold that it has leased or withdrawal the gold
from vaults.”
My source at ICBC’s precious metals trading desk told me ICBC has little
gold of itself for leasing, most of the gold lend out is sourced from
third parties. These parties are either SGE members or overseas banks
that supply gold through the Chinese OTC market. ICBC operates in the
lease market as an intermediary by connecting supply and demand, it can lease
from international banks or local gold owners with SGE Bullion Account and
lend the gold to miners, jewelers or speculators. My suspicion is that
the international gold lease rate is lower than the Chinese gold lease rate,
which can attract gold from the international market into the Chinese
domestic gold market.
The Chinese lease market in short: in
China all gold leases are settled through the SGE (there can be an
off-SGE lease market, but it would be highly illiquid). Both lessor
(lender) and lessee (borrower) are required to have an SGE Account. If a
lease is agreed between two parties gold is transferred from one SGE Bullion
Account to the other, when the lease comes due the gold is returned. At SGE
level it’s as simple as that.
There is a big difference between jewelers that lease gold in contrast to
miners and speculators. Jewelers lease gold because they need physical gold
for fabrication; miners and speculators lease gold because they are seeking
cheap funds, they will always sell spot the leased gold (without withdrawing
the metal) at the SGE to use the proceeds. Why would a speculator withdrawal
the metal?
Therefor, if SGE withdrawals capture leased gold this is for
genuine jewelry fabrication that eventually ends up at retail level. When a
jeweler needs to repay the lease it simply buys gold at the SGE to
subsequently transfer it from its SGE Bullion Account to the lessor’s SGE
Bullion Account. It’s not likely a jeweler would buy gold off-SGE to repay a
lease, which then would need to be refined into newly cast bars by an SGE
approved refiner to enter the SGE vaults. Gold leasing by jewelers can
inflate SGE withdrawals but not so much supply to the SGE.
In a report the World Gold Council (WGC) released in April 2014, China’s gold
market: progress and prospects, it was stated:
… No statistics are available on the outstanding amount of gold tied up in
financial operations … but Precious Metals Insights [PMI] believes it is
feasible that by the end of 2013 this could have reached a cumulative 1,000t…
This 1,000 tonnes figure is based on a misunderstanding regarding the
Chinese gold lease market. PMI assumed there was 1,000 tonnes of gold tied
up in financing deals based on the yearly lease volume in China,
which was 1,070 tonnes in 2013. However, the
yearly lease volume is not the gold that is leased out at any point in time,
but reflects the aggregated volumes disclosed on all lease contracts
that are executed over one year’s time in the Chinese domestic gold market
(turnover). Meaning, if 100 mining companies lease 2 tonnes of gold for
1 month in 2016 and all leases are rolled over 4 additional months, the
yearly lease volume would be 1,000 tonnes (100 x 2 x (1 + 4)), while on 31
December 2016 the total amount of gold leased out could be nil. (It’s
impossible there was 1,000 tonnes used in round tripping as gross export from
China has never been more than 330 tonnes)
In addition, the WGC used the words ‘tied up‘ for the gold used
in financing operations, which sounds as if the market will be flooded when
the gold is untied. The words ‘tied up’ can be misleading,
let me explain: If a speculator borrows gold he will promptly sell it
spot, this gold will not leave the SGE system. During such a lease
period there is nothing tied up, there is just a debt to be repaid.
When the lease comes due the lessee has to buy gold in the market
(SGE) to settle the debt, which is the opposite of what the WGC
insinuates what happens when gold is untied. In case a
jewelry company leases gold the words tied up are more
appropriate, in my view, as the borrowed gold bars are in transit from
being processed to being sold as jewelry. Gold involved (tied up) in these
leases can only be a share of the total amount of gold leased out in any
point in time, because we all agree most leases in China are done for
financing. There is only a small percentage of total gold loans tied
up by jewelry companies.
Phillip Klapwijk, analyst with Precious Metals Insights (PMI) in
Hong Kong, previous
Executive Chairman of Thomson Reuters GFMS and consultant for the
World Gold Council, has
stated:
… a good part of the withdrawals represent gold that is used purely for
financing and other end-uses that are not equivalent to real consumption.
Needless to say I don’t agree for the reasons just mentioned regarding
gold leasing and round tripping. Am I the only one? No. When Na Liu
of CNC Asset Management Ltd, visited
the SGE in May 2014 he spoke to the President of the SGE
Transaction Department. From Na:
First, the withdrawal data reflects the actual gold wholesales in China.
In 2013, the total gold withdrawal from the SGE vaults amounted to
2,196.96 tonnes. The President of SGE Transaction Department
(The President) said: “This 2,200 tonnes of gold, after leaving our
vaults, they entered thousands of Chinese households in the form of
jewellery and investment purchases.”
… Second, none of the 2,200 tonnes of gold was bought by the Chinese
central bank. The President said: “The PBOC does not buy gold through the
SGE.”
… Third, the financing deals do not exaggerate SGE’s assessment of
China’s gold demand. This is because “the financing deals do not take place
after the gold leaves the vaults.”
The President of the SGE’s Transaction Department is clearly stating
most leasing happens within the SGE system and this metal is not withdrawn.
Therefor, gold leasing by speculators does not inflate SGE withdrawals and
thus does not explain the difference between SGE
withdrawals and Chinese consumer gold demand as disclosed by the World Gold
Council.
Remarkably, when I asked the WGC about the details in 2014 they
replied [brackets adde by Koos Jansen]:
Gold leasing: Banks have built up this business to support China’s
burgeoning gold industry. Miners, refiners and fabricators all have a
requirement to borrow gold from time to time. For
example, fabricators borrow gold to transform into jewelry, sell and then
repay the bank with the proceeds. It is an effective way for the fabricator
to use the bank’s balance sheet to fund its business. Banks have strict
policies in place for who they can lend to, and these have been tightened
over recent years, but during PMIs field research it identified that, in
some instances, organizations other than genuine gold business had used this
method to obtain gold, which it would then sell to obtain funding [in
this case the gold wouldn’t be withdrawn from the SGE vaults]. It would then
hedge its position. According to PMI, this can generate a lower cost of
funding than borrowing directly from the bank. Our colleagues in China
think this would be a very small part of total gold leasing; the majority of it
would be used to meet the demands of genuine gold businesses.
In their email the World Gold Council admits gold leases that are
withdrawn from the SGE vaults are used for genuine gold business and being
part of true gold demand. This is more confirmation gold leasing cannot
explain the difference.
In conclusion, round tripping gold flows are completely separated from the
Chinese domestic gold market (SGE) and therefor cannot have caused the difference.
In addition, gold leasing only inflates SGE withdrawals when used
for genuine gold business and therefor cannot have caused the difference
either.
More detailed information about the Chinese gold lease market can be
found in my posts A
Close Look At The Chinese Gold Lease Market,Gold
Chat About The Chinese Gold Lease Market, Zooming
In On The Chinese Gold Lease Market, Chinese
Gold Leasing Not What It SeemsandReuters
Spreads False Information Regarding The Chinese Gold Lease Market.