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Crazy Market Thoughts — The Beijing Put

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Published : October 23rd, 2009
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Category : Gold and Silver

 

 

 

 

NOTE: Posted for Metal Augmentor subscribers on October 20, 2009 at 7:22 AM EDT.

 

Earlier this year it was revealed by a Chinese bureaucrat that China has supposedly* acquired several hundred tons of gold for its official reserves during the past few years, representing the biggest purchase of gold by a central bank since the French under de Gaulle tried to clean out Fort Knox. Alas, it appears that many so-called experts have totally misunderstood this new “Gold War” to the point that they actually believe China has instituted a formal policy of preventing the gold price from ever crashing again. This alleged policy of supporting the gold price has been nicknamed by pundits as the “Beijing Put”.

 

*We say “supposedly” because there is really no way to validate these quoted figures and therefore the degree to which you trust them is directly proportional to the degree to which you trust information coming out of China.

 

Here at Metal Augmentor, we have a different view on the matter. There is a Beijing Put alright, but we believe it involves a policy of patiently waiting for opportunities to acquire large quantities of gold at prices that won’t literally break the (central) bank. That means the Chinese are not going to be in the market buying gold when speculators are building leveraged gold positions, such as now. Indeed the Chinese might even be shorting against these speculators. Conversely, the Chinese are going to be in the gold market when speculators are unwinding leveraged gold positions. The beauty of this approach for the Chinese is that they are able to pick up physical gold on the cheap during retreats by the hot money, even when there are no fundamental changes in physical supply or demand. Moreover, by being short against leveraged speculators, the Chinese are able to neuter a major source of competition on the long side that might otherwise drive both the paper and physical gold price higher. This is precisely what some pundits have claimed to be the situation in the silver market for quite some time. While we rarely agree with the pundits, such allegations make sense to us not only in the case of silver but gold as well.

 

Let’s consider the alternative theory being advanced from distant corners of the gold universe, that a floor price for gold is being “guaranteed” by the Chinese government. Supposedly this guarantee is necessary after the introduction by one Chinese bank of a new silver bullion product to Chinese citizens this past summer. There was even a bit of Chinese TV coverage of this new silver bullion product, and the pundits have claimed this to be a sign that the Chinese government itself was making a wholesale endorsement for the “safe” buying of gold and silver by every Feng, Ming and Wei. The pundits further reason that if China is encouraging the buying of gold and silver, it could not very well afford for the price of gold and silver to later crash as that would create discontent and possibly even riots among the good citizens who felt they were misled.

 

Of course, this line of “reasoning” is hopelessly naive on its face. In reality, the Chinese government has encouraged neither silver nor gold buying. The advertisement and buy recommendation came from a Chinese bank, not the government itself. All the Chinese government has done is relax gold or silver trading rules so they start to vaguely resemble those in the West. Previously, the Chinese government approved gold futures trading on the Shanghai Futures Exchange. Did that mean the Chinese government was encouraging Chinese citizens to trade gold futures en masse?

 

Then there was the news that the Hong Kong Monetary Authority was recalling its official gold stored in London. That’s right, all 2 tonnes of it. It was noted with a straight face by several pundits that the announcement has major ramifications for the gold market even though the gold involved is less than the amount owned by the economic powerhouse that is Mozambique (not to mention several dozen other countries the average pundit couldn’t find on a map if his life depended on it). The reason for the move was simple. A new gold vault has been built in Hong Kong and the Hong Kong Monetary Authority wants to use it as the centerpiece of a new Asian hub for physical gold trading. Good for them. Far from being a terminal threat or discredit to the gold trading centers in London, New York, Dubai and elsewhere, the new competition from Hong Kong should mean more efficient gold markets everywhere and therefore we should all welcome this development. But as a long-term implications for the gold price, it is irrelevant.

 

While much of the recent hooplah about Chinese government  involvement in the gold and silver markets is just that, the diversification of Chinese reserves and savings into different asset classes including official gold holdings is a very real and important phenomenon. This doesn’t mean, however, that Chinese gold buying can be counted upon to create a stable upward price trajectory. Indeed, it is possible, even likely, that there will be increasing volatility, both up and down.

 

As previously mentioned, China’s alleged past involvement in the silver market is illustrative. On one hand, there are those (including metal consultancy GFMS) who believe China has been dishoarding its stockpile of demonitized silver very much in the same way that the U.S. dishoarded its strategic silver stockpile. On the other hand, there are those who believe that China has merely been using the futures market to sell silver short on price rallies so as to generate income on an otherwise non-earning asset. Such short selling may have even created the perception of physical dishoarding where no actual selling took place. To the contrary, the Chinese may have bought more silver for their stockpile on price declines. For further speculation about this, see the discussion of “Hung Brothers” from August 2008 over at SILVERAXIS.

 

In hindsight, it seems quite inconsistent for China to have been dumping silver while acquiring gold. Thus, we believe it is more likely that China has retained its substantial stockpile of silver (if not added to it), a portion of which may have been utilized periodically to generate earnings via short positions on futures and forward exchanges. If China has in fact surreptitiously shorted silver during speculative rallies, China can very easily do the same thing with gold. Indeed, this could mean China already has a significantly larger stockpile of gold than the measly 1000 tonnes declared by a Chinese bureaucrat in an interview earlier this year.

 

At the end of the day, the Chinese government wouldn’t mind paying a few percentage point premium to acquire physical gold in multiples of ten tonnes, but the premium would be much bigger than a few percentage points if the Chinese were buying when everybody else was buying, especially if everybody else was buying because the Chinese were buying. Moreover, the Chinese would have a problem with driving up the gold price every time they bought only to see it come back down after each buying program is complete. The Chinese watched and learned from Warren Buffett’s fiasco with silver in 1996 and won’t make the same mistake in their own Gold War.

 

In summary, we look for the Beijing Put to create greater volatility in gold prices instead of creating gold price floors. We expect volatility because we believe the Beijing Put will be exercised only during periods when speculators are retreating from leveraged long positions, causing sharp price declines. The physical gold purchases by China, measured in the tens if not hundreds of tonnes, will then lead to sharp price reversals to the upside. We suspect such price action will be confusing to many, especially to the pundits who can’t understand why China isn’t buying every dip. Moreover, we think price volatility will be high in the short term whether the intermediate trend is up or down. Our favored method to play the Beijing Put will be put options bought moderately out of the money, against which we would go long futures on price declines that bring the put options into the money. Timing of long futures position entry will be set at arbitrary profit points and enhanced by gold basis signals indicating that large physical purchases of gold are being made.

 

Tom Szabo

Silveraxis.com

 

Also by Tom Szabo

 

 

24hGold - Crazy Market Thought...

 

 

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 Subscription is US$ 87 per year, and you will receive in addition the Mining Equities Report: Cash is King?" which includes the following :

 
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Data and Statistics for these countries : China | Hong Kong | Mexico | Mozambique | All
Gold and Silver Prices for these countries : China | Hong Kong | Mexico | Mozambique | All
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Tom Szabo co-founded the Metal Augmentor, a subscription-based investment research service focused primarily on analyzing the mining sector and gold and silver markets
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