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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
Tom Szabo introduces The Metal Augmentor, which will be the detailed coverage of mining equities from junior
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