“POBC paper recommends leasing its reserves to
manipulate gold price” should have been the headline
Koos Jansen used for his blog
post on a paper produced within the People’s Bank of China which
recommended that China “consider
employing some of the PBOC’s gold reserve for market operations and as a
macro-control tool.”
For
some reason, Koos instead thought that the “key
takeaway” from the paper was that in China “the gold on lease is not double counted, leveraged
or fractionally backed, as is often the case in Western gold markets”
(which is incorrect, but more on that later).
Now
saying what the headline should have been (from a Winklebottom point
of view) isn’t the same as saying it is true. The reason is because the POBC
paper is focused on what I’d call “good” leasing, that is, leasing to
businesses involved in manufacturing gold products, and not leasing for short
selling purposes. We can confirm this by the quote “gold leasing is a no-leverage, low-risk transaction”,
which only make sense in the context of inventory financing and not short
selling. Within that context this quote provides more detail on what was
meant by “market operations” and “macro-control”:
“Therefore,
while restricting gold export, taking part of PBOC reserve gold to
participate in leasing operation is a win-win policy. Specifically, the PBOC
may select commercial banks as counter-party to lease out reserve gold when
supply is tight. Gold lease rates may be established through bidding, PBOC
participation would increase liquidity.”
The
paper noted that the supply of physical gold to industrial users was limited
at the time, so recommended utilisation of PBOC’s reserves when “supply is
tight” and to “increase liquidity” within the lease market to support the
gold industry. Assuming the PBOC did implement these recommendations it
is likely that today their leasing may be minimal given that the PBOC did
implement the recommendation “limitation
to imports should be loosened in favor of a policy that is ‘easy in, strict
out’” and as such today physical supply to Chinese industry
is being met by significant amounts of imported gold.
However,
in some sense my headline is true, although not that PBOC is explicitly short
selling gold. In the paper they recommend that “enterprise participants can be left to commercial
banks to be evaluated for risk of doing business, not unlike evaluating
business loans.” In other words, you can trust the banks to
be prudent in choosing who to lend gold to. Subsequent events indicate that
Chinese banks weren’t so prudent, the result being “bad” leasing for short
selling.
By
September 2012 we first hear of abuse of improved liquidity in the Chinese
leasing market with growing round
tripping and collateral
trades (the gold tied up in such would be financed/hedged by
leasing). Business Week reported “rapid
growth” in precious metals leasing business in September 2014. Koos’ sourcing
of PBOC paper also confirms the observation
in a WGC report that “most of the
gold stuck in financing deals has been built up since 2011”
(note the PBOC paper is dated January 2011) and provides evidence that PBOC
paid attention to the paper’s recommendations. Later we find
out how individuals and non-gold businesses were using gold loans in
risky leveraged transactions. How much of Chinese bank leasing was for such
short selling we don’t know, but given that the paper recommended
- “increasing gold reserves optimizes the makeup
of China’s assets which will lay a good foundation for RMB
internationalization” and
- “when gold in the domestic market is
sufficient, or for strategic needs, PBOC may purchase gold from
commercial banks to reach its gold reserve target”
it is probably not unreasonable to expect that the
PBOC wouldn’t be too worried that a light touch approach to regulating gold
leasing may result in downward pressure on gold prices.
Back to
Koos’ statement that “the gold on lease
is not double counted, leveraged or fractionally backed, as is often the case
in Western gold markets”. Regarding double counting, the IMF
paper Koos quotes is referring to how many central banks report physical gold
and gold loans as one line item. When done this way, the addition of such
figures with other figures of gold holdings will result in double counting of
physical gold.
However,
Koos incorrectly thinks that the SGE rulebook that possession/title of gold
from lessor to lessee somehow gets around this problem. The very same
transfer occurs in the situations the IMF is referring to, and this doesn’t
solve the problem. It is not about transfer but about reporting. To the
extent that Chinese bank’s financial reports do not break down physical gold
stocks from gold loans, there will be double counting. To the extent that
banks following accounting standards, like the Reserve Bank of Australia does,
there won’t be double counting.
In
respect of Koos' claim that Chinese gold leasing is not fractional backed,
well, by definition gold leasing results in a bank being fractionally
reserved. As Koos notes, the SGE rules result in transfer of physical gold
from the bank, in which case, they no longer have physical gold backing their
gold liabilities! Hence they only have a fraction of physical gold against
all their gold liabilities. Hence “the
gold on lease IS … fractionally backed”. Chinese
bullion banks are no different from their Western counterparts, as Koos himself
reported:
“ICBC launched gold accumulation schemes,
swaps, forward hedging, lease/financing, collateralized loans and other
financial services ahead of time”. That sounds exactly like
what bullion banks do in Western gold markets to me.
