An important segment of the Chinese gold market that is often misunderstood in my opinion is the gold lease market. To get a better perspective on gold leasing in China I present a translation of a paper written by the PBOC, Problems Affecting The Development Of The Gold Lease Market And Recommendations, originally published in 2011.
Although the lease market was much smaller back then, the structure of the market hasn’t changed. Bullet points from the paper:
- All leases are done through the Shanghai Gold Exchange (SGE).
- In 2011 the PBOC had no gold leased, but the paper suggests the PBOC may participate in the domestic gold lease market to provide liquidity and develop the lease market. (If the PBOC has any gold leased at this moment I don’t know.)
- The PBOC wanted to boost the lease market in 2011 to develop the overall Chinese gold industry – the mining and jewelry business. (This has been realized, the Chinese lease, mining and jewelry markets have grown substantially.)
- There was a shortage of physical gold back then to meet demand in the lease market. The paper recommends to lift import restrictions, while preserving export restrictions. (This has also been realized; net gold import was 1,500 tonnes in 2013.)
To illustrate gold leasing by Western central banks, please read the next quotes from an IMF paper, Repurchase Agreements, Securities Lending, Gold Swaps And Gold Loans: An Update, published in 2004:
Gold loans or deposits are undertaken by monetary authorities to obtain a non-holding gain return on gold which otherwise earns none. The gold is “lent to” (or “deposited with”) a resident or nonresident financial institution (such as a bullion bank) or another party in the gold market with which the monetary authority has dealings and confidence and which is probably acting as an intermediary for a gold dealer or gold miner which has a temporary shortage of gold.
… In particular, gold may be double counted with either a gold swap or gold loan/deposit if the party acquiring the gold were to on-sell it outright, because both the original owner and the outright purchaser would report ownership of the gold.
In contrast, the SGE rulebooks:
Any member or customer who is the holder of such precious metals as gold, platinum, or silver that are placed under the custody of the Exchange may use the leasing services offered by the Exchange.
The lessor and lessee to a stock of gold, platinum, silver or other precious metals to be leased shall sign a lease agreement. The Exchange shall be responsible for transferring the possession of such precious metals in accordance with the requests put forth by the lessor and the lessee.
Upon a lessor approved for transfer and the corresponding lessee each submits a leasing request to the Exchange’s system, the system shall verify the requests and transfer the precious metals from the lessor’s Bullion Account into the lessee’s Bullion Account.
For the ones who are unfamiliar with gold leasing I have penned three simplified examples:
- A gold miner needs funds to invest in new production goods. It can borrow dollars from a bank at an 7 % interest rate, or borrow gold from a central bank at 2 % – the gold lease rate is usually lower than the dollar interest rate. The miner chooses to borrow 10,000 ounces from a central bank 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, if compared to a dollar loan. The movement in the price of gold during the lease period is neglected in this example.
- 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, 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. If one buys (long) 10,000 ounces through a futures contract for delivery in a year’s time, initially he is required to pay a margin, for example 10 %. When the contract expires and he wants to take physical delivery he must pay the remaining 90 %.
- A pseculator is looking for cheap funds. It can borrow dollars from a bank for 7 %, or borrow gold for 2 %. He borrows 10,000 ounces, 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.
The general consensus in the gold space is that gold leasing is bad thing, though in essence it’s not. If gold is a currency what’s wrong with lending it? The problems emerge when there are multiple claims on one gold bar.
The oncoming paper is translated by Soh Tiong Hum, who I like to thank from the bottom of my heart. He has translated most of the essential articles on my blog and has helped us all in understanding the Chinese gold market. Without him we would never have gotten such accurate information out of China. Thanks TH!
Problems Affecting The Development Of The Gold Lease Market And Recommendations
Source: Shanghai Finance, Date: January 2011, Authors: Ji Ming, Yan Xiaomei, Zhou Qiong, People’s Bank of China, Shanghai Headquarters.
Summary: This paper describes the current status of China’s gold lease market, discusses the problems that exist in the gold lease business and puts forward policy recommendations.
1. Brief introduction of gold leasing
The concept of gold leasing
Gold leasing is a business model carried out by commercial banks whereby physical gold is leased to fellow banks or enterprises, the same amount of physical gold is to be returned at the expiration of a contracted period together with an interest or fee. In practice, according to the nature of the counter-party, an arrangement between commercial banks is also known as gold lending whereas commercial banks to lease gold to business enterprises is called gold leasing.
Background of the emergence of international gold leasing
International gold leasing business began in the 1980s, when central banks were willing to lent part of their gold reserves to commercial banks, commercial banks then provided gold financing services, thus increasing physical support of gold in the international gold market. The appearance of gold leasing was widely welcomed by gold producers and gold jewelers. For gold producers [mining companies], gold leased from banks offered supply ahead of upcoming production, which could be sold spot to pay for operating expenses and to lock in stable prices in anticipation of a fall in the price of gold. As for jewelers, gold leasing helps to lower costs of goods sold, avoids the impact of gold price fluctuation on company finance and lowers associated market risk. The world’s first gold leasing deal was done in 1988 when three banks including the Royal Bank of Canada leased 30 tonnes to a US miner. The domestic commercial bank gold lease business in China came into being after 2005 following rapid developments of the country’s gold market with emerging demand for gold leasing from gold producers, jewelers and small and medium commercial banks.
The international gold lease business model
After twenty years of development, the gold lease market is more mature in terms of market size, body composition, pricing models and system development. Central banks (especially banks of European countries) are major suppliers of physical gold for leasing. Central banks lease out part of their gold reserves at lower rates (for example 1 % per annum) to bullion banks like HSBC, Scotiabank and JP Morgan. Once the gold is in their possession, these bullion banks can make two kinds of deals:
- Sell gold for US Dollars, and then use the US Dollars to invest in assets with higher returns like government bonds for spread income. These kind of deals are also known as a ‘carry trade’.
- The second deal, which is a traditional lease deal, is to lease physical gold to other commercial banks or producers and jewelers. At expiration, interest can be settled in physical gold or currency. The gold lease rate (GLR) is LIBOR minus GOFO, with tenors from 1 month to 1 year.
International gold leasing is very market-oriented. It has a high level of transparency as rates are published daily on major websites. The gold lease rate plays an important role in the gold market; on one hand the gold lease rate is the benchmark for gold derivatives and new product innovation in the international gold market, on the other hand it is seen as an indicator for short term central bank-controlled supply and demand, because central banks lease supply affects the gold lease rate and causes gold price fluctuations.
2. Current shape of China’s gold lease market
Status of gold lease market participants
Current participants in the gold lease market are commercial banks, gold miners and jewelers. Commercial banks stand on the supply side while gold producers and jewelers fall on the demand side. Industrial gold users capture the bulk of demand with jewelers as the main body. Jewelers utilize gold leasing to lower working capital requirement and avoid price fluctuations. There is less participation from gold producers because gold producers have always been a minority among members of the Shanghai Gold Exchange (SGE). Besides, gold producers have the option to hedge market risks through gold futures or by delaying physical delivery; because of complicated vetting and approval required by leasing operations, gold producers are not keen about leasing. China Construction Bank is a major commercial bank participating in gold leasing.
Besides market participants discussed above, 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.
Mechanism of domestic gold lease operations
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. Commercial banks have similar processes but there is no standardized approach.
- 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 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 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.
Leasing between commercial banks basically follow the flow between commercial bank and enterprise but is carried out between head offices of both parties. As commercial banks enjoy higher credit ratings, gold leasing rate is slightly lower than the rate applied to enterprises.
The size of domestic gold leasing business
China’s first leasing deal was done on 11 March 2005 when China Gold Coin Incorporation [the Chinese Mint] leased 800 kilograms of gold from the Bank of China (BOC). More organizations participated in gold leasing once they understood the process. A new bull market in gold arrived after 2007 that spurred leasing activity and doubled the size of transactions. As of 2009, cumulative leasing to enterprises by commercial banks reached 200 tons while trading volume reached an average annual growth rate of 2 – 3 times. Leasing commanded an increasing share of the SGE’s trading volume and became one of SGE’s businesses with the highest development potential.
3. Issues that exist in the current leasing business
Limited domestic supply for physical gold
Since the establishment of the SGE, China’s physical gold market has grown rapidly every year with rising efficiency from domestic sources. Annual domestic production, however, is under 300 tones while demand is 400 tons. Under-supply persisted for years combined with low turnover in domestic physical gold so that the demand of some players could not be met by the market. Therefore many domestic and foreign commercial banks adopt a proactive attitude and have high hopes for gold leasing, especially foreign banks like Scotiabank and ANZ bank, which have rich operating experience.
The biggest problem at the moment is source physical gold. Firstly, after long operating under direction, key participants in the gold market including commercial banks have limited physical gold in reserve. Not enough to support development of the huge leasing business. Secondly, gold produced by domestic producers are sold directly into the market. From capital utilization point of view, these producers have little incentive to retain large inventory. Thirdly, China limits import of goods so that apart from the four banks [currently 15 banks] that can import physical gold according to quota, no other financial entity has any channel to acquire physical gold from the international market. In addition, the PBOC’s gold reserves have never entered the domestic gold market. Over the long run, shortage of physical supply will curb development of gold leasing in a big way.
Few players, the system is not mature
Gold leasing requires demand and supply of physical gold to have a match through price discovery. A physical gold user must find a supplier, build trust, reach an agreement on the gold lease rate and then arrange the transactions, custody, settlement, transfer and so on to be completed on time. A sophisticated gold lease market requires an electronic trading platform, physical custodian and settlement entity as well as accompanying support. At the moment there are few participating organizations in China. Among physical suppliers, there are only seven commercial banks. There are also very few enterprises on the demand side. In the leasing business, most participants are large scale gold merchants reaching private deals with lessors that they have a long established relationship with. Most of market demand is not met because information is unavailable or parties that want to deal are unable to build trust or evaluate credit. As can be seen in recent years, more small and medium commercial banks want to participate in gold leasing. They, as well as recent foreign entrants, show strong appetite but because of poor policy, understanding and inadequate service, their participation can be improved.
Differences in the way commercial banks operate
A survey of some commercial banks found there are differences in the way banks operate.
One, there are differences in commercial banks their management model. For example, ICBC’s gold leasing is centrally managed by head office with centrally defined direction and operating procedures. On the other hand, CCB’s head office only supplies physical gold but business management is run out of branch offices. CCB does not have a specialized management for gold leasing.
Second, there are differences in the way the gold leasing rate is determined. CCB’s leasing rate is derived from its own leasing rate from the international market, plus risk premium and management fee. ICBC’s asks for a sales fee on top of gold leasing rates and quotes the gold lease rate in fixed rate and floating rate.
Third, difference appears in the way counter-parties are selected. ICBC sets requirements for potential lessees, for example having an existing fund settlement account with the bank but CCB accepts lease applications from potential lessees that are arranged through third party banks. Each commercial bank also has different templates for lease agreement, penalty for non-compliance with leasing terms and so on.
Information is inadequate
At the moment, most leases are privately negotiated. Apart from information available at the SGE, the PBOC and its subsidiaries have few other sources for information. The PBOC does not fully follow the development of the leasing business much less provide direction. Despite rapid growth in the gold lease business since 2007, the PBOC’s level of attention in this business is not high. Many SGE members remain uninformed about the business and even deals between commercial banks are few in number and volume.
4. Policy recommendations
Actively acquire new sources of physical gold
China should consider policies that increase the number of sources available to market participants. Limitation to imports should be loosened in favor of a policy that is ‘easy in, strict out’. Specifically, set up a qualification for the Big Four banks according to their market scope and level of development and contribution, so as to increase their imports in accordance with performance of joint stock company. Physical gold import must meet the volume required for gold leasing. Concurrently, foreign banks that have plentiful experience in gold leasing such as HSBC, Standard Charted, Scotiabank and ANZ may be given approval to import physical gold from their head office within the “People’s Republic of China Foreign Exchange Management Regulations”. Additionally, consider employing some of the PBOC’s gold reserve for market operations and as a macro-control tool.
In the first half of 2010, official gold reserve increased from 600 tons to 1054 tons – sixth placed in the world. From a strategic point of view, increasing gold reserves optimizes the makeup of China’s assets which will lay a good foundation for RMB internationalization. Gold however is an asset that has little yield. 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. 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.
Set up electronic trading platform for gold pricing and transparency
At the moment, gold leasing’s core areas – physical handling, custody and settlement are done at SGE and demand and supply participants are members and customers of the exchange. Setting up a price-finding and information platform at the SGE is a foremost way to expand the exchange’s service competency. Once an electronic trading platform is set up, commercial banks and large gold merchants can use the platform according to their own business model, to engage in one-to-one and one-to-many trading and price discovery, which will lead to higher physical gold turnover. For example, bank A may want to borrow 2 tonnes of gold whereas B and C each have 1 tonnes available. A can approach B and C concurrently so that all 3 parties reach a deal. The electronic trading platform is conducive to a fair and transparent gold lease system. By disclosing gold lease information on the electronic platform, participants can get more timely information on lease volume and rates. This will give them better judgment of demand and supply and is good for reference and strategizing. Supervisory functions would also be improved leading to more effective monitoring.
Improving effectiveness of regulation
Firstly, perfect various control measures. The PBOC should quickly come up with its guidance for the gold lease business, to come up with regulatory principles separately for businesses between commercial banks and businesses between commercial banks and enterprises so as to achieve an orderly market to avoid unfair competition. Next, the SGE must become supervisor in the lease market – to perfect various control measures. Thirdly, commercial banks in the leasing business must define management measures, report to the PBOC, the China Banking Regulatory Commission and the SGE, to accept supervision and management.
Methods to regulate business. Gold leasing is a no-leverage, low-risk transaction where the biggest risk encountered by participants is the credit risk of counter-parties. Over the long run, commercial banks constantly improve risk management but also establish a set of effective risk management rules. They have accumulated a lot of experience to select counter-parties and evaluating exposure. Therefore regulators do not have to set barriers of entry for commercial banks that want to participate in gold leasing as long as they are SGE members that are financial in nature and can be both domestic or foreign. Enterprise participants can be left to commercial banks to be evaluated for risk of doing business, not unlike evaluating business loans. In day-to-day operation, PBOC regulation should focus on monitoring market information. Firstly, support SGE business information disclosure, timely release information on market supply and demand and report on penalizing violators. Secondly, look out for irregular transactions (example, wide discrepancy between market rate and transacted rate), conduct in-depth analysis on the occurrence of irregularities and provide warnings for systemic risk.