Koos Jansen
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Koos Jansen
Posted on 21 Jan 2014 by

Chinese Gold Leasing: Hidden Danger

I got this article from a source in the mainland.

In short, some enterprises in China use gold leasing from banks to solve their short-term funding problems in the hope of buying back the gold at lower levels to repay the lease. However they can be short-squeezed when gold moves higher. My source was so kind to do a quick translation for us (the west):

 

bulls vs bears china gold leasing

 

The Gold Bear Market Game: Spread Arbitrage Through Gold Leasing For Individuals

January 20, 2014

By Chen Zhi, Shanghai

It’s Spring Festival time again. A private business owner Chen Qian (Alias) is unhappy with her own investment impulse.

At the beginning of January, she got the 11 million RMB from a due trust product and she wanted to use it as the cushion to pay for the bills for procurement. 2 weeks later, because she couldn’t resist the temptation of a real estate trust product with an annualized rate of 11%, she put her money into this product.

To her surprise, because another sum of sales proceeds was said to be delayed, she now needed some money to pay for business procurement.

In fact, this is not her first time to be in a shortage of funds. In the past, she could pledge trust products at banks to apply for short-term bridge loans. This year, she was told banks didn’t have enough lending capacity so the bridge loan was impossible.

Therefore, she had to try the gold lease business.

Gold lease is like this: eligible businesses can lease gold from banks and pay the same quantity and grade gold when the gold lease is due and pay the relevant gold lease rate. During the lease, businesses can sell the gold to get short-term funding.

However, to her surprise, gold lease is not only a new financing tool but many business owners use it as a modern arbitrage means.

“Among my friends, there are business owners investing tens of millions of RMB and play the gold lease risk-free spread arbitrage.” Chen Qian said. But in her opinion, this kind of risk free arbitrage may have unfathomable risks.

6.7 % Funding Cost: The Involvement Of Individuals

Chen Qian’s first experience with gold lease is from the recommendation of a jewelry manufacturer.

In the past, through gold lease, this jewelry manufacturer could easily get tens of millions yuan of “cheap”funds, even in the time of credit crunch, which made her jealous.

It works like this: the jewellery manufacturer first leases 33kg of gold from a bank and then sells it through the Shanghai Gold Exchange to get around 10 million yuan (at 303 yuan/gram). Then he uses 1.5 million (15% margin rate) to buy 33 kg of gold futures contracts and use the 8.5 million left for the short-term funding of businesses.

Because the finance expenses including the gold lease expense, the brokerage fee for the futures contract are less than 0.55 million yuan, then the effective cost for the gold lease is close to 6.7 %. At the same time, the total finance expenses for bank loans (including loan rate, to cost to buy wealth management products, business audits, etc) are more than 9 %.

But not all businesses are qualified for gold lease as a means to get low rate loans. Chen Qian’s first application for gold lease was turned down. The reason is banks only lease gold to companies involved in gold market, including gold production, fabrication, sales and trade. Gold lease is not available for high net worth individuals.

Under the guide of the jewellery manufacturer, Chen Qian found that high net worth individuals can circumvent rules to get gold lease contracts. Way No. 1: set up an enterprise related to gold business. One only needs to put the phrase “gold jewellery business” into the business license to satisfy the internal compliance needs of banks. Way No 2: use the “tunnel” provided by financial lease companies and gold fabricators. One just needs to ask them to lease gold from banks to re-lease to individuals.

In her opinion, her enterprise’s internal credit rating in banks is B+ and has enough credit limit and funds so leasing gold is simple.

“Some bank insiders say, gold lease is an off-sheet lease activity. When authorities are putting tight controls on on-sheet lending, this kind of off-sheet lease business is flexible” Chen Qian said. The biggest flexibility in her opinion is lack of generalised pricing standards.

At the moment, ICBC, CCB, SPDB, BOC etc all have gold lease businesses. The 3 banks Chen met had the following rates: the lowest 3.5 %, highest 4.2 % and one is 3.8 %

“The pricing (of the lease) is related to banks’ internal pricing of risks” a person working at a Bank’s precious metals dept. This is related to the bank’s cost to deal with future gold volatility, the cost for physical delivery etc. But he emphasized that to prevent enterprises and individuals to use gold lease to get funds for speculation, most banks don’t allow non-gold related enterprises to get involved.

Every rule has loopholes. Chen found in casual chat that gold lease has become a fashionable spread arbitrage game among the enterprise owners around.

Picking Pennies In Front Of A Bulldozer Through Spread Arbitrage.

Spread arbitrage is like this: these business owners, in the background of gold’s 28% pullback in 2013, remain bearish on gold. They “borrow”gold through different ways and sell the gold on the SGE for funds. They hope to buy back the same amount of gold to repay and get the spread when gold falls further to their targets in 2014.

“A business owner signed a 3-month gold lease agreement at the end of last year and sold the gold at $1300/oz. He said he would buy back and return the gold when gold fell to $1150/oz in Q1 2014 and pocket the $150/oz difference.” Chen said. This business owner used tens of thousands of yuan. Because banks had many limitation on gold lease targets, he chose to lease physical gold from gold producers/merchants.

Gold merchants have a lot of physical gold in hand and this gold has no interest. So they would rather lease out the gold for a return.

This method is similar to banks’ gold lease. It needs business owners to put a certain percentage as margin and use real estate as pledge. During the lease, the hedge in the gold futures agreement must be done through the gold merchant’s account to control gold price volatility. But if the gold’s fall is far less than business owner’s target price to buy back the gold at the beginning of the lease, the business owner has to meet margin calls or even suffer losses.

“Gold lease is usually shorter than 1 year because the shortage the tenor, the easier to control price volatility.” The person working at the Bank’s precious metals department said. But there are some radical rich investors.

Recently, some rich people even use the funds through gold lease to invest in high yield real estate trust products to achieve “getting something from nothing”. The spread between the yield on trust products and gold lease rate is risk free in their eyes.

“Is it really risk free?” Chen was suspicious. On the one hand, many real estate investment products are facing default risks and on the other, gold lease arbitrage is facing the volatility of gold price. If these 2 risks occur at the same time, this seemingly risk-free arbitrage could be in fact “picking pennies in front of a bulldozer.”

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  • Donebenson

    It sounds as if the business person borrowing gold is similar to the bullion banks of a few years ago: they sell the borrowed/leased gold and invest the proceeds in the business or other financial products. Both parties are at risk of a rising gold price, but while that may impact the borrower negatively, does it serve to depress the gold price, if the gold has already been sold [and now owned by someone else]? Izabella Kaminska of the FT’s Alphaville had a series articles in the last 12-18 months about the negative impact of borrowing gold, but for her the negative impact on the gold price was because the initial acquisition of the gold was immediately hedged by selling gold futures in order to lock in that acquisition price [similar to the old days when gold miners sold future production forward in order to get loans to pay for exploration & production]. If the Chinese businessman does not hedge his acquisition of gold, then it doesn’t seem to imply a negative impact on the gold price if he loses money because the price of gold rises.

    • In Gold We Trust

      Unfortunately I read an article from Izabella Kaminska about Keynes once; I had to make the decision to never ever read anything from her again.

      • Donebenson

        I agree that Ms. Kaminska can be flaky at times, but she also has some insightful points as well. It’s sort of like choosing which comments by confirmed gold bugs are valid, or just pure speculation.

  • http://goldchat.blogspot.com/ Bron Suchecki

    “They “borrow”gold through different ways and sell the gold on the SGE for funds”
    Like I said, there is sales back of gold imported into China on the SGE. It is entirely possible that a lot of the “gap” we have been discussing is this selling of borrowed gold (with the purchase of the borrowed gold also showing up on the SGE data).
    I am sure these leasing “products” are related to the reported round tripping of gold between China and HK, that show up as re-exports in the HK data.

    • Salacious Monk

      Could you please stop pontificating on something that you have zero idea? I bet you even don’t know what’s the difference between general trade and processing trade. Sure you can do round tripping 1000 times through processing trade between Hong Kong and some Customs Specially Regulated Zones. But if you want to that gold to enter the SGE vaults, you need a permit issued by the PBoC. And these permits are ONLY issued to a handful of Chinese SOEs and every deal must have a separate permit unless you want to do some smuggling…

      • marc

        netiquette

    • In Gold We Trust

      Yes Bron, processing trade is something completely different than general trade in China. http://www.yusen-logistics.com/china/english/law/trade/about.html

  • Jeff Christian

    Interesting insights. These comments give lie to the simplistic view that all the gold bought in China, or anywhere else, is used or invested in. There are many financial aspects about gold that mean it gets used as quasi-money, which is lost in many simplistic commentaries. I could tell you some really interesting stories of great trades.

    There is one point I would clarify, both in your article and in Donebenson’s comments on it. Most spread traders hedge their positions. They are borrowing gold, selling it for cash, investing the cash in higher interest-rate bearing assets, and buying a forward or futures position to hedge their exposure to gold prices. That way, they make the spread regardless of what happens to gold prices.

    Some speculators do not buy the hedge, but the vast majority of these trades are hedged — in gold and in various currencies. There is a misunderstanding that the carry trades are unhedged and that adverse price moves in the currencies or assets involved can cause losses to the banks, traders, or investors engaged in these trades. That is only true for a small percentage of the trades involved. Understanding this allows one to understand how it is that banks and others make money even if the markets move against them, and how it is that they will not ‘blow up’ or go bust if prices rise or fall sharply.

    In most of these trades, neither party is at risk of a rising, or falling, gold price.

    • In Gold We Trust

      My mainland source and translator of this article told me some traders, indeed, borrow gold unhedged. Though It’s not explicitly mentioned in the article.

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