The last bits of data are coming in from the countries that export gold to China, with which we can compute the total the Chinese have imported in 2016. There are four main gold exporters to China, which are Hong Kong, Switzerland, the UK and Australia (it’s not publicly disclosed how much South Africa exports directly to China ). Let’s start discussing the largest gold exporter to China.
Since 2011 when the gold price slowly started to decline and China embarked importing gold at large, Hong Kong has been the main conduit to the mainland. According to data by the Hong Kong Census And Statistics Department (HKCSD) the special administrative region net exported 771 tonnes of gold to China in 2016, ranking first once again. Net exports were down 10 % compared to 2015.
As I mentioned in November 2016 there were rumors that part of the bullion exports from Hong Kong to China were fake – over-invoiced to move capital out of the mainland – which overstated the flow of gold into China. Let’s investigate if the data by the HKCSD can substantiate this rumor. The net amount of bullion going from Hong Kong to China is the residual of exports (materials lastly fabricated in Hong Kong) plus re-exports (materials not altered in any way, shape or form but merely re-distributed by Hong Kong) minus imports (materials imported into Hong Kong from China through processing trade). If one is to engage in over-invoicing exports from Hong Kong are more suitable than re-exports, because the origin of exports are harder to track. For re-exports the origin of the material must be recognized by the HKCSD, which makes any illegal scheme more difficult to conceal.
Notable is that from February through August 2016 there was an increase of gold exports relative to re-exports from Hong Kong to China (see dark green bars in the chart above). Usually the shipments from Hong Kong to China are re-exports, so the increase in exports was remarkable. But the HKCSD data is no hard evidence any transfers were overstated.
In another example: if we look at the composition of Hong Kong’s export and re-export to the UK in 2016, we can see something similar, the majority were exports.
I doubt Hong Kong’s flow of gold to the UK has been overstated; UK residents have no motive to surreptitiously move capital abroad. And if the data on Hong Kong’s shipments to the UK are accurate, why can’t the data on Hong Kong’s shipments to China be accurate? Thereby, the Chinese customs department is not retarded. I’m quite sure the Chinese customs department is aware of over-invoicing schemes and as a consequence it can strictly monitor cross-border gold flows. My conclusion is that net shipments from Hong Kong to China in 2016 have likely been close to 771 tonnes. If I do ever find hard evidence it was less I will report accordingly.
Most likely Hong Kong’s position as the largest gold exporter to China will slowly fade in the coming years, as the State Council is stimulating gold freight to go directly to Chinese cities (hoping the Shanghai International Gold Exchange will eventually overtake Hong Kong’s role as the primary gold hub in the region). Consequently, gold exports to China are increasingly bypassing Hong Kong.
In December 2016 we got a preview of what is about to come: Switzerland net exported an astonishing 158 tonnes directly to China, up 418 % from November 2016, up 168 % from December 2015, and 106 tonnes more than what Hong Kong did.
It will take more time before Hong Kong’s role as supplier to China is fully over though. In the past years a significant part of gold exports to China has been used to quench Chinese jewelry demand. The core of the Chinese jewelry manufacturing industry is located in Shenzhen, which is right across the border from Hong Kong. But as far as I know there aren’t many flights going directly from Switzerland, Australia or the UK to Shenzhen yet. Hong Kong on the other is well connected; so in the near future Hong Kong’s airport is more convenient to supply gold from abroad to Chinese jewelry manufacturers.
In total the Swiss net exported 442 tonnes directly to China mainland in 2016, up 53 % from 288 tonnes in 2015.
The United Kingdom
Direct gold shipments from the UK to China have been tepid in 2016. Only 15 tonnes have been net exported to the mainland over this time horizon. Noteworthy though, in December 2016 the UK exported 172 tonnes to Switzerland, which in turn moved 158 tonnes to China – as I mentioned in the previous chapter. So although the UK didn’t directly export metal to China in December, it sure was the main supplier.
Not all data from the Australian Bureau of Statistics (ABS) has been released for 2016, but from what we have Australia seems to have exported less to China than in 2015. From January through September direct shipments amalgamated to 53 tonnes, while Australia directly net exported 78 tonnes to China over the same months in 2015. (ABS has notified me they changed the way how they disclose gold export data, but they failed to clarify the details. Until I get more information I will stick to my own formula to compute Australia’s direct export to China, which was confirmed to be accurate by ABS early 2016.)
It can be Australia’s direct exports where strong in last three months of 2016 as the price of gold went down over this period and the Chinese increase gold purchases on a declining gold price.
Combining gold trade data by Hong Kong, Switzerland, the UK and Australia, reveals China has imported at least 1,281 tonnes in 2016. Though this figure excludes Australia’s exports for October, November and December, so I’m estimating total Chinese gold import will reach roughly 1,300 tonnes.
According to the data at my disposal there have been practically zero tonnes of gold imported from China by other nations across the globe than the ones discussed above. Signalling there is very little gold being exported from the Shanghai International Gold Exchange (SGEI) located in the Shanghai Free Trade Zone. Possibly foreign central banks buy gold on the SGEI and ship it home as monetary gold which doesn’t show up in any customs reports. However, in the history of the SGE/SGEI a mere 3 tonnes has been traded in 12.5 Kg bars, all the rest was in smaller bars, mainly 1 Kg. And I assume central banks would prefer large bars. All in all I think that up till now the SGEI has mainly been used by Chinese banks to import gold from the Shanghai Free Trade Zone into the domestic market.
A few weeks ago I estimated Chinese gold import 2016 would aggregate to 1,300 tonnes, to which I calculated 5,000 tonnes of gold have been moved into the Chinese domestic market from 2007 through 2016 on top op the imports to satisfy Chinese consumer demand. In my post The West Has Been Selling Gold Into A Black Hole I explain how I think this will strengthen a forthcoming gold bull market.
Last but not least: SGE withdrawals for January 2017 came in at 184 tonnes, down 18 % from January 2016.
Last week the Shanghai Gold Exchange (SGE) launched a new English website to offer international customers more information and tools on trading gold in renminbi through its subsidiary in the Shanghai Free Trade Zone the Shanghai International Gold Exchange (SGEI). BullionStar took the opportunity to translate a speech by a Teng Wei, Deputy General Manager of the SGEI, named “How China’s Gold Market Can Help The RMB Achieve International Status” that was held at the Renminbi World summit in Beijing on the 29th and 30th of November 2016. In the speech Teng Wei outlined his vision for the SGEI going forward regarding renmibi (RMB) internationalization, connecting the onshore and offshore renminbi market and increasing gold market share.
My comment before you read the translation:
1) In the financial blogosphere the general perception is that the SGEI has been a failure since it was launched in September 2014. This analysis is based on the assumption that the trading volume of the most popular SGEI contract (1 Kg 9999 – iAu99.99) has been tepid for two years now. But this analysis neglects two important elements.
First, iA99.99 can be traded competitively “on Exchange”, but also in the OTC market. The OTC possibility is hardly known by commentators in the English world, though the related volumes are significant. Have a look at the next chart in which I’ve plotted iAu99.99’s weekly trading volume “on Exchange” and in the OTC market. Clearly iAu99.999 is traded mainly in the OTC market.
Second, international customers of the SGEI can not only trade the SGEI gold contracts, but they can also trade SGE (domestic) gold contracts. Logically, as at present liquidity on the SGE is much higher than on the SGEI, many international customer that seek to trade gold in renminbi, and don’t need to export the metal, will choose to trade SGE gold contracts.
When observing total trading of all SGE(I) gold contracts, there is a clear rise in volume since the SGEI was launched.
Up till now international customers are mainly trading SGE contracts. The significant rise in trading volume of all SGE(I) contracts since September 2014 is due to the inception of the International Board (SGEI). In the second week of November 806 tonnes was traded on the SGE(I), the highest amount ever.
So the launch of the SGEI has not been a failure in my opinion – it has elevated gold trading in (offshore) renminbi.
2) Teng Wei mentions that in 2015 gold demand in China and India was 985 and 849 tonnes respectively. In the case of China this refers only to consumer demand, not institutional demand. Chinese consumer and institutional demand in 2015 combined was well north of 2,000 tonnes.
3) A gold exchange doesn’t flourish overnight. The SGE was launched in 2002; in that year its total trading volume was 22 tonnes and withdrawals accounted for 16 tonnes. Ten years later total trading volume was 3,175 tonnes and withdrawals accounted for 1,138 tonnes. In 2015 total trading volume was 17,033 tonnes and withdrawals accounted for 2,582 tonnes. The development of the SGE, becoming the largest physical gold exchange globally, took time and it can be no different for the SGEI.
Document Translation [brackets added]:
Teng Wei: China’s Gold Market Opens Up To Boost RMB Internationalization
The 2016 RMB summit was held in Beijing on the 29th and 30th of November. Deputy General Manager of the Shanghai International Gold Exchange Center Teng Wei participated in the forum and discussion on “How China’s Gold Market Can Help the RMB Achieve International Status”. He expressed that using Shanghai’s free trade zone status, investors can open trading accounts denominated in RMB and participate in trading directly through the Exchange’s international board [SGEI] that allows access to most of the precious metal products that are traded in China. The international board has developed relatively well since establishment with active participation from international members and steadily increasing trading volume.
Gold on the international board is quoted and settled in RMB, which effectively connects the RMB onshore market and offshore market. This will extend the scope of RMB usage across borders and provide a new channel for inward capital flows. It is a move that is beneficial to expand the RMB usage to steadily promote internationalization of the RMB.
The actual speech:
Ladies and gentlemen, good afternoon, I am Teng Wei from the Shanghai International Gold Exchange. I am delighted to participate in this forum organized by the Asian Bankers Association to have a chance to speak and interact with everyone about opening China’s gold market to the world and how that can help the internationalization of the RMB.
This afternoon, I would like to touch upon on three topics. The first topic is the new pattern of the internationalization of the RMB and the global gold market. China’s gold market was established in 2002 with the launch of the Shanghai Gold Exchange. If anyone is familiar with the history of China’s gold market, you will know that before the year 2002 the Chinese gold market was entirely ran by the People’s Bank of China, including the process of purchasing, allocating and storing of gold. There wasn’t a single unified market where all participants could trade at the same time. Since the year 2002, with approval of the State Council, the People’s Bank Of China developed gold spot trading on the Shanghai Gold Exchange, as well as gold futures trading and over-the-counter trading via commercial banks, etc, which formed the basis for a multi-level diversified gold market system. While the Chinese gold market was developing rapidly, the pattern of the global gold market was also having a dramatic change. As time passed, the international gold spot market was heavily concentrated in London and the international gold futures market has been concentrated in New York. However, in recent years, with the rise of gold demand in China, India and other Eastern nations, and with the exit of European and American banks from the precious metals market, it’s clear that Western gold is moving to the East. In 2015 gold demand in China and India was at 985 tons and 849 tons respectively. These figures alone account for 45% of global [consumer] gold demand. With gold demand from other markets dipping to various levels, China is not only the world’s largest gold producer and importer of gold, but has also become the world’s largest gold consumer.
Just now, I mentioned that the two main centers for gold trading are London and New York, and the current situation is Western gold flowing to the East. Everyone, have a look at some statistics that I have here, showing that just China and India alone make up over 45% of global gold demand. This was last year’s data.
Since the year 2005, when the RMB exchange rate was reformed, international investors’ willingness to trade in RMB denominated assets has also increased. This has objectively enhanced the Chinese gold market’s international status and garnered attention. In recent years, the RMB exchange rate is expected to have some changes.
The Shanghai Gold Exchange provides the important infrastructure for China’s gold market. ECB officials have mentioned that an important part of promoting the internationalization of the RMB is having a good financial market infrastructure. The exchange is also an important “all-in-one” foundation for gold transactions, clearing, delivery and storage. It serves with the commitment to provide gold investors with efficient and convenient market services. It has been 14 years since establishment of the exchange in the year 2002 and development has been rapid with annual trading volumes increasing 40% on average.
At the end of 2015 there were over 8.6 million individual accounts, over 10,000 institutional accounts and the total gold trading volume for the year reached 17,000 tonnes. The exchange was ranked as one of the largest and we firmly grasped an important opportunity for the internationalization of the RMB with the profound changes happening in the gold market. At the same time, we want to build a harmonious ecological gold market that sets a new path for the global gold market and achieve the status of being a global gold power from a large gold holding nation.
For the second point, I would like to explain how opening up China’s gold market externally to the world can help the internationalization of the RMB. To further promote and innovate China’s gold market, on 18th September 2014, the Shanghai Gold Exchange set up an international board [SGEI], open directly to foreign investors. This move has effectively connected China’s domestic gold market and the international gold market. Using Shanghai’s free trade zone, investors can open trading accounts denominated in RMB and participate in trading directly through the exchange’s international board that allows access to most of the precious metal products that are traded in China. The international board has developed relatively well since establishment with active participation from international members and steadily increasing trading volume.
As of now, the exchange has 67 international members, including most of the world-renowned gold suppliers and traders like Mr Thomas McMahon, who is also our Exchange’s member. At the end of the third quarter of 2016, the international board had recorded a total of 7,837 tonnes of gold traded, with a turnover valued at nearly 200 billion RMB. The Shanghai International Gold Exchange is the test pilot and pioneer for opening up China’s gold market to the world. It is significantly important for further increasing the capacity, expansion and international influence of China’s gold market. In addition, the international board uses RMB for settlements, producing an effective convergence of the RMB offshore and onshore markets, expanding the cross-border use of the RMB and providing a new channel for return of funds. All these points steadily promote the internationalization of the RMB and serve as a useful exploration.
For RMB denominated gold products to gain popularity outside of China, we think the prerequisite is to provide a fair offering for global gold market transactions, with reliable gold benchmark pricing in RMB, using the Shanghai Gold Exchange benchmark pricing mechanism [Shanghai Fix] for our trading platforms. The weight of the gold traded is 1 kilogram, with a fineness of no less than 99.99%. Using a price inquiry method and market volume, a balance is reached to form the benchmark price of gold measured in RMB. The price announcements will be released externally each trading day at 10:15 and 14:15.
At present, the Shanghai gold benchmark price is being used by domestic gold producers and suppliers for hedging and settlements. More and more commercial banks are also using the Shanghai gold benchmark price for gold leasing and financing as the standard. More and more products linked to the Shanghai gold benchmark will be made available.
Other than domestic usage, the Shanghai gold benchmark price is also being actively studied more and more by external markets regarding its application. In October, the exchange signed an agreement with Dubai for the right to use the Shanghai gold benchmark price and authorization was given for the Dubai gold exchange to use the Shanghai gold benchmark price as the standard for offshore RMB denominated futures. The signing of this agreement marks the use of the Shanghai gold benchmark price in international financial markets for the first time. This greatly helps to elevate the international influence of the exchange in global markets and improves the image and reputation of the RMB abroad.
For the third point, I would like to share with everyone how the Shanghai Gold Exchange acts as an important infrastructure for internationalization in three steps. As the forerunner for opening domestic markets and innovation, the Shanghai Gold Exchange cannot forget its historical mission. We are determined to take the international and market-oriented strategy.
Overall, for the internationalization process, we have three steps to take. The first step is to be open and inclusive, actively inviting foreign investors to come in. Just now, we have introduced our international board after the establishment of the Exchange and we will continue to increase publicity efforts. In accordance to high standards and multifaceted principles, we will continue to increase and expand international membership of the Exchange. Accordingly, we have carried out a variety of promotional activities in major financial hubs and countries and regions along the new Silk Road to allow more international market participants to hear the sound coming from the Chinese gold market. The exchange also takes the opportunity to actively learn from the experience of advanced international markets in the optimization of various trading systems and innovation of all kinds of trading products.
For the second step, since we have invited guests inwards, we also have to step outwards. Through cooperation and win-win situations, the gold Exchange can be promoted and step out of China. The Shanghai gold benchmark price has now taken a first step with the Dubai Gold Exchange agreement. This can be considered an ice-breaking move and serve as a cooperation model for other overseas markets and improve the recognition, branding and acceptance of the Shanghai gold benchmark price. Taking this as an opportunity, the Shanghai Exchange, together with the Chicago Mercantile Exchange (CME, COMEX), the Hong Kong Stock Exchange, the Malaysian Stock Exchange and a number of foreign exchange markets explored on long-term cooperation mechanisms that will allow foreign investors to directly participate in our gold market, in RMB denominated gold trading, standard gold settlement, and many other aspects and modes of cooperation that will increase the Shanghai Gold Exchange’s international market influence.
The third step is to realize RMB internationalization and increase global transaction on the exchange through integration and upgrades. As the international financial markets continue to merge and develop, market boundaries are increasingly blurred and we believe that market fragmentation will be removed gradually. In recent years, we can all notice that there are more and more mergers and acquisitions among major exchanges in the world. We hope to learn from the experiences of such joint stock mergers and acquisitions between global exchanges and explore the different modes of industry integration with overseas exchanges. By offering a wide range of local and overseas products through an open platform [SGEI], we hope to create a world class exchange group. The journey of the internationalization of the Shanghai Gold Exchange will epitomize the opening of China’s financial markets to the outside world and play an important part in the internationalization of the RMB. With Shanghai becoming the third most important market in the world after London and New York, the Chinese gold market will make a great contribution to the internationalization of the RMB. Thank you everyone.
What came to light as on odd discrepancy between GFMS’ Chinese gold demand and “apparent supply” has proven to be a tenacious cover-up by the oldest consultancy firm in the gold market. And not only does GFMS publish incomplete and misleading data on Chinese gold demand, all its supply and demand data is incomplete and misleading. As a result, the vast majority of investors across the globe has been brainwashed to believe total gold supply and demand mainly consists of global mine output and jewelry demand. In reality, the supply and demand data GFMS publishes is just the tip of the iceberg. But the firm is reluctant to admit this publicly, lest their business model would be severely damaged.
GFMS has denied all allegations about their incomplete Chinese gold demand statistics by continuously making up false arguments. Therefore, BullionStar will debunk, once more, such arguments spread by GFMS – which are supposed to explain how from January 2007 until September 2016 the difference between GFMS’ Chinese gold demand and apparent supply reached over 4,500 tonnes – in order to expose true Chinese gold demand.
Since 2013 I’ve witnessed GFMS shamelessly present nine arguments in their Gold Survey reports, but along the way abandoned the arguments that I had debunked on these pages. Indeed, few of all these arguments have ever proven to be valid, illustrated by the fact that GFMS perpetually keeps making up new ones. What’s left is to disparage are the final three arguments from GFMS’ most recent annual report: the Gold Survey 2016 (GS2016). Because GFMS chooses their arguments to be ever more complicated, I’ll have to be precise in my wordings not to allow any margin for interpretation errors. For detailed information regarding the mechanics of the Chinese gold market and supply & demand metrics readers can click the links provided.
Debunking Final GFMS Arguments
In the Chinese domestic gold market nearly all supply (import, mine output, scrap supply) is sold through the Shanghai Gold Exchange (SGE), and so Chinese wholesale gold demand can be measured by the amount of gold withdrawn from the SGE vaults; data published on a monthly basis. As I’ve been reporting on withdrawals from the Chinese core exchange since 2013, the debate between me and Western consultancy firms like GFMS with respect to true Chinese gold demand has centered around these infamous SGE withdrawals (exhibit 1). Per mentioned above, GFMS has put out nine arguments in recent years explaining their reader base why SGE withdrawals do not reflect gold demand. Firstly, let us have a look at the five arguments now abandoned by GFMS:
Chinese commercial bank assets to back investment products. “The higher levels of imports, and withdrawals, are boosted by a number of factors, but notably by gold’s use as an asset class and the requirement for commercial banks to hold physical gold to support investment products.” (Gold Survey 2015, page 78).
Defaulting gold enterprises send inventory directly to refiners and SGE (Gold Survey 2015 Q2, page 7)
No need to discuss these anymore, as GFMS dedicated a full chapter in the GS2016 report titled, “A Review And Explanation Of How China’s SGE’s Withdraw Numbers Are Impacted By Other Trading Activities”, in which the arguments above are not listed, implying GFMS ceased to recognize them as relevant. However, there are three new arguments listed, and one old one, that will be discussed in this post:
Gold leasing activities and arbitrage opportunities (in China gold is money at lower cost) (Gold Survey 2016, page 57, Gold Survey 2015, page 78)
Because gold leasing is an old argument it will only briefly be addressed here.
1. Tax Avoidance
This argument entails an illegal Value-added tax (VAT) invoice scheme. Although this scheme exists, it can not have the impact on SGE withdrawals like GFMS wants you to think.
GFMS introduces its special investigation chapter by stating:
The first and foremost factor behind why we believe the SGE’s withdrawal number differs from the country’s total gold demand is related to China’s current tax system, with some people exploiting this grey area.
… the number of industry participants mushroomed in 2014 and 2015 as other traders became aware of the potential loophole.
The GFMS team uses the terms “tax avoidance” and “loophole”. For the ones that don’t know, tax avoidance and tax evasion are two opposing practices. Tax avoidance is the legal usage of a tax regime to one’s advantage in order to reduce the amount of tax payable by means that are within the law (Wikipedia). Tax evasion is the illegal evasion of tax payable (Wikipedia). In other words, tax avoidance is legal while tax evasion is illegal. In the introduction the GFMS team pretends the tax scheme is legal, while this is anything but true. In China one can risk life imprisonment or the death penalty when caught for tax evasion:
Whoever forges or sells forged special invoices for value-added tax shall, if the number involved is especially huge, and the circumstances are especially serious so that economic order is seriously disrupted, be sentenced to life imprisonment or death and also to confiscation of property.
Then, to add to the confusion, further down the GFMS team writes, “of course, all of the activities are considered illegal by the Chinese government.” Maybe GFMS doesn’t understand the difference between tax avoidance and tax evasion, two diametrically different practices, which makes their professionalism highly questionable.
GFMS writes, “the first and foremost factor behind why we believe the SGE’s withdrawal number differs from the country’s total gold demand is related to China’s current tax system”. So we’re supposed to believe that after all these years – GFMS is operational for decades – and all that has been written on the Chinese gold market, now GFMS has finally found the “first and foremost reason” why SGE withdrawals do not reflect demand? Or did it recently stumble upon this scheme to use in its defence? I think the latter.
Regarding using VAT invoices for tax evasion, the GFMS team must have read this news article by the Shenzhen Municipal Office. In the news, a company called Longhaitong used SGE VAT invoices for tax evasion. How does it work? For example: the prevailing spot gold price on the SGE is 234 CNY/gramme. Company X tells a mom-and-pop jewelry fabricator that they can supply good quality cheap gold, say the SGE spot price minus 2 CNY/gramme, but without a VAT invoice. The mom-and-pop fabricator wants to buy 1 Kg so it gives 232,000 CNY to company X (the mom-and-pop shop will fabricate jewelry from the gold to be sold covertly without VAT to consumers). Company X buys 1 Kg of gold on the SGE at the spot price of 234 CNY/gramme, paying 234,000 CNY. Then company X gives the gold to the mom-and-pop fabricator but keeps the VAT invoice. Up till now, company X has incurred a loss of 2,000 CNY (bear in mind, because of China’s VAT system buyers pay the spot price at SGE which doesn’t include any VAT, but when companies withdraw the metal they receive a VAT invoice from the tax authority that describes 17 % of the all-in price is VAT, because the gold leaves a VAT exempt environment). However, company X can then sell the VAT invoice for 4,000 CNY to, in example, a brick trader. Company X effectively makes 2,000 CNY. If the brick trader alters the subject header on the invoice from “gold” into “bricks” he can tax deduct 34,000 CNY (234,000 / (1+17%) * 17%) from his VAT payable. In this scenario, the brick trader effectively makes 30,000 CNY (34,000 CNY minus the 4,000 it paid to company X). Naturally, all exemplar numbers can vary.
For sure this illegal VAT scheme exists and has been used. But, only to a limited extent – in my conclusion I will tell you the upper bound. Mind you, in the scenario I just described the gold does meet demand, albeit through an illegal scheme!
In addition, the discrepancy between the GFMS Chinese demand figures and SGE withdrawal numbers first appeared in 2008, and have exploded since 2013.
In the GS2016 GFMS writes:
We initially became aware of the scheme in 2013 when it first emerged, but based on information gathered from our contacts, the number of industry participants mushroomed in 2014 and 2015 as other traders became aware of the potential loophole.
The GFMS team wants readers to believe that it was the tax scheme that caused the discrepancy between GFMS Chinese demand and SGE withdrawals since 2013, but the VAT regulation regarding gold has remained unchanged since 2002. Is it believable that criminals found the possibility of these illegal practices 11 years later, exactly when Chinese demand exploded? No. If you click this link, you will see a similar incident that happened in 2010 and was reported at the end of 2011. The VAT scheme has existed for many years and crime incidents happen, but not like GFMS wants you to think.
If the GFMS team was indeed aware of the illegal practices as late as 2013 and thought that was the year when these practices first emerged, then GFMS is not properly informed in the Chinese gold market.
More from GS2016:
One of our contacts with some understanding of this activity estimated that just from Shenzhen alone, such trading activities could have possibly impacted the SGE’s withdrawal volumes by a few tonnes per day. Approximately half of the gold being sold in the black market at discounts would eventually flow back to the SGE.
In my opinion this is speculation. According to the news available, buyers in the black market are those who want the gold to fabricate jewelry that eventually is being met by true demand. In contrast, GFMS wants readers to believe half of the gold involved in the scheme flows back to the SGE. But bars withdrawn from the SGE vaults are not allowed to re-enter, only if they’re recast into new bars by SGE approved refineries (the gatekeepers of the Chinese chain of integrity). For gold involved in VAT invoice schemes to flow back to the SGE, technically SGE approved refineries would be complicit. Though the SGE conducts a campaign to crack down on such illegal tax activities.
As stated above, the VAT scheme is real, though it can not involve as much gold as GFMS wants you to believe. Unfortunately we can’t compute the exact amount recycled through the SGE through this practice, we can only identify the upper bound, which we’ll do in the conclusion.
As background information: when gold is withdrawn from SGE vaults and promptly flows back to the SGE, this overstates withdrawal numbers as it creates equal demand and supply that has no net effect on the price. Therefore, such recycle flows should not be counted in supply and demand statistics. Readers can click this post for more information.
Financial Statement Window Dressing
The GFMS team writes:
Some companies attempted to build up their revenues by merely trading and withdrawing physical gold from the SGE vault so it would appear they have a high level of business activity, while in reality there is no real genuine demand behind this.
Trading can build up revenues but why do these companies withdraw gold? That doesn’t make economic sense. If a company buys gold on the SGE and leaves the gold in the SGE vault, the gold will be recorded as “inventory” on the company’s balance sheet. If the company then withdraws the gold, the gold is still regarded as “inventory”, so what’s point of withdrawing gold? Changing the location of the gold doesn’t change the accounting nature of the gold.
It is technically possible to buy gold on the SGE, withdraw, refine it into new bars, redeposit the bars into SGE vaults and sell the bars. However, this will incur expenses. When the point is “window dressing”, why incur unnecessary expenses? More logic would be to leave the gold in the SGE system. This argument is false.
Retailers Selling Unsold Inventories Directly to Refiners
In this section, the GFMS team writes:
Retailers often prefer to sell a portion of their working stock at a discount directly to refiners in order to maintain inventories at a desirable level.
Why waste the fabrication costs of jewelry when retailers can sell the products at a discount to customers?
By selling to refiners, even if such a transaction may result in a financial loss, it still counts as revenue; but doing the latter only increases the expense category and provides no benefits to the company’s revenues or asset value.
Let’s assume an unsold jewelry stock is worth of 1,000 CNY. The retailer sells it to a refiner at 800 CNY, which results in a loss of 200 CNY. The inventory item on the retailer’s balance sheet is reduced by 1,000 CNY and the cash item increases by 800 CNY. The net result is that the total asset value of the retailer decreases by 200 CNY, then how can this practice provide benefits to the asset value?
As an example, during a field research trip earlier this year, a local refiner indicated that one jewellery retailer has sold approximately 40 tonnes of unsold jewellery pieces to them in a single two month period.
But this quote doesn’t mention what the unsold jewelry pieces become in the end. Possibly, these pieces become gold wires, which might be used by jewelry fabricators instead of becoming gold bars that flow back to the SGE. GFMS pretend the majority of gold in China is continuously recycled through the SGE, which is not true. Many refineries are note even approved by the SGE to supply gold bars.
Gold Leasing Activities And Arbitrage Opportunities
This argument is one of the oldest and most persistent. But we can be short about this; in the Chinese gold lease market nearly all trades are conducted within the SGE system. Any speculator borrowing gold for cheap funding will not withdraw his metal loan, as his incentive is to sell spot for the proceeds. GFMS fools readers by mentioning high leasing activity, but it neglects to mention leases aren’t withdrawn from the vaults. Only a jewelry fabricator would withdraw borrowed gold because he wants to fabricate products to meet demand. For more information you can read this post on the Chinese gold lease market.
Over recent years we have observed a rising number of commercial banks participating in the gold leasing market. … It’s estimated that around 10% of the leased gold leaves the SGE’s vaults. The majority is for financing purposes and is sold at the SGE [and stays within the SGE vaults] for cash settlement.
This argument is false.
Furthermore, it’s noteworthy that GFMS writes:
From the perspective of the bank, lending physical gold is an off-balance sheet item,…
But as I’ve demonstrated in this and this post the majority of the “precious metals” on the Chinese bank balance sheets reflects back-to-back leasing. Meaning banks borrow gold in the SGE system to subsequently lend out at a higher lease rate. So neither do the Chinese bank balance sheets influence SGE withdrawals. What withdrawals largely reflect are direct purchases by individual and institutional investors at the SGE. True demand.
There is a very limited extent to which the VAT scheme can explain the difference between GFMS’ demand and SGE Withdrawals. I wrote previously that indeed there is certain amount of gold being withdrawn from SGE vaults, which, for various reasons, finds its way back to the SGE in newly cast bars – overstating SGE withdrawals as a proxy for wholesale demand. Unfortunately nobody knows exactly the volume flowing through the SGE that distorts withdraw data. But, we do know the upper and lower bound. The upper bound is the difference between SGE Withdrawals and apparent supply, the lower bound is zero.
GFMS only measures consumer demand (jewelry, retail bar and coin, and industrial demand) and not institutional demand (direct purchases at the SGE). This is not speculation this is a fact, and in China everyone can buy gold directly at the SGE so this explains the immense withdrawals. GFMS is fully aware of this but refuses to acknowledge it – because that would ruin their business model. Instead GFMS pretends that the difference between consumer demand and SGE withdrawals is all caused by gold being recycled through the central Chinese exchange. But how is this possible? If the Chinese gold market would simply be a merry-go-round fest, how come the Chinese import thousands of tonnes of gold that are not allowed to be exported? What GFMS suggests is not possible. The fact China keeps importing reveals demand. Another chart:
Theoretically the upper bound for the VAT scheme to have recycled gold through the SGE equals the difference between SGE withdrawals and apparent supply (the difference in exhibit 4 between the red and center columns). That’s the sole leeway we can debate about. As supply equals demand, demand cannot be lower than apparent supply. I should add, not unimportant, we know GFMS’ scrap supply data does not include disinvestment (institutional selling directly to refineries). So disinvestment must be included in the difference between SGE withdrawals and apparent supply as well. Have another look at exhibit 3. But, because we don’t know the amount of disinvestment, neither do we know the amount of distortion (VAT scheme and other recycling flows).
That’s why in exhibit 1 I’ve disclosed the aggregated difference between apparent supply and GFMS demand. There can be no mistake about this volume, it reflects true demand and it has mushroomed into +4,500 tonnes since 2007. GFSM can present many more arguments in future reports, but it won’t change the fact that true demand is at least equal to apparent supply.
Important for a thorough understanding of the Chinese domestic gold market – the largest physical gold market globally – is the local Value-added Tax (VAT) system.
In the Gold Survey 2016 by Thomson Reuters GFMS there is a complex illegal scheme described whereby criminals obtain VAT invoices from the Shanghai Gold Exchange (SGE) for tax evasion. According to GFMS this scheme is one of the reasons why SGE withdrawals are significantly higher than “Chinese consumer gold demand”. To be able to properly clarify this scheme I will first expand on the workings of the VAT system in China’s Gold Market in this article. The scheme has certainly existed for years, but not anywhere near the volume and frequency GFMS portrays.
The Current VAT system in China was adopted in 1994 as part of the economic reform and is often regarded as one of the most complex systems in the world. Here the discussion is simplified somewhat, not to get entangled in details that are not important. Be aware this article does not discuss income tax.
The General VAT System In China
China’s VAT is chargeable on the sale of goods, provision of processing and repair services, and the importation of goods. The standard VAT tax rate is 17 %, a couple of household necessities enjoy a preferential 13 % VAT rate. When visiting any shop or supermarket in China, you will never see any VAT disclosed separately from the unit price. In China it’s common practice to show customers VAT-inclusive prices. In addition, all the prices listed on China’s Commodity Exchanges, the Shanghai Futures Exchange, Dalian Commodity Exchange, Zhenzhou Commodity Exchange and Shanghai Gold Exchange, are VAT-inclusive prices. As a result, if you see a notepad computer priced at 3,510 CNY (onshore renmibi) in China, the VAT is 510 CNY and the VAT-exclusive price is 3,000 CNY.
The “VAT-liable entities” are responsible for collecting the VAT and hand in the money to the tax authority. The VAT-liable entities in China are divided into two categories: general VAT taxpayers and small-scale VAT taxpayers. General VAT taxpayers are large firms that have annual sales large enough and the ability to maintain an accounting system sophisticated enough to accurately calculate output VAT and input VAT. Small-scale VAT taxpayers are firms that don’t satisfy these criteria. Since small-scale VAT taxpayers are not relevant to our discussion, so the focus will be put on general VAT taxpayers.
The formula for computing the VAT payable to the tax authority for a general VAT taxpayer is:
VAT payable = output VAT – input VAT
Output VAT = current period taxable sales * applicable VAT rate
Input VAT = current period costs of eligible purchases * applicable VAT rate
Here is a small example to illustrate VAT computing. Suppose company A is a laptop wholesaler that purchases laptops from Dell, and re-sells them to local retailer B. Company A buys 100 laptops from Dell at the VAT-exclusive unit price of 3,000 CNY. The total VAT-exclusive amount for the goods is 300,000 CNY and total VAT is 51,000 CNY.
Dell then issues a VAT invoice on which the 300,000 CNY and 51,000 CNY are recorded.
From Dell’s perspective, the 51,000 CNY is Dell’s output VAT, but from company A’s perspective the 51,000 CNY is its input VAT.
After having bought the laptops from Dell, company A then re-sells them to retailer B at the VAT-exclusive unit price of 4,000 CNY. Implying, the total VAT-exclusive amount for the laptops is 400,000 CNY and the total VAT is 68,000 CNY.
Company A then issues to retailer B a VAT invoice on which the 400,000 CNY and 68,000 CNY are recorded. From company A’s perspective, the 68,000 CNY is its output VAT but from retailer B’s perspective the 68,000 CNY is its input VAT.
At the end of the month, the VAT payable by company A is 17,000 CNY, which is to be paid to the tax authority.
VAT payable by company A = output VAT – input VAT = 68,000 – 51,000 = 17, 000 CNY
Company A has to keep Dell’s VAT invoice safe and demonstrate the invoice to the tax authority. If company A couldn’t produce Dell’s invoice to the tax authority, then the 51,000 CNY wouldn’t be allowed to be deducted and company A would have to pay the tax authority 68,000 CNY.
They are four kinds of receipts and invoices in China we will discuss:
Special VAT invoice (SVI)
Customs office special receipt for the payment of import VAT
General VAT invoice
Shanghai Gold Exchange invoice (SGE invoice)
In order for input VAT to be used as a tax credit to offset the output VAT, the input VAT must be substantiated by a “special VAT invoice” (SVI) or “customs office special receipt for the payment of import VAT”. SVIs are issued when a general VAT taxpayer sells taxable goods and services. General VAT taxpayers must purchase blank SVIs from the tax bureau. In China, entities can’t produce any VAT invoice of their own – or it will be fake – but all transaction nee to be recorded through an invoice. An SVI looks like this:
A “customs office special receipt for the payment of import VAT” is used for imported goods. Suppose company A buys a computer from Australia at the price 10,000 CNY, assuming no tariffs. The exporter in Australia can never give company A a Chinese SVI, but the imported computer does enjoy VAT. Therefore company A must pay the Chinese Customs Office 1,700 CNY (10,000 CNY * 17 %). Upon receiving the money, the Chinese customs office will issue a “customs office special receipt for the payment of import VAT”. With this special receipt, company A can obtain the tax credit (input VAT) from the imported computer.
A VAT general invoice looks like this:
A general VAT invoice looks very similar to an SVI, though a general VAT invoice cannot be used in obtaining VAT credits when calculating payable VAT. In other words, if you declare to the tax authority that you have 1,000 CNY input VAT but can only produce a general VAT invoice to substantiate your declaration, the tax authority will not recognize the invoice. General VAT invoices are issued by general VAT taxpayers strictly for accounting purposes when they make sales to consumers that will not use the purchase for input VAT. Effectively, general VAT taxpayers issue SVIs for sales to other general VAT taxpayers, and general VAT invoices for sales to consumers.
The “Shanghai Gold Exchange invoice”, or SGE invoice, is designed by the Shanghai Gold Exchange under the supervision of the national tax authority. It’s a pity I can’t find an image of a SGE invoice.
VAT Policy For Gold In China
In China, gold is divided in several categories. There are gold,gold products and ore, and gold is subdivided in standard gold and non-standard. Gold is unwrought/unforged gold, like bars and ingots (HS code 7108120000 and 7108200000). Standard gold refers to gold bars or ingots having a fineness of 9999, 9995, 999 or 995, and a weight of 50g, 100g, 1kg, 3kg or 12.5kg. On the Shanghai Gold Exchange and the Shanghai Futures Exchange (SHFE) only standard gold can be traded. Non-standardgold includes any gold that doesn’t satisfy standard gold criteria, in example 200g ingots. Gold products mean semi-finished gold and finished products of gold, like coins, jewelry and ornaments.
When gold producers and gold traders (general VAT taxpayers and small scale VAT payers) sell non-standard gold off-SGE the VAT is exempt. Gold imported into the domestic market (non-standard and standard gold), for the ones that have an import license, is also VAT exempt.
If standard gold is not sold through the Shanghai Gold Exchange (or Shanghai Futures Exchange), a 17 % VAT tax rate will apply. If standard gold is sold through the Shanghai Gold Exchange (or the Shanghai Futures Exchange), then the VAT is exempt. But it’s the invoicing procedure that is quite complex. An example will follow to illustrate the whole process.
Let’s tie everything together. Suppose the following trades occur. ICBC imports 1 kg of Au99.99 (SGE 1 Kg 9999 gold ingot), which is standard gold, from Switzerland at the price of 230 CNY/gramme (around 1,033 USD/oz). ICBC then sells the gold on the SGE at the price of 234 CNY/gramme. Jewelry manufacturer Laofengxiang is on the other side of the trade. Laofengxiang then withdraws the gold, makes it into gold ornaments, and sells all of them to a retailer at the VAT-exclusive price of 300 CNY/gramme. The VAT payable and receipts and invoices of different parties are as follows:
When ICBC imports the gold, it receives a “customs office special receipt for the payment of import VAT”. On this receipt the total VAT-exclusive amount for the gold is 230,000 CNY and the VAT is 0 (ICBC’s input VAT), because imported standard gold is VAT exempt. When ICBC sells the gold at the price of 234 CNY/gramme on the SGE, it needs to issue to the SGE a general VAT invoice, on which it’s recorded 234,000 CNY for the gold and 0 VAT (ICBC’s output VAT), because selling standard gold on the SGE is also exempt from VAT. Upon issuing the general VAT invoice, ICBC will receive an SGE invoice from the exchange.
After ICBC and Laofengxiang have concluded the deal, the SGE will issue both ICBC and Laofengxiang an SGE invoice respectively. After Laofengxiang withdraws the gold from the vault, the tax authority will issue a SVI on behalf of the SGE, which the SGE distributes to Laofengxiang. On the SVI, the total VAT-exclusive amount for gold is 200,000 CNY and the amount of VAT is 34,000 CNY. The tax authority decides these two numbers using the following formula:
The total VAT-exclusive amount for gold on the SVI = SGE transaction price * quantity / (1+17%) * 100 % = 234 * 1,000 / (1+17%) * 100% = 200,000 CNY
The VAT amount for gold on the SVI = SGE transaction price * quantity / (1+17%) * 17 % = 234 * 1,000 /（1+17%）* 17 % = 34,000 CNY
To understand the reasoning behind this calculation, please note that after withdrawing the metal, this standard gold leaves a VAT exempt environment (the SGE system), for an environment that is not exempt from VAT, and hence VAT is born into existence. When Laofengxiang doesn’t withdraw the gold, the SGE invoice is the only invoice it will receive for accounting purposes – Laofengxiang needs some evidence for accounting entries. If it withdraws the gold, then it will receive an SVI because the standard gold withdrawn can be manufactured into new gold products and sold off-SGE. Therefore Laofengxiang will need to claim input VAT. General VAT taxpayers that withdraw will get a SVI, individuals that withdraw form the SGE will not. The input VAT noted on Laofengxiang’s SVI from the SGE is not an amount Laofengxiang paid to ICBC as VAT, but Laofengxiang is allowed to deduct this amount from its output VAT.
As mentioned, after concluding the purchase of 1kg 9999 gold on the SGE at the price of 234 CNY/gramme, Laofengxiang receives an SGE invoice and also an SVI after it withdraws the gold. The input VAT is 34,000 CNY, which is described above. Laofengxiang then fabricates and sells all the gold ornaments made from the 1kg of gold at the VAT-exclusive price of 300 CNY/gramme. Therefore the output VAT is 51,000 CNY.
Therefore, the VAT payable for Laofengxiang is 17,000 CNY. Since Laofengxiang has the SVI from the SGE, the tax authority will accept the 34,000 CNY input VAT as a tax credit to deduct from the output VAT.
Up till now, readers will have a general idea on how the VAT system works in China’s gold market.
Core Supply & Demand Data Chinese Gold Market Q1-Q3 2016
Chinese gold demand is still going strong this year, albeit less than in 2015. The most likely reason for somewhat lower demand has been the strength in the price of gold in the first three quarters of this year, to which the Chinese reacted by subduing purchases. From 1 January until 30 September 2016, the gold price went up 24 % in US dollars per troy ounce, from $1,061.5 to $1,318.1; measured in renminbi the price went up 28 % over the same period.
Now I have proven the gold on Chinese commercial bank balance sheets has little to do with physical gold ownership of these banks, but mainly reflects back-to back leases and swaps, we can be positive that data on withdrawals from the vaults of the Shanghai Gold Exchange (SGE) roughly equals Chinese wholesale demand. For now that is, as future developments can always alter our metrics.
Below is a chart showing withdrawals from the vaults of the SGE and the price of gold in yuan per gram. The most significant trends of recent years are still in effect; in the short term, when the gold price is falling Chinese demand increases (2013 and 2015), when the gold price is rising Chinese demand declines (2016). This trend is supported by SGE premiums that have an inverse correlation with the price of gold, when the price of gold declines, SGE premiums escalate and vice versa – I will show charts below. Furthermore, in the long term we can observe consistent growth in Chinese gold demand due to the opening up and development of the domestic market.
SGE withdrawals in the first three quarters of 2016 accounted for 1,406 tonnes – still impressive – down 29 % from 1,986 tonnes in 2015, which was a record year. Annualized SGE withdrawals are set to hit 1,877 tonnes in 2016.
Notable, “known net import” by China is relatively strong compared to SGE withdrawals in 2016. Total net import in the first three quarters of this year has aggregated to 905 tonnes – annualized 1,206 tonnes – or 64 % of SGE withdrawals, versus an import/withdrawals ratio of 53 % in 2015. As mine supply to the SGE is fairly constant, recycled gold through the SGE must be lower this year than last year. As a rule of thumb, we use the equation:
The largest net exporter to China is still Hong Kong, having transhipped 608 tonnes to the mainland from January until September 2016, up 5 % compared to 2015. The volume Hong Kong exports to the mainland has been quite constant since 2014, while in 2013 China’s special administrative region was a substantial larger supplier.
(There have been rumors that Hong Kong ’s export to China is overstated in the official data by the Hong Kong Census & Statistics Department, caused by fake exports. In the chart below you can see that the share of exports relative to re-exports from Hong Kong to China this year has increased from previous years. Potentially this signals fake exports, as it’s easier to over invoice an export than re-export, though I haven’t found hard evidence for this scheme. When I do I will report accordingly.)
The second largest exporter to China is Switzerland, having supplied a net 229 tonnes so far this year, which is 22 % more than last year. Clearly, direct shipments from Switzerland to China have replaced shipments via Hong Kong.
Direct net exports by the UK to China mainland have collapsed by 92 % this year compared to 2015, from 210 tonnes to a mere 18 tonnes. The reason being, the UK has been the largest net importer globally this year, which is related to the strength in the gold price early this year. UK net gold trade is a proxy for Western institutional supply and demand.
Australia’s direct export to China is down this year as well (in the first eight months, data for September has not yet been released). I’ve computed the data as described in my post Australia Customs Department Confirms BullionStar’s Analysis On Gold Export To China. Following this method, the land of down under has sent 50 tonnes of gold directly to China during the first eight months of this year, down 23 % from 65 tonnes in 2015.
Despite press releases suggesting Russian gold enterprises are strengthening ties with the SGE, I have identified only one shipment of 30 Kg by the Russian Federation directly to China in 2016. In 2013 the Russians directly net exported 50 Kg to China.
Data on gold export from South Africa to China is not publicly available.
Since 2014, when the Shanghai International Gold Exchange (SGEI) was erected, there is a possibility “SGE withdrawals” are inflated by withdrawals from vaults in the Shanghai Free Trade Zone; gold that is allowed to be exported abroad – the free trade zone is not part of the domestic market. But as far as I know any activity on the SGEI lacks foreign enterprises that buy gold to withdraw and export. A couple of months ago a source at a large Chinese bank told me the SGEI is mainly used by Chinese banks to import gold into Chinese domestic market. In addition, I haven’t bumped into any large importers from China. Occasionally India imports a few hundred Kg, but that’s it.
The emblematic difference between “Chinese gold demand as disclosed by GFMS” and SGE withdrawals – displayed in exhibit 7 – is due to GFMS’ incomplete metrics. For decades this consultancy firm has been denying the existence of institutional supply and demand in above ground gold, which is far more important to price formation than retail sales and mine supply, the predominant flows published by GFMS. The essence of this swindle can be read in my blog post The Great Physical Gold Supply & Demand Illusion. I also have a few more blog posts in the pipeline that discuss GFMS’ most recent gold supply and demand data.
I expect November to be a very strong month for SGE withdrawals. Mentioned in the introduction segment of this post, there is a trend in Chinese wholesale gold demand in relation to the gold price. Whenever, the gold price is climbing, Chinese demand is subdued, accompanied by low SGE premiums; when the gold price is decreasing, SGE withdrawals and premiums in China shoot up. The relationship between the gold price and SGE withdrawals can be viewed in exhibit 1. Below in exhibit 8 & 9, readers can see the relationship between “SGE end of day prices and premiums”.
Note, the gold price on the SGE and the premium have an inverse correlation.
I already mentioned that SGE withdrawals in the first nine months of 2016 have been subdued due to a rally in the gold price. However, high premiums at the SGE in November forecast elevated withdrawals for the month. Since Trump got elected on November 9, and price of gold started tumbling, SGE premiums have broken a three-year record. This signals strong demand.
In the next chart from Goldchartsrus.com we can see the premium on the SGE’s most traded physical contract Au99.99 has risen since November 9 and reached 3 % by 24 November. Levels not seen since 2013 (exhibit 8).
Although the relationship between the gold price and SGE premiums has been in place for years, Reuters reports the high premiums in November are caused by worries on import restrictions. From Reuters:
Gold premiums in top consumer China jumped to the highest in nearly three years this week on worries over a supply shortage that traders said were due to Beijing’s efforts to restrict import licenses.
“While we don’t have the exact numbers, we hear that they (Chinese government) have limited the number of importers,” said Dick Poon, general manager at Heraeus Precious Metals in Hong Kong.
To me this statement doesn’t make sense. At this moment that are 15 banks approved by the PBOC to import gold. Limiting the number of importers would cause less importers to import more gold in order to balance the domestic market (supply gold from abroad when necessary). In the Measures for the Import and Export of Gold and Gold Productsdrafted by the PBOC in March 2015 it states:
… An applicant for the import … of gold … shall have corporate status, … it is a financial institution member or a market maker on a gold exchange [SGE] approved by the State Council.
… The main market players with the qualifications for the import … of gold shall assume the liability of balancing the supply and demand of material objects on the domestic gold market. Gold to be imported … shall be registered at a spot gold exchange [SGE] approved by the State Council where the first trade shall be completed.
The Chinese government could lower imports by distributing less “import licences” to approved banks. As, every approved bank still needs to submit for a license for every gold import batch. Logically, lowering imports would be done by the PBOC through handing out less licences.
In the Netherlands we have a financial newspaper that prints on pink paper and is named “Het Financieel Dagblad”. Basically it’s the Dutch equivalent of the Financial Times. A few weeks ago I was interviewed by two of their reporters, Joost van Kuppeveld and Lenneke Arts. Today the interview was published as part of a series of interviews with gold experts, among others, with myself and Aerdt Houben, Director Financial Markets at the Dutch central bank (DNB). Perhaps not surprisingly I disagree with several statements of Houben in his interview, to which I would like to respond in a forthcoming post. For now, you can read my interview below. In case readers didn’t know my real name is Jan Nieuwenhuijs, and Koos Jansen is my Internet alias. Het Financieel Dagblad preferred to disclose my real name.
“The whole world is now in the same boat. Everywhere there are low interest rates and on all continents money is printed. Only the United States has paused printing for the moment.
There are many flaws in fiat money. You can print it without limitations, which is politically too tempting. Fiat money printing was used to save the financial system in 2008, but since then nothing has changed. Banks are not split. In a next crisis it’s going to end badly with paper money. There will be significant inflation.
Gold is a hard currency. It can’t be printed – like fiat money. It is divisible and it does not perish. It retains its purchasing power in the long term. If it’s in the center of the monetary system, it will also be more stable in terms of purchasing power in the short and medium term. That has to do with economic principles; it is a commodity. In that respect I feel safe by keeping a portion of my savings in physical gold. I am protected from economic shocks. If the euro falls gold rises, and so my purchasing power is maintained.
Something has to happen in the international monetary system. It cannot stay centred around the dollar. Since 1971 – when the dollar was detached from gold – the United States has an exorbitant privilege. Most trade in the world is settled in dollars. Therefore, there is a huge demand for dollars in the world, and the US can simply print these dollars.
In the new system gold is going play a role. Look at the developments in Europe. The Netherlands and Germany get their gold back from America. Austria and Belgium are also repatriating. Russia and China buy a lot of gold. The Chinese have too many dollars in foreign exchange reserves and are therefore at the mercy of the whims of US policy. The transition to a new system will be gradual. No one wants a new shock.
With my blog I try to fill the gap between mainstream media, who do not understand gold, and conspiracy theorists. I always try to seek the truth. Because if we get a new financial crisis, we must know the truth. The Dutch central bank shouldn’t state it holds 600 tonnes if it can’t show us the audit reports and gold bar list. That’s why I’m pushing for the audit reports and gold bars list to be publicly released, but those requests find a lot of resistance at my national bank. While you would think they can be fully transparent. What’s there to hide?”
Gold supply and demand data published by all primary consultancy firms is incomplete and misleading. The data falsely presents gold to be more of a commodity than a currency, having caused deep misconceptions with respect to the metal’s trading characteristics and price formation.
Numerous consultancy firms around the world, for example Thomson Reuters GFMS, Metals Focus, the World Gold Council and CPM Group, provide physical gold supply and demand statistics, accompanied by an analysis of these statistics in relation to the price of gold. As part of their analysis the firms present supply and demand balances that show how much gold is sold and bought globally, subdivided in several categories. It’s widely assumed these balances cover total physical supply and demand, which is incorrect as the most important category is excluded. The firms though, prefer not to share the subtle truth or their business models would be severely damaged.
The supply and demand balances by the firms portray gold to be more of a commodity than a currency, as the gist of the balances reflect how much metal is produced versus consumed – put differently, the firms mainly focus on how much gold is mined versus how much is sold in newly fabricated products. However, in reality gold is everlasting and cannot be consumed (used up), all that has ever been mined is still above ground carefully preserved in the form of bars, coins, jewelry, artifacts and industrial products. Partly because of this property the free market has chosen gold to be money thousands of years ago, and as money the majority of gold trade is conducted in above ground reserves. Indisputably, total gold supply and demand is far in excess of mine production and retail demand.
As most individual investors, fund managers, journalists, academics and precious metals analysts consider the balances by the firms to be complete, the global misconception regarding gold supply and demand is one of epic proportions. Physical gold is a profound anchor in our global financial system and thus it’s of utmost importance we understand the fine details of its trading characteristics.
Supply & Demand Metrics By The Firms
The firms can argue that the difference between what they present as supply and demand (S&D), as opposed to what I deem to be a more unadulterated approach of S&D is due to contrasting metrics. Accordingly, we’ll discuss their metrics to reveal their infirmity. In a nutshell, the firms only count the physical gold S&D flows that are easy to measure, while leaving out the most important part: institutional supply and demand.
Although the firms all have slightly different methodologies to measure S&D, from comparisons the numbers appear to be quite similar. For our further investigation we’ll spotlight the metrics and models by GFMS. The reason being, GFMS has been the only firm that was willing to share a full description of their methodology for publication – to be viewed here. Metals Focus (MF) provided a partial methodology, the World Gold Council and CPM Group declined to comment.
Let’s have a look at GFMS its S&D categories. On the supply side is included:
Mine supply (newly mined gold)
Scrap supply (gold sourced from old fabricated products)
On the demand side is include:
Jewelry demand (gold content used in newly manufactured jewelry products bought locally at retail level, adjusted by jewelry exported and imported).
Industrial demand (the volume of gold used in industrial applications, for example bonding wire, products used in semiconductors/electronics and dental alloys).
Retail bar investment (the net volume of bars that are purchased by individual investors through retail channels).
Coin investment (a combination of published data from mints and also a proprietary survey conducted by GFMS detailing where coins are sold).
The above four demand categories summed up are often referred to as “consumer demand” by the firms.
Furthermore GFMS includes:
Net hedging (change in physical market impact of mining companies’ gold loans, forwards, and options positions)
Net official sector (total central bank selling or buying)
ETF inventory build (change in ETF inventory)
Exchange inventory build (change in exchange inventory)
The last four categories can be either supply or demand. In example, when central banks (the official sector) in total are net sellers this will be listed as a negative demand figure, as is shown in the S&D balance by GFMS below from 2006 until 2009, when central banks in total are net buyers this will be listed as a positive demand figure, as is shown in the balance from 2010 until 2015. For a clear overview of the GFMS S&D balance please have a look at all line items below.
According to GFMS Supply consists of Mine production, Scrap and Net Hedging. In turn, Demand consists of Jewelry, Industrial Fabrication, Retail Investment, and Net Official Sector. After balancing Supply and Demand this results in a Physical Surplus/Deficit. Then, ETF Inventory Build and Exchange Inventory Build are added/subtracted from the Physical Surplus/Deficit to come to a Net Balance.
GFMS likes to pretend their balance is complete and occasionally articulates any surplus or deficit arising from it is positively correlated to the price of gold, which is anything but true, as I will demonstrate step by step.
The Firms Exclude Majority Gold Supply & Demand
Most important what’s excluded from the balance is what we’ll refer to as institutional supply and demand, which can be defined as trade in bullion among high net worth individuals and institutions. Usually the bullion in question comes in 400-ounce (12.5 Kg) London Good Delivery (GD) bars having a fineness of no less than 995, or smaller 1 Kg bars having a fineness of no less than 9999. In addition, bullion bars can weigh 100-ounce or 3 Kg, among other less popular sizes, generally having a fineness of no less than 995. Bullion can be traded without changing in weight or fineness, but it can be refined and/or recast for transactions as well, in example from GD bars into 1 Kg bars. In some cases institutional supply and demand involves cross-border trade, when bullion is sold in country A to a buyer in country B, in other cases the bullion changes ownership without moving across borders.
Provided are two exemplifications of institutional S&D:
An (institutional) investor orders 400 Kg of gold in its allocated account at a bullion bank in Switzerland – which would be purchased in the Swiss wholesale market most likely in GD bars. This type of S&D will not be recorded by GFMS.
A Chinese (institutional) investor buys 100 Kg of gold directly at the Shanghai Gold Exchange (SGE), the Chinese wholesale market, in 1 Kg 9999 bars and withdraws the metal from the vaults. Neither this transaction will be registered by GFMS – or any other firm.
These examples show the S&D balances by GFMS are incomplete.
For illustrational purposes, below is a chart based on all S&D numbers by GFMS from 2013, supplemented by my conservative estimate of institutional S&D. Including institutional transactions total S&D in 2013 must have reached well over 6,600 tonnes.
GFMS Covers The Tracks With Help From The LBMA
Although GFMS intermittently admits their number are incomplete (they have to), at the same time they’ve been battling for years to eclipse apparent institutional S&D for its audience.Dauntless tactics were needed when in 2013 institutional demand in China reached roughly 1,000 tonnes and over 500 tonnes in Hong Kong. Institutional demand in the East was predominantly sourced through GD bars from the London Bullion Market, which were refined into 1 Kg 9999 bars that are more popular in Asia. For the cover up GFMS went to great lengths to refute the volumes of gold withdrawn from SGE vaults, and accordingly have the London Bullion Market Association (LBMA) adjust statistics on total refined gold by its member refineries. Remarkably, the LBMA cooperated. Allow me to share my analysis in detail.
In 2013 something unusual happened in the global gold market as Chinese institutional demand exploded for the first time in history. Hundreds of tonnes of institutional supply from London in the form of GD bars were mainly shipped to Switzerland to be refined in 1 Kg 9999 bars, subsequently to be exported via Hong Kong to meet institutional demand in China. From customs data by the UK, Switzerland and Hong Kong the institutional S&D trail was clearly visible. From 2013 until 2015 there was even a strong correlation between the UK’s net gold export and SGE withdrawals. Demonstrated in the chart below.
Stunningly, since 2013 GFMS has tried to convince its readers through numerous arguments why SGE withdrawals crossed 2,000 tonnes for three years in a row, while Chinese consumer demand reached roughly half of this. Yet the arguments have failed miserably to explain the difference – they rationalize only a fraction, read this post for more information.
And GFMS did more to eclipse apparent institutional S&D. They colluded with the LBMA.
To be clear, I cannot exactly measure global institutional S&D. However, let me make an estimate of apparent institutional demand for 2013. Notable, in 2013 a flood of gold crossed the globe from West to East. Chinese institutional demand accounted for 914 tonnes and Hong Kong net imported 579 tonnes – the latter we’ll use as a proxy for additional Asian institutional demand, as Hong Kong is the predominant gold trading hub in the region.
In total apparent institutional demand in 2013 accounted for (914 + 579) 1,493 tonnes. If we add all other demand categories by GFMS shown in exhibit 1, total demand in 2013 was at least 6,619 tonnes. Be aware, this excludes non-apparent institutional demand.
Because nearly all wholesale gold demand in Hong Kong and China is for 1 Kg 9999 bars, the global refining industry was working overtime in 2013, mainly to refine institutional and ETF supply in GD bars coming from London. In December 2013 I interviewed Alex Stanczyk of the Physical Gold Fund who just before had spoken to the head of a Swiss refinery. At the time Stanczyk told me [brackets added by me]:
They put on three shifts, they’re working 24 hours a day and originally he [the head of the refinery] thought that would wind down at some point. Well, they’ve been doing it all year . Every time he thinks it’s going to slow down, he gets more orders, more orders, more orders. They have expanded the plant to where it almost doubles their capacity. 70 % of their kilobar fabrication is going to China, at apace of 10 tonnes a week. That’s from one refinery, now remember there are 4 of these big ones [refineries] in Switzerland.
As a consequence, statistics on “total refined gold production” in 2013 by “LBMA accredited gold refiners who are on the Good Delivery List”, which the four large refineries in Switzerland are part off, capture the immense flows of institutional S&D – next to annual mine output and scrap refining. On May 1, 2015, the LBMA disclosed total refined gold production by its members at 6,601 tonnes for 2013 in a document titled A guide to The London Bullion Market Association. It’s no coincidence this number is very close to my estimate on total demand (6,619 tonnes), as apparent institutional demand in Asia was all refined from GD into 1 Kg bars.
Here’s exhibit 2 from another angle.
In the table below we can see the LBMA refining statistics for 2013 at 6,601 tonnes.
After this publication GFMS was trapped; these refining statistics revealed a significant share of the institutional S&D flows they had been trying to conceal. What happened next – I assume – was that GFMS kindly asked the LBMA to adjust downward their refining statistics. First and painstakingly exposed by my colleague Ronan Manly in multiple in-depth posts, the LBMA kneeled and altered its refining statistics to keep the charade in the gold market going.
On August 5, 2015, the LBMA had edited the aforementioned document, now showing 4,600 tonnes in total refined gold production. (Click here to view the original LBMA document from the BullionStar server, and here to view the altered version from the BullionStar server.) Have a look.
In the altered version it says:
Total refined gold production by the refiners on the List was estimated to be 4,600 tonnes in 2013, owing to recycling of scrap material, above world mine production of 3,061 tonnes (source Thomson Reuters GFMS).
A few important notes:
In the altered version the LBMA mentions “an estimate” for “total refined gold production”, while it doesn’t need to make an estimate as all LBMA accredited gold refiners who are on the Good Delivery List are required to provide exact data to its parent body. The exact data was disclosed in the first version of A guide to The London Bullion Market Association, and it stated, “total refined gold production by the refiners on the List was 6,601 tonnes”.
In the altered version the LBMA states the refining statistics were sourced from Thomson Reuters GFMS, but the LBMA doesn’t need GFMS for these statistics. The fact they mention GFMS, though, suggests a coordinated cover up of institutional S&D. Not only the firms, also the LBMA publishes incomplete and misleading data.
The altered version stated refining production totaled 4,600 tonnes, which is a round number and obviously quickly made up. A few weeks after the numbers were adjusted, the LBMA adjusted the numbers again, this time into 4,579 tonnes (click here to view from the BullionStar server).Clearly, on several occasions there has been consultation with the LBMA to get the statistics in line with GFMS.
In the original document the LBMA states, “Total refined gold production by the refiners on the List was 6,601 tonnes in 2013, more than double world mine production of 3,061 tonnes”, while in the altered version they state, “Total refined gold production by the refiners on the List was estimated to be 4,600 tonnes in 2013, owing to recycling of scrap material, above world mine production of 3,061 tonnes”. Notable, GFMS prefers to have total supply focused around mine and scrap production, instead of including institutional supply.
The original refining statistics (6,601 tonnes) are still disclosed in the LBMA magazine The Alchemist (#78 on page 24), to be viewed from the LBMA server here.
And so nothing is spared in trying to uphold the illusion of the GFMS S&D balance to be complete. In another example GFMS excluded gold purchases by the central bank of China from its S&D balance. In June 2015 the People’s Bank Of China (PBOC) increased its official gold reserves by 604 tonnes, from 1,054 tonnes to 1,658 tonnes. During that quarter (Q2 2015) all other central banks worldwide were net buyers at 45 tonnes. Thus, in total the Official Sector was a net buyer at 649 tonnes. Now, let’s have a look at GFMS’ S&D balance for Q2 2015:
Net Official Sector purchases are disclosed ay 45 tonnes. GFMS decided not to include the 604 tonnes increment by the PBOC simply because it didn’t fit their balance model. A 604 tonnes increment in would have set the “net balance” at -480 tonnes. Readers would have questioned the balance from this outlier, and so GFMS decided not to include the tonnage.
According to my sources PBOC purchases were sourced from institutional supply (from abroad and not through the SGE), which is a supply category not disclosed by GFMS and therefore the tonnage was a problem. (Note, GFMS disclosed the PBOC increment in text, but not in their balance.) For more information read my post PBOC Gold Purchases: Separating Facts from Speculation.
Gold Is More A Currency Than A Commodity
The biggest flaw of the balance model by GFMS is that it depicts gold to be more of a commodity than a currency. It’s focused on mine output and gold recovered from old fabricated products on the supply side, versus retail sales of newly fabricated products on the demand side. In parlance of the firms, how much is produced (supply) versus consumed (demand). Official sector, ETF and exchange inventory changes are then added to the balance. This commodity S&D balance approach by GFMS has caused deeply rooted misconceptions about the essence of gold and its price formation.
The price of a perishable commodity is mainly determined by how much is annually produced versus how much is consumed (used up). However, gold is everlasting, it cannot be used up and its exchange value is mainly based on its monetary applications, from being a currency, or money if you will. Logically the best part of its trading is conducted in above ground reserves. From my perspective the impact of global mine supply, which increases above ground stocks by roughly 1.5 % annually, and retail sales have less to do with gold’s price formation than is widely assumed.
Back to GFMS. Have a look at the picture below that shows their S&D flows for 2015.
GFMS pretends total supply is mine production plus some scrap, which is then met by jewelry demand in addition to retail investment, industrial fabrication and official sector purchases. The way they present it is misleading. These S&D flows are incomplete; they suggest gold is traded like any other commodity. But what about institutional S&D in above ground bullion? Trades that define gold as an international currency.
Let’s do another comparison; this time between what GFMS calls Identifiable Investment demand, consisting of…
Retail bar & coin
…versus my what I deem to be a more unadulterated approach of investment demand, consisting of…
Total [global] Identifiable Investment, … posted a modest 5 % increase in 2015, to reach 990 tonnes.
That’s quite a tonnage between global Identifiable Investment by GFMS at 990 tonnes and apparent Chinese institutional demand at 1,400 tonnes. We should also take into account non-apparent institutional demand, gold that changes hands in trading hubs like Switzerland. Unfortunately we can’t always measure institutional S&D, but that doesn’t justify denying its subsistence.
Have a look at the chart below that shows the large discrepancy. In the next chapter we’ll specifically discuss the significance of investment demand in relation to the price of gold.
My point being: what many gold market participants and observers think is total supply and demand is just the tip of the iceberg.This truly is a staggering misconception created by the firms.
When observing the GFMS balance in exhibit 1 its incompleteness is self-evident. At the bottom we can see the line item “net balance”, which reflects the difference between total supply and total demand. According to GFMS, if the “net balance” is a positive figure there was a surplus in the global gold market, and if “net balance” is a negative figure the market has been in deficit. In the real world this figure is irrelevant. Gold supply and demand are by definition always equal. One cannot sell gold without a buyer, and one cannot buy gold without a seller. Furthermore the gold market is deep and liquid. So how come there is a difference between total supply and total demand in the GFMS balance? As I’ve demonstrated before, because GFMS doesn’t include institutional S&D that in reality makes up for the difference and far beyond. In all its simplicity the “net balance” item reveals their data is incomplete.
Let’s have another stab at this. How can “net balance” exist in the real world, for example in 2009? According to GFMS the gold market had a 394 tonnes surplus in 2009. But how? Were miners left with 394 tonnes they couldn’t sell? Or some supranational entity decided to soak up the surplus to balance the market? Naturally, this is not what happens. Total supply and total demand are always equal, but GFMS doesn’t record all trades.
Moreover, in my opinion the words “surplus” and “deficit” do not apply to gold. There can be no deficit in gold; there will always be supply. At the right price that is. Sometimes Keynesian economists claim there is not enough gold in the world for it to serve as the global reserve currency. Austrian economists then respond by saying that there will always be enough gold at the right price. I agree with the Austrians and their argument also validates why there can be no deficit in gold.
There is more proof the “net balance” item presented by GFMS is meaningless. Although according to GFMS the market had a 394 tonnes “surplus” in 2009 the price went up by 25 % during that year. This makes no economic sense. A surplus suggests a declining price, not the other way around. Tellingly, S&D forces presented in GFMS balances are often negatively correlated to the gold price, as was the case in 2005, 2006, 2009, 2010 and 2014 (exhibit 1). In conclusion, GFMS S&D balances are not only incomplete, the resulting “net balance” items are misleading with respect to the price. Below are a few charts that demonstrate this conclusion.
If we plot “net balance” versus the end of year price of gold we can see the correlation is often negative. Have a look below. Green “net balance” chart bars show a positive correlation to the gold price, red chart bars show a negative correlation (note, the left axis is inverted for a more clear overview between any “deficit/surplus” and the price of gold). As you can see nearly half of the “net balance” chart bars are negatively correlated to the price of gold.
Mind you, although the “net balance” item is often negatively correlated to the gold price, in the Gold Survey 2016 GFMS states on page 9:
In terms of the Net Balance, 2015 marked the third year in which the gold market remained in surplus, and therefore it is not surprising that the bear market continued.
And on page 14:
The forecast reduction in global mine output and a gradual recovery in demand will see the physical surplus narrow in 2016, providing support to the gold price and laying the foundation for better prospects.
GFMS likes to pretend any “surplus” or “deficit” arising from their balance is correlated to the price, but the facts reveal this is not true.
Let us plot the “physical surplus/deficit” line item by GFMS (exhibit 1) versus the gold price. This results in even more negative correlations.
This exercise reveals that a positive correlation between either a “surplus” or “deficit” arising from a GFMS balance and the price of gold is just a coincidence. No surprise when one is aware their S&D data is incomplete.
Remarkably, the last chart was also published in the Gold Survey 2016, but GFMS chose not to invert the left axis and doesn’t disclose what we see is a surplus or deficit. As a result the largest surpluses (2006, 2007, 2009, 2010) seem to correlate with a rising price, though in reality they did the opposite. Compare the chart below with the one above.
GFMS also publishes S&D balances for silver (a monetary metal that is comparable to gold). For silver the presented correlations by GFMS between a “surplus” or “deficit” in relation to the price are even weaker.
According to GFMS the silver market is always in deficit, but the price goes up and down. Obviously GFMS neglects to measure institutional S&D for silver.
In my opinion, when Gold Fields Mineral Services (GFMS) was erected many decades ago they made a mistake to adopt a commodity S&D balance approach.Surely with the best intentions they gather intelligence and retrieve data from the market. But we must be aware this is not the full picture. The most significant data is not disclosed by GFMS.
When it comes to what drives the price of gold GFMS and I agree it’s determined by gold’s role as a currency in the global economy. When reading the chapter PRICE AND MARKET OUTLOOK in the Gold Survey 2016, GFMS shares its insights with respect to the gold price. Factors mentioned are:
Turmoil in global stock markets
A Chinese hard landing
Geopolitical tensions in the Middle-East
Central bank stimulus (QE)
Global economic weakness
Interest rates policy by central banks
Low risk asset / safe haven demand
So if these factors drive the gold price, in what S&D category would this materialize? Would (large) investors buy and sell jewelry? Or bullion bars? I think the latter. According to my analysis the price of gold is largely determined by institutional demand, and to a lesser extent ETF and retail bar & coin demand.
Let’s do an exercise to see what physical gold S&D trends correlate to the price. The majority of supply on the GFMS balance consists of mine output and the majority of demand on the GFMS balance consists of jewelry consumption. But if we plot these volumes versus the price of gold in a chart, there is no push and pull correlation*. For example, when the gold price surged from 2002 until 2011 jewelry consumption was not rising. Neither was it outpacing mine supply. The opposite happened, to be seen in the graph below. This is because jewelry demand is price sensitive – when the price goes up jewelry demand goes down, and vice versa. Jewelry demand is not driving the price of gold.
I also added retail bar & coin demand. Interesting to see is that retail bar & coin demand is on one hand a price driver, moving up and down in sync with the gold price, on the other hand it can be price sensitive having brief spikes when the price of gold declines.
The best correlation between physical S&D in relation to the gold price can be seen in institutional and ETF S&D. One of the largest gold trading hubs in the West is the UK, home of the London Bullion Market that also vaults the largest ETF named GLD. The UK has no domestic mine production, no refineries and national gold demand is neglectable in the greater scheme of things. Therefore, by measuring the net flow of the UK (import minus export) we can get a sense of Western institutional and ETF demand and supply. For example, if the UK is a net importer – import demand being greater than export supply – that signals a net pull on above ground stocks. Approximately one third of the UK’s net flow corresponds to ETF inventory changes, the other two thirds reflect pure institutional S&D.
In the charts above we can observe a remarkable solid correlation between the UK’s net flow and the gold price. The UK is a net importer on a rising price and net exporters on declining price. The shown correlation can’t be a coincidence, though there’s no guarantee it will prevail in the future.
The two charts above show the (medium/long term) gold price is mostly determined by institutional supply and demand in above ground reserves. Effectively, GFMS is hiding the most important part of global physical gold flows.
When I asked an analyst at one of the leading firms why his company doesn’t measure institutional S&D he told me candidly, “becauseit’s extremely difficult to accurately estimate it”. And it is. As I wrote previously, I can’t exactly measure global institutional S&D either. However, very often publicly available information gives us a valuable peek at it, and it shows to be more relevant to the gold price than what the firms keep staring at. Not knowing exactly what institutional S&D accounts for doesn’t mean GFMS shouldn’t pay attention to it.
But the firms keep trying to uphold the illusion the data they’ve been selling for decades is complete. For if they would plainly confess it was incomplete, future business could be severely damaged.
What I blame these firms is that they’ve created a meme that the gold market is as large as annual mine supply. This has caused all sorts of misconceptions. Often I read analyses based on a comparison between quantitative demand and mine output. Such analyses are likely to jump erroneous conclusions.
In 2013 we’ve witnessed the inception of the Chinese gold ETF market. At first demand for the gold ETFs was neglectable, as investors mostly preferred to buy the physical gold directly at the Shanghai Gold Exchange (SGE) or buy jewelry or investment bars through retail channels. This year, however, there has been a major shift in gold ETF demand in China.
The physical holdings of Chinese gold ETFs have surged five-fold from 7 tonnes at the end of January, to 35 tonnes at end of August. The Huaán Yifu Gold ETF, which was holding 23 tonnes in August, entered the global top 15 list.
The interest in China’s nascent gold ETF market was even mentioned by the World Gold Council in a recent Gold Demand Trends report. In this post, we’ll add some texture to China’s gold ETF market; how are the gold ETFs constructed and how can they be compared to the largest Western gold ETF, the SPDR Gold Trust. At this moment the market share of Chinese gold ETFs is still small – within China as well as globally, but knowledge about the workings of these ETFs will be valuable when they acquire significant market share in the future.
Kindly note, all mechanics and examples presented in this post are simplified.
What Is A Gold ETF?
ETF is short for Exchange Traded Fund. ETFs trade like stocks and its price usually tracks an underlying asset or index. Like stocks, ETFs have a primary market and a secondary market. The secondary market is the stock exchange where most ETF investors trade. What makes ETFs special is the primary market where ETF shares are created and redeemed. Let us use the SPDR Gold Trust (symbol: GLD) to illustrate how the primary market works. Mainly through the creation and redemption process of shares, the GLD share price tracks the gold price.
The Authorised Participants (the institutions which are authorised to create and redeem GLD shares, at this moment the Authorised Participants are Barclays Capital, Inc., Credit Suisse Securities (USA) LLC, Goldman Sachs & Co., Goldman Sachs Execution & Clearing, L.P., HSBC Securities (USA) Inc., P. Morgan Securities Inc., Merrill Lynch Professional Clearing Corp., Morgan Stanley & Co. LLC, RBC Capital Markets, LLC, Scotia Capital (USA) Inc., UBS Securities LLC and Virtu Financial BD LLC).
If an Authorised Participant (AP) wants to create GLD shares, it needs to deposit gold into the account of the Trust and subsequently the Trustee will provide the AP with GLD shares. The creation application must be made in multiples of 100,000 shares (a block of 100,000 shares is called a basket). Since every GLD share represents approximately 0.1 ounce of gold, in order to create 100,000 GLD shares the AP needs to deposit 10,000 ounces of gold into the account of the Trust. (In reality, 1 GLD share actually represents a little less than 0.1 ounce of gold, the reason for this will be explained later on in this post.)
The redemption process works the other way round. If an AP wants to redeem GLD shares, it deposits 100,000 GLD shares at the Trust and subsequently the AP receives 10,000 ounces of gold.
The purpose of APs creating and redeeming GLD shares is usually arbitrage. As previously mentioned the gold equivalent of 1 GLD share is roughly 0.1 ounce, nevertheless GLD shares and actual gold are traded in two different markets. As a consequence, the price of 1 GLD share can differ from the price of 0.1 ounce of gold. If the price of GLD and the price of gold diverge, this is where arbitrage comes into play for the APs. Accordingly, the arbitrage by APs through creation and redemption of shares contributes to GLD’s price tracking the gold price.
Suppose (simplified), the price of 1 GLD share is $110 – caused by supply and demand for GLD shares at the NYSE Arca – while the price of 0.1 ounce of gold is $100 in the gold market. An AP can grasp this opportunity by buying (or first leasing) 10,000 ounces of gold to deposit in the GLD Trust account after which the Trustee will create 100,000 GLD shares for the AP. The new shares created are then sold by the AP on the stock market, which will cause the price of GLD to go down. The arbitrage opportunity will be used by APs until it’s closed.
If the price of GLD shares is lower than the price of gold, the arbitrage opportunity works the other way around, APs can buy shares, redeem them for gold at the Trustee and sell the gold.
In the aforementioned example trade when the AP (via the Trustee) created 100,000 GLD shares his investment was $10,000,000 (10,000 ounces at $100 per 0.1 ounce). The AP’s revenue was $11,000,000 (100,000 GLD shares worth $110 a piece). The AP’s profit in this exercise was $1,000,000.
($110-$100)*100,000 = $1,000,000
As readers can see from the example, the holdings of GLD were increased by 10,000 ounces of gold. Almost every day the holdings of GLD vary and the change is often caused by arbitrage of APs.
One theory is, when demand for GLD shares is strong (usually by Western investors) and the share price is trending higher than the price of the gold equivalent, the APs jump the arbitrage, create shares and GLD inventory swells. Then, if growth in GLD inventory correlates to a surging gold price (which can be observed in exhibit 3 below) we can speculate the gold bull market in part has been caused by Western investment demand in GLD.
Now we have established the workings of the largest Western gold ETF, we will have a look at how the Chinese gold ETFs are constructed, and compare them to GLD.
China’s Gold ETF Market
Below are the 4 Chinese gold ETFs currently in existence that we’ll discuss.
- Bosera Gold Exchange Open-Ended Securities Investment Fund
- Guotai Gold Exchange Open-Ended Securities Investment Fund
- Huaán Yifu Gold Exchange Open-Ended Securities Investment Fund
- Efund Gold Exchange Open-Ended Securities Investment Fund
In China every gold ETF share represents approximately 0.01 gram of gold. By creating or redeeming gold ETF shares (Chinese) APs receive or deliver a basket of 300,000 shares, which equals to 3Kg of gold. This threshold is much lower than that of GLD, of which a basket equals to 310Kg of gold. The gold acceptable for Chinese ETFs are the spot (physical and spot deferred) gold contracts listed on theSGE – for example Au99.99. Therefore, all the physical holdings of China’s gold ETFs are stored within SGE designated vaults.
Moreover, there is a range of features that make China’s gold ETFs quite different from GLD.
1. Chinese Gold ETF Shares Can Also Be Created Or Redeemed Through Cash
Unlike GLD, which only allows the use of gold to create shares, and only allows the use of shares to redeem gold, China’s gold ETFs also allow shares to be created and redeemed through cash in the primary market. An AP can present cash to the Fund Manager who handles the creation and redemption process for a Chinese gold ETF. The Fund Manager is comparable to the Trustee of GLD. Thereby, through an AP individual investors can create or redeem gold ETF shares with cash as well.
Suppose, a Chinese investor wants to arbitrage the difference between the price of a gold ETF and the price of gold. In this example the price of the gold ETF is higher than the price of gold, so the investor want use cash to create shares to sell on the stock market. The investor can present cash to an AP who in turn will create shares via the Fund Manager. The amount of cash used in this transaction to create shares is equal to the cash value of the spot gold contracts that are needed to create the shares without the use of cash.
Vice versa, in case an investor wants to arbitrage the price of a gold ETF when it’s lower than the price of gold, the investor can present shares to an AP to redeem for cash.
In China the APs can be securities firms and commercial banks. The securities firms are often not SGE members. Therefor, the number of APs that support gold ETF shares creation and redemption through cash is often larger than the number of those that support shares creation and redemption through spot gold contracts. For example, in the case of Efund Gold ETF, the fund has authorised 13 securities firms (APs) to process creation and redemption through cash, but only 2 banks (APs) to process creation and redemption through spot gold contracts (Industrial and Commercial Bank of China and Bank of Communications).
2. The Flexibility Of The Fund Manager
The Trustee of GLD doesn’t have much flexibility in managing the assets. Its duty is mainly processing the creation and redemption orders of GLD shares. Therefore, the gold holdings of GLD are mainly allocated gold and according to the prospectus [brackets added by me]:
Gold held in the Trust [GLD]’s allocated account is the property of the Trust and is not traded, leased or loaned under any circumstances.
In China, the Fund Managers of the gold ETFs have more flexibility. The gold contracts that China’s gold ETFs hold include not only spot physical contracts like Au99.99 and Au99.95, but can also be spot deferred contracts like Au (T+D), and notable all these “spot contracts” may be leased (sometimes swapped) within the SGE system. Additionally, every Chinese gold ETF can invest 10% of its fund assets (5 % of net fund assets in case of Efund Gold ETF) in “other financial instruments” allowed by the China Securities Regulatory Commission (CSRC).
For example, the excerpt below is from the Efund Gold ETF’s prospectus [brackets added by me]:
The investment scope of the Fund [Efund Gold ETF] is liquid financial instruments, including gold physical contracts (including spot physical contracts, spot deferred contracts, etc), bonds, asset-backed securities, bond repos, bank deposits, money market instruments, and other financial instruments which laws, regulations or the CSRC allow the Fund to invest in the future (but these have to satisfy the relevant rules of the CSRC).
If laws, regulations or regulatory institutions allow the Fund to invest in other instruments (including but not restricted to gold derivatives like forwards, futures, options and swaps), after necessary procedures, the Fund Manager will include them into the investment scope.
The portfolio percentage: The fund asset invested in gold spot contracts is not lower than 95% of the net asset value of the Fund.
All the 4 gold ETFs in China can participate in gold leasing. Some can participate in gold swaps and some can pledge the gold to borrow money.
The excerpt below is from the Huaán Yifu Gold ETF Prospectus:
The Fund can do gold lease and pledge gold to borrow money.
Effectively the Fund Manager of the Huaán Yifu Gold ETF can make money by, for example, leasing the fund’s assets.
The excerpt below is From the Guotai Gold ETF Prospectus:
The Fund can do gold lease, gold swap and invest in gold spot deferred contracts, etc, in order to lower the operating expenses and lower tracking error. The Fund does margin trade only for the purpose of risk management and enhancement of the efficiency of the asset allocation.
As a result, the Fund Managers of Chinese gold ETFs have significant flexibility in handling the fund assets. Please remember that all gold leasing, swapping, etc. has to be done within the SGE system and the gold cannot leave the SGE designated vaults.
Article 4. Gold ETFs may not deposit physical gold into the [SGE] vault or withdraw physical gold from the [SGE] vault. Margin trade is only for the purpose of risk management and enhancement of the efficiency of the asset allocation.
3. NAV Per Share Recalculation
Since the inception of GLD in 2004 its share gold equivalent is steadily declining lower than 0.1 ounce of gold. That’s because the Sponsor, Trustee and Custodian don’t provide services for free. They need to earn money and their earnings must come from the Net Asset Value (NAV) of the ETF. In other words, the gold in the Trust is gradually sold to pay for operational expenses. From the GLD prospectus:
The amount of gold represented by the Shares will continue to be reduced during the life of the Trust due to the sales of gold necessary to pay the Trust’s expenses irrespective of whether the trading price of the Shares rises or falls in response to changes in the price of gold.
Each outstanding Share represents a fractional, undivided interest in the gold held by the Trust. The Trust does not generate any income and regularly sells gold to pay for its ongoing expenses. Therefore, the amount of gold represented by each Share has gradually declined over time. This is also true with respect to Shares that are issued in exchange for additional deposits of gold into the Trust, as the amount of gold required to create Shares proportionately reflects the amount of gold represented by the Shares outstanding at the time of creation. Assuming a constant gold price, the trading price of the Shares is expected to gradually decline relative to the price of gold as the amount of gold represented by the Shares gradually declines.
On November 18, 2004, 1 GLD share exactly equaled 0.1 ounces of gold, but by now (September 2016) 1 GLD share equals 0.09542 ounces of gold, a decline of almost 5 % over the course of 12 years. This explains why currently the amount of ounces needed by an AP to create a basket of shares has become less than 10,000 ounces, and continues to decline.
In China’s gold ETF market, although the gold represented by the ETF instruments also decline as with GLD, the share values are periodically re-adjusted to ensure the NAV per share remains (roughly) 0.01 gram of gold.
For example, from the Bosera Gold ETF prospectus:
Fund share re-calculation means the fund manager based on the necessity of the operation of the fund, under the premise that the total NAV is unchanged, adjusts the total fund shares outstanding and NAV per share.
There is nothing complicated about the re-calculation. There are simply periodic adjustments when the Fund Manager sets the value of the shares (in yuan) higher because the gold content equivalent is elevated, from below 0.01 gram to 0.01 gram, whereby the Fund Manger “adjusts the total fund shares outstanding” downward.
4. Linked Funds
In China, every gold ETF is accompanied by a Linked Fund. The Linked Fund mainly invests in the Target Gold ETF as can be seen in the list below. The Linked Fund is usually a common open-ended mutual fund. While 90 % of the assets under management of the Linked Fund must be invested in its Target Gold ETF, the Fund Manager still has some room for managing the remaining 10%.
For example, from the Bosera Gold ETF-linked Fund’s prospectus:
The Fund mainly invests in Bosera Gold Exchange Open-Ended Securities Investment Fund, gold contracts listed on the Shanghai Gold Exchange, gold futures contracts listed on the Shanghai Futures Exchange, bonds and other financial instruments which the CSRC allows the fund to invest, like securities lending and borrowing, gold lease, etc.
For more clarity I’ve drawn a graph to illustrate the ratios of investment allocation by the Guotai Gold ETF and the Guotai Gold ETF-linked Fund.
Although, at this stage it’s not completely clear to me what would be the benefit for investors to invest in the Linked Fund, as opposed to the Target Gold ETF.
5. Voting Rights
GLD holders only have limited voting rights. The excerpt below is from the GLD prospectus,
Under the Trust Indenture, Shareholders have no voting rights, except in the following limited circumstances: (i) shareholders holding at least 66.66% of the Shares outstanding may vote to remove the Trustee; (ii) the Trustee may terminate the Trust upon the agreement of Shareholders owning at least 66.66% of the outstanding Shares; and (iii) certain amendments to the Trust Indenture require 51% or unanimous consent of the Shareholders.
In China’s gold ETFs shareholders have more voting rights and can vote to decide on a lot of important issues. The excerpt below is from the prospectus of Bosera Gold ETF:
In one of the following circumstances, based on the consent of the fund manager, the fund custodian or the fund shareholders who hold 10% (including 10%) of the fund shares outstanding, it is mandatory to hold fund shareholders’ meeting:
1. Termination of the fund contract;
2. Change of the operation of the fund;
3. Increase of the remuneration of the fund manager or the fund custodian, but excluding the circumstances in which the increase of the remuneration is mandatory by the requirements of laws or regulations;
4. Replacement of the fund manager or fund custodian;
5. Amendment of the fund category;
6. Amendment of the fund investment target, scope or strategy (excluding the circumstances in which laws, regulations or the CSRC have other relevant requirements);
7. Amendment of fund share holders’ meeting proceedings, voting methods and voting procedures;
8. Termination of listing but excluding circumstances in which the fund no longer satisfies listing requirements and the listing is terminated by the Shenzhen Stock Exchange;
9. Merger of the fund with other fund(s);
10. Other items that have material influence on the rights and responsibilities of the parties to the fund contract and necessitate the fund share holders’ meeting to amend the fund contract;
11. Other items that are required by laws, regulations, the fund contract or the requirements of the CSRC to hold the fund share holders’ meeting.
Even the Linked Fund shareholders of China’s Gold ETFs can participate in voting:
The fund shareholders of the linked fund of this fund can attend or send representatives to attend the fund shareholders’ meeting and participate in voting, based on the share holding of the linked fund. The equivalent number of fund shares with voting rights and correspondent votes are: the product of the total shares of this fund held by the linked fund multiplied by the linked fund shares held by the respective link fund share holder as a percentage of the total linked fund shares outstanding. The result of the calculation is rounded to the nearest whole number.
Ironically, to me there seems to be more democracy and openness in China’s gold ETFs than in GLD. On the other hand, Chinese gold ETFs have a fundamentally different foundation, a hybrid design I would say.
China’s gold ETF market was erected in 2013 and is still evolving. In the future, there may be more complex gold ETF related financial structures that have a big impact on China’s overall gold market. I shall follow it closely.
There has been much conjecture since 2014 about the increasing numbers in the “precious metals” category on the balance sheets of Chinese commercial banks. By the end of 2015 China’s largest banks were holding RMB 598 billion in precious metals.
Some analysts think that the precious metals on Chinese commercial bank balance sheets are gold reserves purchased on behalf of the Chinese central bank, while others surmise that Chinese banks buy gold at the Shanghai Gold Exchange (SGE) and then lend it out so the precious metals on the balance sheets solely represent leased gold. In the latter analysis it’s then assumed the leasing inflates the amount of gold withdrawn from SGE designated vaults. Most certainly there is leased gold on Chinese banks’ balance sheets, but this can hardly influence SGE withdrawals, as I have previously explained. Read this and this article for more information.
What do we know beyond the gossip about the precious metals holdings on Chinese commercial bank balance sheets?
From studying the annual reports of the respective banks and additional documentation we know the precious metals can be at least the following things:
Gold savings that belong to the banks’ customers
Gold inventory for the banks’ retail gold business
Gold leasing business
Gold held for hedging purposes
Gold held outside China
Since the Chinese silver market was liberalized much earlier than gold I don’t think there is any edge for Chinese commercial banks to have a predominant role in the silver market. So, probably most of the precious metals on the balance sheets in question are gold related.
Below is an overview of the precious metals holdings of listed Chinese commercial banks as of 31 December 2015, measured in yuan (RMB). There are 16 listed Chinese commercial banks on China’s A-share market but Huaxia Bank didn’t disclose its precious metals holding in its annual report. If all aggregated precious metals holdings relate to gold, the upper bound is approximately 2,682 tonnes of gold.
A substantial amount of the precious metals reflect (fully backed) customers’ gold deposits in the form of Gold Accumulation Plans (GAP), recorded as an asset and a liability on the balance sheets of the banks. However, to me it’s unknown how much gold is exactly accumulated in China through GAPs.
Let’s go through the annual reports of the Chinese banks having the largest precious metals holdings, seeking for information with respect to GAPs.
Precious metals comprise gold, silver and other precious metals. The Group retains all risks and rewards of ownership related to precious metals deposited with the Group as precious metals deposits, … and it records the precious metals received as an asset.A liability to return the amount of precious metals deposited is also recognized.
From the BOC website its GAP seems to be in its infancy, so I don’t expect it to comprise much gold. ICBC on the other hand, introduced a GAP in 2010 and is thought to be largest in China.
Seizing the opportunities arising from customers’ wealth increase and capital market growth, the Bank made efforts to establish a mega asset management business system across the whole value chain and enhance its specialized operating capabilities on the strength of the Group’s asset management, custody, pension and precious metal businesses, …
The [ICBC] Group records the precious metals received as an asset. A liability to return the amount of precious metals deposited is also recognized. …
While consolidating our traditionally advantageous businesses in housing finance and cost advisory service among other things, we actively expanded our presence in … precious metals.
The Bank supported product innovation, provided and optimized new products such as … gold purchase and saving.
The Bank proactively responded to changes in the precious metals market via pursuing marketing expansion, enlarging customer base and enforcing product innovation. The Bank launched innovative products and business models, including gold accumulation plan ….
To me it’s unknown how much gold CCB’s GAP comprises.
All in all, part of the precious metals on the listed Chinese commercial banks’ balance sheets are gold savings held on behalf of clients instead of reflecting the banks own metals.
Gold saved in Chinese GAPs are partly stored in SGE designated vaults.
2. Bank Gold Inventory
Chinese banks offer a wide range of retail gold investment products for sale at local branches and through internet order. Naturally, any gold inventory for this business is recorded on the balance sheets. From ICBC’s 2015 annual report:
To echo the changes in market demands, the Bank developed a variety of new brands on assorted themes and introduced a slew of products, e.g. Chinese Zodiac Coins and Panda Gold and Silver Coins, under agent sales. The Bank expanded the online channels, through which the flagship store “ICBC Gold Manager” witnessed substantial growth of sales, and it also piloted the direct distribution of logistics suiting to the characteristics of e-commerce.
According to the World Gold Council roughly 60 % of Chinese retail gold investment demand is supplied through commercial banks. Consequently, Chinese banks’ own gold inventory for retail business can not be neglectable.
Additionally, according to my analysis the gold inventory in the vaults of the SGE does not appear on the Chinese bank balance sheets.
3. Gold Leasing
Probably the largest share of the precious metals on the balance sheets have to do with gold leasing. At the moment, there are no standard accounting rules or guidelines related to how to record bank’s gold leasing activities. (In this post, I don’t distinguish between gold leasing and gold lending because the essence is the same.) However, most banks seem to still put gold leasing activity in the precious metals category of their balance sheet.
Precious metals that are not related to the Group’s trading activities including coins and medallions sales are initially measured at acquisition cost and subsequently measured at the lower of cost and net realizable value. Precious metals that are related to the Group’s trading activities including precious metals lease and [precious metals] interbank lending are initially and subsequently recognized at fair value, with changes in fair value arising from re-measurement recognized directly in profit or loss in the period in which they arise.
Apparently, the Bank Of Communications has its gold leasing business disclosed on its balance sheet in the precious metals category.
Below is from the 2015 annual report of Shanghai Pudong Development Bank (page 17):
Shanghai Pudong Development Bank saw its precious metals holdings grow from RMB 11,707,000,000 on December 31, 2014, to RMB 28,724,000,000 on December 31, 2015. As the main cause for the growth in precious metals is considered to be “increased physical gold leases”, we must conclude in the case of Shanghai Pudong Development Bank nearly all precious metals on its balance sheet relate to gold leasing. But does this mean Chinese banks buy gold on the SGE and then lease it out? Not necessarily.
Chinese banks mainly do back-to-back gold leasing – simply connecting supply and demand. Banks don’t have much money of their own. They need to borrow money or gold either from savers or in the interbank market to make loans. Would it make sense for banks to borrow money in order to buy gold to subsequently lend out gold? Or would it be more logic for banks to borrow gold to subsequently lend out gold?
ICBC operates in the lease market as an intermediary by connecting supply (lessors) and demand (lessees), while striking a fee. ICBC can borrow gold from international banks or local gold owners with an SGE Bullion Account, and lend the gold to miners, jewelers or speculators. My assumption is that the international gold lease rate is lower than the Chinese gold lease rate, which attracts gold from the international market into the Chinese domestic gold market. (Whenever a gold loan is to be repaid from the Chinese domestic gold market to an international lender, not the physical metal is exported, but funds cross the Chinese border, as physical gold export is prohibited from the Chinese domestic gold market.)
Also note, if banks would buy the gold to lend out, they are exposed to the price risk of gold. In order to cover this risk, banks need to hedge but this will involve additional costs. As a result, the logical solution is for banks to do back-to-back gold leasing.
The Bank of Beijing is a good example to illustrate back-to-back gold lending. Unlike other Chinese banks, the Bank of Beijing does not put gold leasing in the precious metals category. It has a separate line in its books for gold leasing.
According to the 2015 annual report of the Bank of Beijing (page 123 and 132):
As readers can see from the excerpts above, the Bank of Beijing indeed does back-to-back gold leasing as precious metals “leased in” (RMB 1,400,000,000) are equal to precious metals “leased out”(RMB 1,400,000,000). I suspect most gold leasing by Chinese banks is back-to back leasing.
Because the Bank of Beijing has its leasing business noted in a separated line than its “precious metals”, we can see a huge discrepancy between the Bank of Beijing’s precious metals holdings in exhibit 1 (RMB 55,000,000) and its back-to back leasing business in exhibit 3 (RMB 1,400,000,000).
Other banks don’t have a separate line for the gold leased out but as mentioned before, they put it in the precious metals category. A widely-accepted method to treat borrowed gold is to include a liability called “financial liability at fair value through profit and loss”. Readers who can understand Chinese are recommended to click this and this link. The ICBC annual report provides an example of how the liability is recorded.
In conclusion, back-to-back gold leasing will result in an asset and a liability on the banks’ balance sheets, for most banks highly “overstating“ the precious metals category. When looking at exhibit 4 we can see the enormous growth in yearly Chinese gold leasing turnover, which must have enlarged Chinese banks’ balance sheets.
According to my analysis a large portion of the precious metals on the balance sheets of Chinese banks is back-to-back leasing, which is nearly all gold that stays inside the SGE vaults, and thus does not impact SGE withdrawals.
China’s commercial banks offer derivatives to retail and institutional customers. Bank of China’s Qi Jin Bao is an example. Qi Jin Bao is in fact gold option business. The retail customer pays a certain amount of money (option premium) and buys a gold call option or put option.
For example (simplified): suppose the current gold price is $1300/oz and a retail customer is bullish on gold and believes that the gold price will rise in 3 months time. Therefore, the retail customer buys a 3 months call option with a notional amount of 100 oz of gold at the strike price of $1300/oz from Bank of China and pays an option premium of $35/oz. If the gold price indeed goes up in 3 month’s time, the retail customer will make money. However, derivatives are a zero-sum game. If the retail customer makes money, then the Bank of China definitely loses money. If the gold price goes up to $2000/oz, Bank of China will lose big time. In order to mitigate this risk, Bank of China will (borrow money to) buy gold to hedge the short call position and the gold purchased will appear on the balance sheet.
5. Gold Held Outside China
Gold on the balance sheets of Chinese commercial banks doesn’t necessarily have to be gold held in China. Chinese banks like ICBC, BOC and Bank of Communications have direct access to the LBMA. As a result, gold on the balance sheets of Chinese commercial banks can be located outside China mainland.
On January 29, 2014, ICBC bought 60 % of the existing shares in Standard Bank Plc from Standard Bank London Holdings Limited. After completion of the acquisition, Standard Bank Plc was renamed as ICBC Standard Bank on 27 March 2015. In the 2015 annual report of ICBC (Group), which includes ICBC Standard Bank data, we see that ICBC Standard Bank held RMB 18,426,000,000 in precious metals assets (equivalent to 83 tonnes of gold) on December 31, 2015.
From the descriptions above, the precious metals holdings on the balance sheets of Chinese commercial banks are quite complicated to decipher. One thing is for sure, it’s not all gold owned by banks and leased out, neither is it all purchased by banks on behalf of the Chinese central bank.
In order for us to learn more exactly what the precious metals on the balance sheets represent we need more information, more investigation is needed by gold analysts. Hopefully this blogpost can serve as a springboard to a better collective understanding.
… As a major precious metal market maker in the PRC, the Bank provided customers with precious metal trading, investment and hedging services through … trading of precious metal derivatives … and trading … the Shanghai Futures Exchange and the London precious metals market.
So, through ABC clients can trade paper gold, but these derivatives would be recorded off-balance sheet, or in a separate line next to “precious metals”. More from the ABC annual report 2014:
Our off-balance sheet items primarily include derivative financial instruments, contingent liabilities and commitments. We enter into currency rate, interest rate and precious metals related derivative financial instruments for the purposes of trading, asset and liability management and business on behalf of customer.
Off-balance sheet items include derivative financial instruments, …. The Group entered into various derivative financial instruments relating to … precious metals and other commodities for trading, hedging, asset and liability management and on behalf of customers.
Implying, from my judgement, all the precious metals on-balance sheet are not (customers’) paper gold.
Debunking the Thomson Reuters GFMS Gold Survey 2016 report. New information provides a more detailed perspective on the Chinese domestic gold market.
In the Gold Survey 2016 report by GFMS that covers the global gold market for calendar year 2015 Chinese gold consumption was assessed at 867 tonnes. As Chinese wholesale demand, measured by withdrawals from Shanghai Gold Exchange designated vaults, accounted for 2,596 tonnes in 2015 the difference reached an extraordinary peak for the year. In an attempt to explain the 1,729 tonne gap GFMS presents three brand new (misleading) arguments in the Gold Survey 2016 and reused one old argument, while it abandoned five arguments previously put forward in Gold Survey reports and by GFMS employees at forums. Very few of all these arguments have ever proven to be valid, illustrated by the fact that GFMS perpetually keeps making up new ones, and thus gold investors around the world continue to be fooled about Chinese gold demand. For some reason GFMS is restrained in disclosing that any individual or institution in China can directly buy and withdraw gold at the Shanghai Gold Exchange, which is the most significant reason for the discrepancy in question.
According to my estimates true Chinese gold demand in 2015 must have been north of 2,250 tonnes.
The reason I keep writing about this subject (the discrepancy in question) is that it eventually will enable me to show that global physical gold supply and demand as presented by GFMS is just the tip of the iceberg. And, as stated in my previous post true physical supply and demand is far more relevant to the gold price than the numbers by GFMS.
New Information has enabled me to shine a fresh light on the Chinese domestic gold market, so we’ll zoom in once again to get the best assessment of the mechanics of this market. This post is part two of an overview of the Chinese gold market for 2015. In the first part we focused on the (paper) volumes traded on the Shanghai Gold Exchange (SGE) and Shanghai International Gold Exchange (SGEI). In this post we’ll focus on the size and mechanics of the Chinese physical gold market, while at the same time addressing the fallacious information in the Gold Survey 2016 (GS2016).
The Gold Surplus In China According to GFMS
First, let’s have a look at an overview of the key supply and demand data points for 2013, 2014 and 2015, as disclosed in Gold Survey reports by GFMS.
Without GFMS mentioning the volume of SGE withdrawals for 2015 (2,596 tonnes) in the GS2016 they disclose apparent supply in the Chinese domestic gold market at 2,293 tonnes. Mine output accounted for 458 tonnes (page 22), scrap supply for 225 tonnes (page 36) and net import was 1,610 tonnes (page 54). The latter is incorrect because GFMS has double counted 63 tonnes Australia exported to China, as demonstrated in my post Australia Customs Department Confirms BullionStar’s Analysis On Gold Export To China, but the let’s not nitpick.
On other pages in the GS2016 we read total (consumer) demand for 2015 was 867 tonnes (page 52), consisting of retail bar demand at 199 tonnes (page 52) and gold fabrication at 668 tonnes (page 41).According to their own data there was a surplus of 1,426 tonnes (2,293 – 867) in the Chinese gold market. Whilst, in 2013 the surplus accounted for 826 tonnes and in 2014 for 917 tonnes, according to data disclosed in previous Gold Survey reports. Meaning, in the past three years GFMS has observed 3,169 tonnes (826 + 917 + 1,426) that were supplied to China not to meet demand, but for reasons that are constantly changing- wait till we get to the plea.
Remarkably, in the GS2016 report GFMS writes:
Hong Kong remained the primary conduit of Chinese gold imports, though its share has been contracting since 2013 … Gold import from this conduit was traditionally regarded as a simple proxy to estimate Chinese consumption … The declining dominance of Hong Kong and the increasing proportion directly routed into Beijing and Shanghai therefore points to the necessity of changes on methodology to calculate Chinese gold demand.
GFMS states that when all Chinese imports came in through Hong Kong this inflow was “regarded as a simple proxy to estimate Chinese consumption”, but now gold is also being imported directly from countries like Australia, the UK and Switzerland, such inflow “points to the necessity of changes on methodology to calculate Chinese gold demand”. How can it be that a couple of years ago Chinese gold import from Hong Kong reflected demand, but a few years later direct massive additional import from the UK and Australia does not reflect demand?
As you probably know (otherwise you can read it here) most of the gold supply in China flows through the SGE. Consequently wholesale demand can be measured by the amount of gold withdrawn from SGE designated vaults. Comparable to the difference between apparent supply and consumer demand shown in exhibit 1, is the difference between SGE withdrawals and consumer demand – the latter being even wider.
In the GS2016 GFMS has written a chapter fully dedicated to the humongous difference between SGE withdrawals and their assessment of demand. The chapter is titled “A Review And Explanation Of How China’s SGE’s Withdraw Numbers Are Impacted By Other Trading Activities”. In this post we’ll only briefly discuss whether the arguments are valid, as one of them has to do with China’s highly complex VAT system and I like to expand on this subject in detail in a separated post. However, we’ll expose more of the mechanics of the Chinese domestic gold market in this post, which conveniently demonstrates why nearly all the arguments by GFMS that will be discussed later on are bogus.
This might surprise you, but I actually had fruitful correspondence in the past months with a Senior Precious Metals Analyst at GFMS and a Senior Analyst at Metals Focus (MF). Both gentlemen have been very helpful in sharing their methodology for computing (Chinese) physical supply and demand data.I have to say both of them have answered all my questions. This service is seldom provided by the the World Gold Council, the Bank Of England or the London Bullion Market Association. Based on the information shared by GFMS and MF I’ve refined my view on our on-going disagreement with respect to the Chinese gold demand.
The Mechanics Of The Chinese Domestic Gold Market And Estimating True Chinese gold demand.
Let us refresh our memory regarding the structure of this market. In the Chinese domestic gold market nearly all physical gold supply and demand flows through the SGE because all bullion import1 into the domestic market is required to be sold first through the SGE and there are rules and tax incentives that funnel nearly all domestic mine output and scrap supply through the central bourse. As gold in the Chinese domestic market is not allowed to be exported1,the amount of gold withdrawn from SGE designated vaults therefore serves as a decent indicator for wholesale demand.
However, there are a few possibilities through which SGE withdrawals can be distorted for measuring demand.
If metal is in some manner recycled2 through the central bourse. When gold is bought and withdrawn from the SGE vaults and promptly sold and deposited into SGE vaults (for example though process scrap), these flows would inflate SGE withdrawals while not having a net effect on the price of gold, hence the related supply and demand volumes would be deceiving. Although article 23 from the Detailed Rules for Physical Delivery Of the Shanghai Gold Exchange states that bars withdrawn from SGE designated vaults are not allowed to re-enter these vaults, this rule does not fully prevent gold from being recycled through the exchange. If bars withdrawn are re-melted and assayed by an SGE approved refinery they are allowed back into the vaults. And thus, some recycled gold can inflate SGE withdrawals as a measure for true demand.
For ease of reference we’ll label the amount of gold recycled through the SGE that has no net effect on the price, and gold withdrawn from SGEI vaults that is not imported into the Chinese domestic market as distortion2.
Therefor, in order for us to make the best estimate of true Chinese gold demand we should subtract the amount of distortion from SGE withdrawals. The crux of true Chinese gold demand is establishing the amount of distortion, that’s it.
Previously I assumed the scrap numbers by GFMS mainly reflected gold that was making it’s way back to the SGE and these flows included disinvestment. Both assumptions appeared to be false.
Scrap numbers from GFMS and MF, although they’re certainly not equal, are collected from refiners that are not all SGE members. Implying not all refineries scrap is making its way to the SGE, but is sold through other channels.
Scrap numbers from GFMS and MF include jewelry and industrial products sold back from consumers, they do not include disinvestment that flows directly through refineries to the SGE. GFMS does measure disinvestment at retail level, for example, when people sell bars back to banks these will get netted out to compute net retail bar demand. But if an affluent investor or institution wants to sell (disinvest) 500 Kg they’re likely to approach a refinery directly.
In my nomenclature “distortion2” is the part that inflates SGE withdrawals as a measure for demand, “scrap” is supply from sold fabricated products like old jewelry, and “disinvestment” is supply coming from investment bars sold directly to refineries making its way to the SGE.
As a consequence, these new insights regarding scrap and disinvestment supply have changed my perspective on the Chinese supply and demand balance.
To reach a more clear understanding of what was just described, I’ve conceived an exemplar graph to visually interpret the Chinese physical gold supply and demand balance. Have a look.
As you can see in the graph above total supply and total demand are exactly equal, this is because one cannot sell gold without a buyer or buy gold without a seller. Consequently we can gauge demand by measuring supply. Please note, in the supply and demand balance shown above, and in our further investigation, two elements are left out. On the supply side I left out stock carry over in SGE vaults from previous years, as this information is not publicly available. On the demand side I left out gold bought at the SGE that was not withdrawn from the vaults, as this information is also unknown.
In all its simplicity the example chart shows that the difference between consumer demand and true Chinese gold demand is caused by direct purchases from individual and institutional clients at the SGE. While GFMS merely counts demand at retail level, by jewelry and bar sales at shops and banks, the real action is at wholesale level, at the SGE.
GFMS fully neglects direct purchases at the SGE (demand) and any corresponding disinvestment to the SGE (supply). Hence our disagreement.
Yijintong is the first professional mobile terminal of state-level gold market jointly researched and developed by the Gold Exchange and all its members …
Yijintong has comprehensive functions and advanced systems, which are compatible with various Android and iOS operating systems. Right now, it possesses market, transaction, search and information functions, so investors can conduct transactions via mobile phones … In early 2016, Yijintong will support mobile phone online account opening. After that, new users will be able to establish Shanghai Gold Exchange’s “Gold Account” business on their mobile phones directly, and avoid the step of visiting stores. It has brought convenience for personal investors to participate in gold and silver transactions.
Investors can log into Yijintong through mobile phones to conduct daily and nightly market transactions and search, utilizing all-day mobile phone services for gold and silver transactions, allowing Yijintong to become a mobile phone gold and silver investment edge tool that integrates functions and practicability, which also helps investors to do well in both work and financial management.
Exhibit 8. Download methods: iOS and Android mobile phone users can scan the QR code and open it in the browser to download and install directly.
The China Gold Association (CGA) makes yearly estimates of direct purchases at the SGE. In their Gold Yearbook 2013 direct purchases (net investment) were assessed at 1,022 tonnes, computed as SGE withdrawals minus consumer demand. The CGA neglects any distortion flowing through the SGE hence I stopped using their methodology. Have a look at the screenshot below.
Unfortunately me personally can’t exactly compute true Chinese gold demand, as I don’t have business relationships with all Chinese refineries to gauge disinvestment supply flowing to the SGE. In any case, these are the formulas:
True Chinese demand = net import into the Chinese domestic market1 + scrap + disinvestment + domestic mine output
Although a tad complex, the exact formula including SGE withdrawals is:
SGE withdrawals = net import into the Chinese domestic market1 + (domestic mine output – domestic mine output that not flows to the SGE) + (scrap – scrap that not flows to the SGE) + disinvestment + distortion + (an amount equal to “domestic mine output that not flows to the SGE + scrap that not flows to the SGE” being disinvestment or distortion)
Although not all scrap as disclosed by GFMS ends up at the SGE, it’s definitely all genuine supply and therefore useful in the first formula above. Same goes for domestic mine output.
The part of scrap and domestic mine output that doesn’t travel to the SGE (although being genuine supply) must be replaced by either disinvestment or distortion at the SGE (exhibit 4). Note, in the knowledge direct purchases from the SGE are immense in China (exhibit 9) we can safely assume that disinvestment flows to the SGE are sizable as well.
My new insights unfortunately do not imply that we can make a more precise estimate of true Chinese gold demand. However, I think the best approach is to set the lower bound of true Chinese gold demand at net import1 + mine output + scrap. While I think true demand is likely higher because disinvestment to the SGE can be significant.
Sadly because disinvestment is unknown, distortion is also unknown (exhibit 4)
Let’s return to our discussion with GFMS. The big question is of course, how can total Chinese gold demand by GFMS be 867 tonnes, in a market where mining output accounted for 450 tonnes (source), net imports by my calculations accounted for 1,575 tonnes1, and there is also scrap and disinvestment supply, but export is prohibited and the premium on gold in China was positive throughout the whole year?! This cannot be.
I would like to show a real life example to illustrate what’s going on the Chinese gold market: In 2015 the Chinese stock market (the Shanghai Composite Index) declined by 40 % from June till August. Seeking for a safe haven the Chinese bought physical gold en masse directly at the SGE; some weekly withdrawals in July, August and September transcended 70 tonnes. The gold was of course sourced by imports (look at the premium in exhibit 10), yet GFMS doesn’t consider this to be demand.
Although true Chinese demand cannot be less than SGE withdrawals minus distortion, GFMS pretends their arguments can explain the gigantic gap between SGE withdrawals and consumer demand. Illustrated in the chart below.
All arguments presented can only explain the size of distortion (exhibit 4), not the difference between SGE withdrawals and consumer demand! Actually, I should stop writing here, but I won’t. Let’s briefly go through these arguments to see if they make any sense.
The chapter in question, “A Review And Explanation Of How China’s SGE’s Withdraw Numbers Are Impacted By Other Trading Activities” (Gold Survey 2016), surprisingly lists three new arguments…
Tax avoidance (page 56).
Financial statement window dressing (page 58).
Retailers selling unsold inventories directly to refiners (page 58)
…and one old argument:
Gold leasing activities and arbitrage opportunities (in China gold is money at lower cost) (Gold Survey 2016, page 57, Gold Survey 2015, page 78)
Given the fact GFMS has gone all out in this chapter one would assume it to be complete. But strangely, arguments presented in prior Gold Survey reports and at forums have been abandoned. The following arguments were presented by GFMS in recent years:
Chinese commercial bank assets to back investment products. “The higher levels of imports, and withdrawals, are boosted by a number of factors, but notably by gold’s use as an asset class and the requirement for commercial banks to hold physical gold to support investment products.” (Gold Survey 2015, page 78).
Defaulting gold enterprises sent inventory directly to refiners and SGE (Gold Survey 2015 Q2, page 7)
What happened to arbitrage refining as described by GFMS Senior Precious Metals Analyst Samson Li at the Reuters Gold Forum in 2015? Has this arbitrage opportunity ever existed or did the market change and now the opportunity is closed? I never thought this argument was very compelling. Maybe GFMS changed its mind on arbitrage refining.
What happened to the round tripping of gold between Hong Kong and Shenzhen, put forward in the Gold Survey 2014 and 2015 as a reason that inflated SGE withdrawals? Did criminals stop using this scheme, or did GFMS find out it never inflated withdrawals because gold flows through Free Trade Zones are separated from the Chinese domestic gold market and the SGE system1? In several posts I’ve extensively shown round tripping does not inflate SGE withdrawals, for more information click here.
What happened to the argument Chinese commercial banks buy and withdraw gold at the SGE to back investment products they offer to customers, a practice which boosts import and withdrawals but was not considered demand by GFMS? Or is it demand now, as GFMS dropped this argument from the list? Ok, gotcha.
Now briefly about the new arguments listed by GFMS in the GS2016:
The definition of tax avoidance is that it’s a legal way to pay as little tax as possible. However, the scheme GFMS describes in the GS2016 report is tax evasion, which is highly illegal, and worst case the perpetrator can suffer life imprisonment. This is not some legal loophole as GFMS purports (page 56).
We initially became aware of the scheme in 2013 when it first emerged, but based on information gathered from our contacts, the number of industry participants mushroomed in 2014 and 2015 as other traders became aware of the potential loophole.
By writing the scheme is a way of tax avoidance and a loophole GFSM is misleading their readers. In addition, this illegal scheme did not emerge in 2013. The tax rules are now the same as when the SGE was erected in 2002. In fact, if you click here, you can read an article about the same crimes in 2009. But as mentioned before, we’ll save the details for a forthcoming post, when we’ll also address “financial statement window dressing” and “retailers selling unsold inventories directly to refiners”.
About gold leasing that would inflate SGE withdrawals, I’ve written numerous blog posts about this in the past. Best you can read my post Chinese Commodity Financing Deals Explained. In all the posts I’ve written over the years on the subject I’ve stated that the gold leased is not likely to leave the SGE vaults except when the gold will be used for jewelry manufacturing (which is genuine demand). Effectively, all the gold leasing by enterprises, investors and speculators to acquire cheap funding happens within the SGE system and do not inflate withdrawals. Ironically, in the latest World Gold Council (WGC) report it’s written [brackets added by me]:
Over recent years we have observed a rising number of commercial banks participating in the gold leasing market. … It’s estimated that around 10% of the leased gold leaves the SGE’s vaults. The majority is for financing purposes and is sold at the SGE [and stays within the SGE vaults] for cash settlement.
So, I hope to have clarified why according to my estimates true Chinese gold demand in 2015 must have been north of 2,250 tonnes (import 1,575 tonnes, mine output 450 tonnes, scrap supply 225 tonnes). More details in the next post when we will discuss the tax scheme.
1. Estimating China’s net gold import is difficult. For one, because China’s customs department doesn’t publicly disclose its cross-border trade statistics for gold so we depend on bullion export data (HS code7108) from the rest of the world. Data from Hong Kong, the UK, Switzerland, the US, Canada and Australia is publicly available, but for example data from South Africa is not. Therefor provisional data on China’s net import is not always fully accurate. Only when the CGA publishes the import amount in their Gold Yearbook can we know for sure. My estimate is 1,575 tonnes for 2015.
Net bullion exports to China in 2015: Hong Kong 861 tonnes, Switzerland 292 tonnes, the UK 285 tonnes, the US 6 tonnes, Japan 5 tonnes, Australia 124 tonnes, Canada 3 tonnes.
In China gold is not allowed to be exported from the domestic market (SGE Main Board). However, gold is allowed to be imported into / exported from China through processing trade, usually done in Free Trade Zones. This is the only way gold can be exported from China. Note, processing trade flows are completely separated from the Chinese domestic gold market. For detailed information read my post Chinese Cross-Border Gold Trade Rules.
In order to track how much gold China is net importing, it’s necessary to net out bullion export to China by foreign countries, with import from China by foreign countries (HS code 7108). Although, it’s also possible that bullion is imported into China through processing trade and exported as jewelry (China has a vast jewelry manufacturing industry), which falls under a separated trade category (HS code 7113). Suppose, a jewelry manufacturer in Shenzhen import 2 tonnes of gold from Hong Kong under HS code 7108 through processing trade, processes the gold into jewelry to subsequently export the finished products back to Hong Kong under HS code 7113. This would blur our view on net bullion import by China, however I neglect this phenomenon in my calculations.
The fine gold content in jewelry exported from China (HS code 7113) is very difficult to measure as the total value of the products shipped also contain other precious metals, gems and includes the fabrication costs. Hence, the value and weight of jewelry exported from China does not reveal the fine gold content. The reason why I do not adjust net bullion inflows into China by jewelry outflow is because the gold content in jewelry exported from China is roughly offset by imports of gold doré or gold as a by product in ores and concentrates.
For example, the most recent CGA Yearbook in my possession, covering calendar year 2014 (exhibit 13), states “Chinese domestic and overseas gold mining output” was 512.775 tonnes. In the same report it’s mentioned “domestic mining output” accounted for 451.799 tonnes, implying overseas mine supply accounted for 60.976 tonnes. And thus, I net out overseas mining imported into China (60.976 tonnes) against jewelry exported from China. If I find more information on Chinese cross-border gold trade flows I will adjust my methodology accordingly.
Last but not least, gold can be imported through processing trade into the Shanghai Free Trade Zone (SFTZ) where the Shanghai International God Exchange (SGEI) vaults are located. Potentially, this gold in SGEI vaults, once sold to foreigners is withdrawn and exported abroad (inflating SGE withdrawals). However, a source at ICBC has indicated to me that regarding physical flows the SGEI is mainly used by Chinese domestic banks to import gold into the Chinese domestic market, at least this was the case until December 2015. So I don’t see a possibility there were exorbitant large volumes of gold in SGEI vaults in 2015, or have been withdrawn and exported.
The only noteworthy imports from China (the SGEI) I have observed are by India, which has taken in 370 Kg during 2015 (source Zauba), and by Thailand that presumably bought 7 tonnes (source COMTRADE).
2. For the sake of simplicity I have categorized under “distortion” everything that is not true demand, namely: process scrap, stock inventory change, arbitrage refining (if it exists), the VAT scheme, smuggling and SGEI withdrawals.
Since 2015 I’ve stated the raw data published by the Australian Bureau of Statistics (ABS) on gold export to China mainland do not accurately reflect what is imported by China from the land of down under. In my previous post I’ve written Australia’s gold “export to China” should be adjusted by Hong Kong’s gold “import from Australia” as a substantial amount of gold Australia declares to export to China is in fact travelling through Hong Kong. A written statement from ABS now supports this analysis.
Obviously, what we’re after is exactly how much (non-monetary) gold China is importing from all countries around the world. As China doesn’t disclose its cross-border trade statistics for gold, the only way to reach our objective is by establishing net gold export from all countries around the world to China, subsequently to aggregate these numbers and come to an estimate of total Chinese gold import.
One of the largest exporters of gold to China is Australia, but calculating Australia’s gold export to China is complicated, as we need to be cautious to avoid double counting in computing China’s total net gold import.The thing is,ABS bluntly alters any “export to Hong Kong” into “export to China” when they suspect the gold is shipped to Hong Kong but will reach the mainland as its final destination – this is what ABS confirmed to me.Therefor, from using Australia’s “export to China” double counting can arise when any gold flowing from Australia via Hong Kong to China would then be declared as “export to China” by Australia and “export to China” by Hong Kong.
Let us clarify this subject. Have a look at the chart below. If we focus on the period from January 2013 until December 2014 we can observe that Australia’s “export to China” (purple bars, data sourced via ABS/COMTRADE) roughly matches Hong Kong’s “import from Australia” (turquoise bars, data sourced from the Hong Kong Census and Statistics Department). We must conclude that over this period roughly all gold Australia exported to China was transferred via Hong Kong. If we then would sum up Australia’s gold “export to China” to Hong Kong’s gold “export to China” this would result in double counting.
Historically, Hong Kong has been the main entry point for gold into China. Not surprisingly Australia’s gold “export to China” was all directed through Hong Kong until December 2014, as we can see above. The situation changed early 2014 when China openly stated to stimulate direct gold imports from all over the world, bypassing Hong Kong. Soon after, we’ve witnessed the birth of direct gold export to China from for example the UK.
The strategic move from Beijing to stimulate direct import was also mentioned on Chinese state television channel CCTV in 2014, see the clip below starting from 1:30.
Exhibit 3. Courtesy CCTV.
Tellingly, what Australia declared as “export to China” started to exceed what Hong Kong declared as “import from Australia” (exhibit 1) in early 2015. The difference reflects Australia’s direct export to China, which took off in January 2015. To compute Australia’s direct export to China we should subtract Hong Kong’s “import from Australia” from what Australia declares as “export to China”.
When I wrote ABS about my general findings displayed in exhibit 1 they replied [emphasize en brackets by me]:
… I can confirm that we are reporting basically as you described.
The ABS developed a policy some time ago in relation to reporting country of origin [final destination] for gold exports. The policy dictates that some trade with a reported country of destination as Hong Kong, should be corrected to China. This was based on our investigations at the time, which found that although Hong Kong is a central hub for gold trade, the goods are predominately sent elsewhere in the Asia/Pacific region. We also confirmed that in some cases the destination beyond Hong Kong was not known by the exporter at the time of export.China was assessed as the most likely destination …. We acknowledge that this blanket approach is not ideal, and can lead to the series differing from expectations.
We will continue to report in this fashion in the foreseeable future. However, as some time has passed since the initial investigation we will be conducting a review of the policy discussed above. We will be sure to inform you of any outcomes resulting from the review process.
Exhibit 4. Quote from email of the Australian Bureau of Statistics (ABS) to Koos Jansen.
Case closed? No, I have a few more thoughts I would like to share.
To come to the most precise amount of bullion net exported from Australia to China mainland we should set up a formula. We have a few flows of bullion between Australia, Hong Kong and China to work with. Some are known and publicly disclosed, some are unknown but can be calculated:
We have publicly disclosed by ABS/COMTRADE what Australia declares as net “export to China” (C).
Effectively, what ABS declares as net “export to China” (C) either is a direct net export to China (Y) or exported to Hong Kong but disclosed by ABS as export to China (X) as they guess the final destination is the mainland (so C = X + Y). What we want to know is the partition of Y and X, but this is unknown.
Then we have also publicly disclosed by ABS/COMTRADE what they consider Australia to net “export to Hong Kong” as a final destination (B). This amount is small but relevant for our formula. (Actually, for us it is not important what ABS thinks the final destination is, as long as we know this gold is arriving in Hong Kong.)
Finally, we have publicly disclosed by the Hong Kong Census and Statistics Department (HKCSD) Hong Kong’s net “import from Australia” (Z).
What we want to calculate is Y (Australia’s direct net gold “export to China”), but the only figures published are C and B by ABS, and Z by HKCSD. Fortunately, we can calculate Y from C, B and Z.
We know Hong Kong’s “import from Australia” (Z) equals Australia’s “export to Hong Kong” (B) plus Australia’s export to Hong Kong data that is altered into “export to China” (X). ABS may alter the data but nevertheless the physical gold flows to Hong Kong. Therefor:
Z = B + X
As Z and B are publicly disclosed, from here we can calculate the amount ABS alters from “export to Hong Kong” into “export to China”, which is X.
X = Z – B
By knowing X we can finally calculate how much gold is directly net exported from Australia to China (Y).
C = Y + X
Y = C – X
By using this formula Australia net exported 124 tonnes of gold to China mainland in 2015. In contrast, GFMS that wrote in their Gold Survey 2016 Australia exported 187 tonnes to China in 2015, which is the raw data disclosed by ABS (Australia’s gross gold “export to China”). The numbers by GFMS cannot de accurate.
One final point. How do we know the gold exports from Australia to Hong Kong are re-exported to China mainland and not for example to Thailand?
Re-exports are products which have previously been imported into Hong Kong and which are re-exported without having undergone in Hong Kong a manufacturing process which has changed permanently the shape, nature, form or utility of the product.
Exhibit 6. Definition of re-exports by HKCSD.
Well, next to the fact ABS isn’t always sure what the final destination is of gold exported to Hong Kong, neither do I. But, once the gold has arrived in Hong Kong we shouldn’t care about ABS data, we must rely on HKCSD’s data. The HKCSD states Hong Kong to re-export hundreds if not thousands of tonnes of gold per year – Hong Kong is one the largest gold trading hubs globally. Therefor, I assume they accurately declare how much imported gold is re-exported. If the HKCSD declares so many re-exports why wouldn’t they accurately declare re-exports from Australia to the mainland?
Eventually, by calculating Australia’s direct net gold “export to China” (Y) through the formula above, and adding Hong Kong’s “export and re-export to China” from HKCSD data we should have the best assessment of China’s net gold import from Australia and Hong Kong.
My assessment for China’s total net gold import for 2015 is 1,575 tonnes. If we add domestic mine output at 450 tonnes and a few hundred tonnes of scrap supply and disinvestment, total supply has been well over 2,000 tonnes for the year. Not surprisingly SGE withdrawals accounted for 2,596 tonnes in 2015.
I know, I owe you all a respons to the Gold Survey 2016 by GFMS in which they stated Chinese gold demand in 2015 was 867 tonnes – quite a gap with SGE withdrawals. As some of you know, or might have guessed by now, I’ve had some health issues in recent years hence my writing hasn’t been constant. Hopefully, things are turning for the better again and I can continue publishing on the Chinese gold market (my ongoing disagreement with WGC and GFMS), global gold flows and a whole bunch of other planned articles.
Chinese wholesale gold demand, as measured by withdrawals from the vaults of the Shanghai Gold Exchange (SGE), reached a sizable 973 metric tonnes in the first half of 2016, down 7 % compared to last year.
Although Chinese gold demand year to date at 973 tonnes is slightly down from its record year in 2015 – when China in total net imported over 1,550 tonnes and an astonishing 2,596 tonnes were withdrawn from SGE designated vaults – appetite from the mainland is still the greatest of all single nations worldwide. At the same time the mainstream consultancy firms (World Gold Council, GFMS, Metals Focus) continue portraying Chinese gold demand to be roughly half of SGE withdrawals, as these firms measure “gold demand” merely at retail level which excludes any direct purchases at the SGE by institutional and individual investors. But to reassure you, Chinese wholesale gold demand still equals SGE withdrawals.
In the month of June (2016) SGE withdrawals accounted for a robust 139 tonnes, although this was down 29 % from June last year. The reason being for “somewhat subdued” Chinese gold demand in recent months is that the price of gold has risen strongly over this time horizon and the Chinese tend to buy gold when its price goes down, in contrast to Western investors that buy gold when the price goes up. From 1 June until 30 June 2016 the price of gold in US dollars jumped by 9 % from $1,214.70 to $1,325.76. Over the first six months of 2016 the price of gold exploded by 25 % (from $1,061.5 on 1 January 2016). So, since January this year when the price of gold started to rise, the Chinese actually stepped down their gold purchases while Western demand, which can be roughly measured by the net flow in/out of the UK, went up impressively.
Let us have a look at a few charts to come to grips with what’s going on in the Chinese (and international) gold market. Below, we can see a chart showing monthly SGE withdrawals plotted against the end of month price of gold in yuan per gram. In recent years, whenever the price of gold goes down the Chinese step up their purchases (buying the physical supply coming from the West) and whenever the price of gold goes up the Chinese slow their purchases.
By looking at a weekly SGE withdrawals chart (from before January 2016) we can see the trend just described – “the Chinese tend to buy more gold when the price goes down” – in a more granular fashion. Have a look below.
In contrast to Chinese gold buying behaviour, let us have a look at gold demand from the West. Our proxy for Western demand is the net flow in/out of the UK where the London Bullion Market (LBMA) and the world’s largest ETF’s such as GLD store physical gold. At the beginning of 2016 (when the price of gold started to rise) the direction of the flow has reversed sharply, from the UK being a net exporter to being a net importer.
From being a large net gold exporter in 2013, 2014 and 2015, the UK is now one of the largest net importers. In April 2016 the UK net imported 195 tonnes of gold – while export to China was nil.
If we look at a chart that reflects the net flow of gold into the UK versus the gold price, we can clearly see the correlation. A declining gold price (blue line) coincides with the UK net exporting gold (black line) and vice versa.
The impressive gold rally year to date, and the accompanied massive growth in GLD inventory in London, predicts sustaining net gold imports by the UK in May and June. In a forthcoming post we’ll discuss more thoroughly how above ground gold stock is moving between which nations and how this correlates to the price of gold.
International merchandise trade statistics always lag a few months, so I don’t know exactly the total amount of gold China has net imported in H1 2016. That I know of, China has net imported 368 tonnes year to date, according to trade data from Hong Kong covering January-April, the UK covering January-April and Switzerland covering January- May. Australia’s export data is not clear yet. If we project the pace of imports to to six months, China has “at least” imported 512 tonnes of gold in H1 2016.
Supply to the SGE can only come from import, domestic mine output or scrap/disinvestment. As, import accounted for 512 tonnes and domestic mine supply for 225 tonnes, consequently scrap/disinvestment through the SGE must have been approximately 236 tonnes in H1 2016.
By using our preliminary estimate of 512 tonnes for China’s net import in H1 2016 and mine output at 225 tonnes, there are currently an estimated 18,444 tonnes of gold within China. Assuming the PBOC has accumulated about 4,000 tonnes by now which has not been supplied through the SGE, that is. For a detailed explanation how I conceived this estimate please read my post “PBOC Gold Purchases: Separating Facts from Speculation”.
If my speculative estimate of PBOC holdings would be incorrect, and China’s central bank holds what is officially disclosed at roughly 1,800 tonnes, there are currently an estimated 16,244 tonnes of gold within China.
Nomura’s SGE Withdrawal Data Is False
Since I’ve been publishing SGE withdrawals and its relation to Chinese gold demand many others have jumped the bandwagon, though some more successful than others. A few days ago I stumbled upon a “SGE withdrawals chart” from Nomura research with false data.
In Nomura’s chart it’s shown that withdrawals from the vaults of the SGE in the first five months of 2016 accounted for 4,425 tonnes. Which of course is false. If that would be true, China should have imported about 3,800 tonnes in five months. No, that did not happen.
What Nomura did is grab the “cumulative delivery amount” from the Chinese Market Data Monthly Reports, instead of the “cumulative load-out volume”.The latter is how the SGE refers to “withdrawals” in English. As I’ve written previously the “delivery amount” is not the same as “load out volume”. The “delivery amount” reflects the volume of gold that changes ownership inside the vaults, computed as the sum of the trading volumes in physical products and the contract delivery volumes of deferred products, whereas “load out volume” tells to the amount of gold that is withdrawn from the vaults.
Let’s have a look at the Chinese Market Data Monthly Report from May, which Nomura used for its withdrawal data for January-May 2016 (“5M16” in their chart).
We can see that at number 4 the “cumulative delivery amount” notes 4,425,035.28 Kg, which is exactly what Nomura shows in its chart as “withdrawn”.
By and by, the “cumulative delivery amount” is counted bilaterally. Effectively, half of this amount (2,212,517.64 Kg) is how much physical gold changed ownership inside SGE designated vaults from January until May 2016.
At number 8, we see the actual amount of gold withdrawn from the vaults over this period (counted unilaterally). In the first five months of 2016 SGE withdrawals accounted for 835 tonnes.
Below is the full explanation of the Chinese trade table.
1) Delivery amount this month, the sum of the trading volumes in physical products and the contract delivery volumes of deferred products for the reported month, counted bilaterally in Kg.
2) Trading volume this month, the sum of all trading volumes in physical and deferred products for the reported month, counted bilaterally in Kg.
3) Delivery ratio this month, the proportion of the delivery amount to the total trading volume of both physical and deferred products for the reported month (1 divided by 2).
4) Cumulative delivery amount, the sum of all monthly delivery amounts from the beginning of the year to the statistical time point, counted bilaterally in Kg.
5) Cumulative trading volume, the sum of all trading volumes in physical and deferred products from the beginning of the year to the statistical time point, counted bilaterally in Kg.
6) Cumulative delivery ratio, the proportion of the cumulative delivery amount to the cumulative trading volume of both physical and deferred products from the beginning of the year to the statistical time point (4 divided by 5).
In two parts I will present an overview of the Chinese gold market for calendar year 2015. In this part we’ll focus on Shanghai Gold Exchange trading volumes. In the next post we’ll focus on physical supply and demand flows in Chinese gold market in 2015.
First, let us quickly assess the core volume data of the largest precious metals exchanges in China and the US. Physical and derivative gold trading at the Shanghai Gold Exchange (SGE) in 2015 reached 17,033 tonnes, up by 84 % from 9,243 tonnes in 2014. Gold futures trading at the Shanghai Futures Exchange (SHFE) in 2015 accounted for 25,421 tonnes, up 7 % from 23,750 tonnes in 2014. Consequently, total wholesale trading volume in China (SGE + SHFE) was 42,454 in 2015, up 29 % year on year. In New York at the COMEX total gold futures volume reached 128,844 tonnes for the year 2015, up 3 % from a year earlier. COMEX trading volume was three times as large as the total volume in China.
It’s unknown how much gold is traded in the Over-The-Counter London Bullion Market. However, a survey conducted by the LBMA in 2011 pointed out approximately 680,783 tonnes of gold per year change hands through the London based market.
All tonnages mentioned in this post are counted single-sided.
The Shanghai Gold Exchange
There are a few more interesting data points to be found in SGE trading for 2015 when examining the developments of the specific contracts.
At the SGE two types of gold products (/contracts) can be traded: physical products and deferred products. The physical contracts traded on the Main Board (SGE / domestic market) are:
Au50g (50 gram gold bar, 9999 fine)
Au100g (100 gram gold bar, 9999 fine)
Au99.99 (1 Kg gold ingot, 9999 fine)
Au99.95 (3 Kg gold ingot, 9995 fine)
Au99.5 (12.5 Kg gold ingot, 995 fine)
The physical contracts traded on the International Board (SGEI / international market) are:
The deferred contracts (only traded on the Main Board) are:
Au(T+D) (1 Kg per lot, delivery in 3 Kg or 1 Kg ingots)
Au(T+N1) (100 gram per lot, delivery in 1 Kg ingots)
Au(T+N2) (100 gram per lot, delivery in 1 Kg ingots)
mAu(T+D) (100 gram per lot, delivery in 1 Kg ingots)
Because the deferred contracts are traded on margin and there is no fixed delivery date, these derivative products embody paper trading.
All SGE contracts can be traded competitively over the Exchange, but the physical contracts can also be negotiated bilaterally in the Over-The-Counter (OTC) market and then settled through the SGE system. The SGE publishes the volume of these OTC trades.
The most traded contract on the Exchange in 2015 was the deferred product Au(T+D). In total Au(T+D) volume accounted for 5,648 tonnes, up 30 % from the previous year. The second most traded contract was the physical product Au99.99, of which 3,465 tonnes changed hands, up 65 % from 2014 - although, if we include OTC trading total Au99.99 volume for 2015 reached 6,998 tonnes, which would make it the number one contract.
Physical trading (including OTC activity) at the SGE in 2015 accounted for 9,745 tonnes (57%), versus 7,288 tonnes in paper trading (43 %).
The growth in total gold trading at the SGE in 2015 was the strongest since the financial crisis erupted in 2008. According to my analysis one reason for this has been the opening of the Shanghai International Gold Exchange (SGEI) in September 2014.
The SGE system services gold trading for the domestic Chinese gold market. This gold traded over the SGE system is prohibited from being exported. The SGEI is a subsidiary of the SGE located in the Shanghai Free Trade Zone, where international members of the Exchange can import, trade and export gold. In terms of physical gold flows the SGE and SGEI are separated venues. For more information please read my previous post, “Workings Of The Shanghai International Gold Exchange”.
On the surface it looks as if the SGEI has been a failure. The most traded contract at the International Board is iAu99.99. At the start of 2015 iAu99.99 trading was weak and after a short peak in April, volume came down to practically nil throughout the middle and the end of the year. Hence, most analysts stated the SGEI was dead. There are two important points that undermine this statement.
The first point is that iAu99.99 can be traded in the OTC market. When it appeared that trading of iAu99.99 was dying out at the Exchange, in the OTC market activity continued. There is no constant trading in iAu99.99 in the OTC market, but the volumes are significantly higher than iAu99.99 trading over the Exchange (see the chart below).
Tellingly, the iAu99.99 trades in the OTC market are all performed in giant batches of 100 or 1000 Kg. Have a look at the data labels in the chart below. We can see that all weekly OTC iAu99.99 volumes are in sizes one hundred (blue bars) or one thousand (red bars) 1 Kg bars. For example, look at the week that ended 3 July 2015, when exactly 73,000 Kg’s were traded. In theory 20,855 Kg’s were traded on Monday and 52,145 Kg’s on Thursday, aggregating to 73,000 Kg’s in total for the week. Though, this coincidence cannot have occurred each and every week. More likely the iAu99.99 traders in the OTC market always buy and sell per 100 or 1000 Kg’s. No other SGE or SGEI contract shows this bulky trading pattern.
The second point is that international members of the Exchange are not only allowed to trade the contracts on the International Board, they’re also allowed to trade the domestic contracts, they’re just not allowed to withdraw the metal from domestic vaults. The international members that focus on arbitraging any price differentials between the US and China will prefer the most liquid contracts on the Exchange. So, for this purpose the international members would trade Au99.99 and Au(T+D). Sources at the SGE confirmed to me that indeed international members are trading Main Board contracts.
If we look at the next chart, we can see that since the inception of the SGEI in September 2014 total SGE volume (including domestic, international, physical and deferred contracts) increased significantly. My conclusion is that the gateway of the SGEI has increased liquidity at the Exchange in Shanghai and enhanced the connection between the Chinese and Western gold markets.
I realize the system of the SGE and SGEI, how trading and physical gold flows are divided, is not easy to understand. The best I can do to clarify this is to present the diagram furnished by the SGE showing how trading in all contracts by all customers is organized (see below). In the next post we’ll examine the physical gold flows going through China and the Shanghai Free Trade Zone.
Note, domestic members/customers are allowed to use onshore renminbi to trade all products on the Main Board, but are also allowed to use onshore renminbi to trade all products on the International Board (although load-in and load-out metal from the vaults is prohibited). In turn, international members are allowed to use offshore renminbi to trade all contracts on the International Board, but are also allowed to use offshore renminbi to trade most contracts on the Main Board (although load-in and load-out metal from the vaults is prohibited).
I’ve received written confirmation by the Shanghai Gold Exchange (SGE) delivery department that the Chinese Market Data Monthly Reports disclose the volume of physical gold withdrawn from SGE designated vaults. I’m thrilled to resume reporting these numbers and everything related to the Chinese gold market!
Because of the structure of the Chinese gold market the volume of physical gold withdrawn from the vaults of the SGE provides us a unique measure of Chinese wholesale gold demand – which in recent years has been more than twice as much as Chinese consumer gold demand reported by the World Gold Council. However, it appeared the SGE ceased publishing SGE withdraw numbers after a press release from 11 January 2016 that stated the bourse “adjusted some terms in the Delivery Reports”. After the announcement SGE withdrawals were not disclosed in the Chinese Market Data Weekly Reports and over the phone I was informed withdraw numbers would not be disclosed any longer by the SGE.
Perhaps I spoke to the wrong people at the SGE or perhaps the SGE has changed its mind. In any case, in the first Chinese Market Data Monthly Report of this year (January) the format was different from the Chinese Market Data Weekly Reports. In the Chinese monthly report it showed a number that looked to be the volume of gold withdrawn from the vaults. Though we couldn’t be too sure as the SGE changed its nomenclature since the press release from 11 January.
Once again I contacted the SGE and finally came in touch with an employee at the delivery department. The person in question told me over the phone that indeed the January monthly report disclosed withdraw data, but because confirmations over the phone can be easily violated, I also asked for written confirmation. Then, a few days later the SGE delivery department confirmed over email that the Market Data Monthly Reports include the volume of gold withdrawn from SGE designated vaults!
So, here we go again. The SGE monthly report from February shows withdrawals from the vaults of the SGE accounted for a modest 107.6 tonnes, down 52 % from January and down 31 % from February 2015.
Year to date SGE withdrawals have reached 333 tonnes, down 19 % year on year.
Subdued SGE withdrawals – indicating suppressed Chinese physical gold demand – in February is very remarkable as in this month the price of gold (in US dollars) increased by over 10 %.
This suggests that the Chinese do not buy physical gold when the price goes up but mainly buy when the price goes down. In addition, because there has been strong buying from Western parties in February, for example GLD inventory in London increased by 15 % over this period, we can conclude the West is the price setter and China up until now has predominantly been a “price taker”. Put differently, China is merely taken advantage of bargain prices.
The same correlation between the price of gold and Western physical buying behaviour can be observed when we compare the gold price to cross-border gold trade from the UK, where many Western investors store their gold.
So for this comparison we use UK cross-border gold trade as a proxy for Western physical gold buying. Although this is not exact science, in the chart above we can see whenever the West is buying physical gold (UK net import increases, see 2012) the price goes up and whenever the West is selling physical gold (UK becomes net exporter, see 2013) the price goes down.
Given the fact the price of gold has increased significantly year to date we may expect the UK was not a net exporter in January and February, more likely the UK was a net importer over this time horizon.
Because there has been so much confusion about the terms used in the new Chinese Market Data Monthly Reports and the Market Data Weekly Reports I included screenshots of both reports below provided with translations as suggested by the SGE press release from 11 January 2016. In the Market Data Weekly Report for week 7 (22 – 26 February) 2016 we can see the following Delivery Report.
Delivery amount this week, the sum of the trading volumes in physical products and the contract delivery volumes of deferred products for the reported week, counted bilaterally in Kg.
Trading volume this week, the sum of all trading volumes in physical and deferred products for the reported week, counted bilaterally in Kg.
Delivery ratio this week, the proportion of the delivery amount to the total trading volume of both physical and deferred products for the reported week (1 divided by 2).
Cumulative delivery amount, the sum of all weekly delivery amounts from the beginning of the year to the statistical time point, counted bilaterally in Kg.
Cumulative trading volume, the sum of all trading volumes in physical and deferred products from the beginning of the year to the statistical time point, counted bilaterally in Kg.
Cumulative delivery ratio, the proportion of the cumulative delivery amount to the cumulative trading volume of both physical and deferred products from the beginning of the year to the statistical time point (4 divided by 5).
In the Market Data Monthly Report for February 2016 we can see this Delivery Report:
Delivery amount this month, the sum of the trading volumes in physical products and the contract delivery volumes of deferred products for the reported month, counted bilaterally in Kg.
Trading volume this month, the sum of all trading volumes in physical and deferred products for the reported month, counted bilaterally in Kg.
Delivery ratio this month, the proportion of the delivery amount to the total trading volume of both physical and deferred products for the reported month (1 divided by 2).
Cumulative delivery amount, the sum of all monthly delivery amounts from the beginning of the year to the statistical time point, counted bilaterally in Kg.
Cumulative trading volume, the sum of all trading volumes in physical and deferred products from the beginning of the year to the statistical time point, counted bilaterally in Kg.
Cumulative delivery ratio, the proportion of the cumulative delivery amount to the cumulative trading volume of both physical and deferred products from the beginning of the year to the statistical time point (4 divided by 5).
The load-out volume for silver does not reflect Chinese wholesale silver demand, as the structure of the Chinese silver market is different from the Chinese gold market.
According to my manual cross calculations the “delivery amount” in the weekly report for week 7 does not match “the sum of the trading volumes in physical products and the contract delivery volumes of deferred products for the reported week”. I’ve send out an inquiry to the SGE to verify the data.
UPDATE 10 March 2016: The SGE replied how they calculated “delivery amount”, it was based on the delivery of Au(T+N1) and Au(T+N2) in 100 gram per lot. It appeared I had an SGE sheet with false specifications of Au(T+N1) and Au(T+N2) – 1 Kg per lot. My manual cross calculations and the SGE numbers match now.
I was invited by Scotiabank to speak about Chinese gold demand at their commodities outlook conference on 12 January 2016 in Toronto. Of course I was thrilled to come over and share what I’ve been studying for the past years – thanks again Scotiabank for inviting me!
In my 20-minute presentation I could clearly explain why I think Chinese gold demand is not what mainstream consultancy firms (GFMS, WGC, Metals Focus, CPM Group) would like you to believe. While I was there I also took the opportunity to talk to Jeffrey Christian, who was speaking right before me on conference day. Mr Christian is a Managing Partner of CPM Group, which is one of the consultancy firms whose Chinese gold demand statistics I’ve fiercely disputed over the years.
Previously, in 2014, me and Mr Christian have debated the subject of Chinese gold demand on these very pages. After I wrote CPM Group an open letter in response to their Market Alert, now sadly offline, Mr Christian took the time to debate me in the comment section of my blog. In my opinion this is how it should be, open debate between the mainstream firms and us the independent gold researchers. Mr Christian showed to be a good sport by discussing our differences.
In Toronto we could briefly resume talking about our differences offstage. We didn’t agree, naturally, but it was valuable to hear some of his arguments – that’s what fuels debate and incentivizes me to investigate certain segment of the gold market more thoroughly. On stage I was pleased to able to present my view on Chinese gold demand right after his.
In a nutshell Mr Christian stated Chinese gold demand was roughly 933 tonnes (30 million ounces) in 2015, while I stated it was more like 2,000 tonnes, as China has imported roughly 1,400 tonnes, mined 450 tonnes and scrap was likely more than 150 tonnes for the year (the details about all data from 2015 will be published shorty).
Unfortunately the recording of my presentation is not allowed by Scotiabank to be republished on YouTube. So what I did is re-record the presentation. Below you can find the video, my voice in combination with the slides, which turned out to be a concise analysis of the Chinese gold market. The first part is about Chinese private gold demand and the structure of the Chinese domestic gold market. In the second part I speculate about purchases from China’s central bank that have to be added to Chinese private gold demand, according to my analysis.
Click here to download the slides in PDF format, or watch the video below.
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