In December 2016 Chinese wholesale gold demand, measured by withdrawals from the vaults of the Shanghai Gold Exchange (SGE), accounted for 196 tonnes, down 9 % from November. December was still a strong month for SGE withdrawals due to the fact the gold price trended lower before briefly spiking at the end of the month, and the Chinese prefer to buy gold when the price declines (see exhibit 1).
In total Chinese wholesale gold demand reached an astonishing 1,970 tonnes in 2016. But will these huge tonnages bought by China ever have an impact on the gold price? I think it will.
As in previous years, SGE withdrawals were mostly supplied through imports, in 2016 at approximately 1,300 tonnes. And as in previous years, SGE withdrawals were roughly twice the size of Chinese consumer gold demand. The latter is published by all “leading” consultancy firms, such as the World Gold Council and Thomson Reuters GFMS. Because these firms have systematically underreported and eclipsed Chinese gold demand since 2007, a significant share of the financial industry is unaware China has imported 5,000 tonnes in the past years, which is not allowed to be exported. My hypothesis is that this 5,000 tonnes decline in above ground gold reserves outside of the Chinese domestic market will make gold rally stronger in a future bull market than it did in previous bull markets. To the extent many investors are uninformed about the shrinking volume of troy ounces available outside of China, their ignorance will boost any price rally coming.
In this post I would like to share my thoughts on how the gold price is correlated to trade in above ground reserves, and how China has slashed these reserves to the tune of 5,000 tonnes, which will significantly impact the next leg up in gold.
Correlated: The Gold Price And UK Gold Trade
Since many decades large investors in the West set the price of gold. Ever since, the heart of the Western gold wholesale market has been London in the United Kingdom. There is thus a correlation between the gold price and the volume of gold net imported or exported by the UK.
In Asia, on the other hand, gold market participants are more price sensitive, implying they buy low and sell high (the opposite of Western investors). I’ve described this trend frequently on these pages, but the same can be read in books by gold author Timothy Green. In The Prospect For Gold from 1987 Green states:
Before we discuss the connection between Western supply and demand trends to developments in the Chinese gold market of the past decade, let me first recapitulate that global physical gold supply and demand is far in excess of the statistics the World Gold Council and GFMS publish. Below is a chart that shows the quarterly averages of all physical supply and demand categories as disclosed by the World Gold Council from Q1 2002 until Q4 2015. These numbers are more or less the same as figures by GFMS.
We can see that over the course of 13 years, the majority of supply consisted of mine output (73%) and the majority of demand consisted of jewelry consumption (64%).
(Note, the categories official sector, net producer hedging and ETFs can be either supply or demand and volumes can greatly vary per quarter. Though, only in 1 of 52 quarters examined has ETF demand been greater than jewelry consumption (Q1 2009). In all other quarters official sector, net producer hedging and ETFs supply or demand has not been greater than mine output or jewelry consumption.)
If the data by the World Gold Council regarding physical gold supply and demand would be exhaustive, mine output and jewelry consumption should have a positive correlation to each other and the price of gold. But they don’t. Have a look at the next chart.
During the bull market from 2002 until 2011 jewelry consumption decreased and it hardly ever transcended mine output. In turn, mine output gradually ascended over this time horizon while the gold price increased six fold! Are the forces between jewelry demand and mine supply driving the medium/long term price of gold? No, clearly not. This shows the data by the World Gold Council is incomplete.
(I should add that mine output does have a correlation to the gold price in the very long term as it can take more than ten years to setup a gold mining project. See the next chart.)
In contrast to the data by the World Gold Council, we can observe a strong correlation between the medium/long term gold price and institutional supply and demand flowing through London. View the chart below.
Strangely, institutional supply and demand are categories not included in the World Gold Council’s data – or in any other precious metals consultancy firm’s data that I’m aware of.
Because in the UK there are no refineries, no gold mines and local consumption demand and scrap supply is immaterial, all gold that is visibly (non-monetary) imported and exported must either relate to ETF holdings stored in London, or Western institutional supply and demand. When we compute the ratio between both, ETF flows compound to roughly 35 % of the UK’s net flow (import minus export) and as a consequence approximately 65 % is Western institutional supply and demand. Effectively the majority of the UK’s net flow is Western institutional supply and demand.
Hereby, consider that all supply and demand categories disclosed by the World Gold Council more or less equal each other (exhibit 4), so for the sake of simplicity we‘ll state that total mine output + scrap supply versus jewelry consumption + bar and coin + industrial demand meets outside the UK and doesn’t set the medium/long term price of gold.
The UK’s net flow, on the other hand, is highly correlated to the medium/long term price of gold. Note how nearly every month the change in net flow corresponds with the direction of the gold price (exhibit 6). Less granular, from the moment my data starts in 2005 the UK has been a net importer until 2012 on a rising price of gold. From 2013 until 2015 the UK was a net exporter on a declining price of gold. And in the first quarter of 2016, when the gold price saw its strongest move up since 1986, the UK was a net importer. Coincidence? I think not.
We can conclude that Western institutional supply and demand in above ground gold reserves is driving the medium/long term price of gold. As it’s likely the price of gold could not have gone up from 2002 until 2011 if there had been no UK net imports, and it’s likely the price of gold could not have gone down from 2013 until 2015 if there had been no UK net exports. (Short term the gold price is pushed around in the paper markets.)
We can think of Western institutional supply and demand (the UK net flow) like this: the majority of the gold gross imported into the UK is demand from above ground reserves outside the UK, and the majority of the gold gross exported from the UK is supply to above ground reserves outside the UK. When the UK is a net importer that means there is a net pull on above ground reserves outside the UK, which corresponds to a rising gold price. When the UK is a net exporter the inverse is true.
Here it becomes apparent that the amount of above ground bullion is essential for future price developments.
The Chinese Black Hole
Let’s turn to China. In the introduction I stated China is importing a lot more gold than is known in the financial industry because most investors base their knowledge on data by the World Gold Council. More precise, China has imported 5,000 tonnes from 2007 until 2016 in addition to what the World Gold Council has portrayed through their demand statistics.
Let’s get our minds around this through some charts. As an example, I’ve drawn a chart showing Chinese gold supply and demand for 2015 (last year I have complete data of).
We don’t know every exact data point for China, but we do know GFMSdemand (purple) and apparent supply, consisting of domestic mine output (green), scrap supply (yellow) and net import (blue). From here on we’ll use GFMS data, as GFMS publishes scrap supply numbers for China and the World Gold Council doesn’t.
According to GFMS Chinese consumer gold demand in 2015 was 867 tonnes. To meet demand GFMS presents 450 tonnes was domestically mined and scrap supply accounted for 225 tonnes. Indirectly GFMS states China net imported 192 tonnes to complete the supply and demand balance in the Chinese domestic market (exhibit 7). For the additional 1,383 tonnes imported GFMS has floated all sorts of excuses, which I‘ve debunked here and here.
The bottom line is, in addition to the 192 tonnes GFMS reports as imported in 2015 to meet consumer demand, China imported 1,383 tonnes to meet institutional demand and all this metal is not allowed to be exported.
If we repeat the same exercise for every years since 2007, the aggregated net imports by China that have not been included in the statistics by GFMS account for 5,000 tonnes. See the next chart.
You can see now, China has enormously diminished above ground reserves outside of the Chinese domestic market without all investors around the world being fully aware. In my humble opinion this will make the price of gold go up turbo charged next time the West shows interest in the metal.
In The Prospect For Gold Green states:
“Selling gold is not a one way street”, wrote Green in 1987. But guess what. Since a few years – from the moment China became an elephant player in the physical market – selling gold is a one way street! Western sell-offs are transhipped to China but do not return. The global gold game has changed.
The consequence is that there are less above ground reserves outside of China for Western investors to buy in a forthcoming bull market, which will elevate the dollar bid per unit gold – in other words the gold price measured in US dollars per troy ounce.
Keep in mind, this phenomenon (China importing vast quantities in addition to Chinese consumer gold demand as disclosed by GFMS) has greatly materialized in 2013, when gold entered a bear market after an 11-year run up. In the previous bull market (2002-2012) above ground reserves outside of China had not been slashed yet. So the ramifications of this phenomenon will only be felt during the next leg up.
Is there any proof to substantiate my hypothesis? I think so. Early 2016 there was some renewed interest in yellow metal from large Western investors. When the price of gold started to climb it went practically vertical ending the first quarter of 2016 up 16.7 %, the strongest quarter since 1986. Coincidence? I think not. It went up strong as it did because there were fewer ounces in above ground reserves available.
A study on how much above ground reserves there are outside China will be saved for a future blog post.
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.
More proof the “precious metals assets” on Chinese commercial bank balance sheets have little to do with the “surplus” gold in China’s domestic market.
The “surplus” in the Chinese gold market is the difference between withdrawals from the Shanghai Gold Exchange vaults and gold demand as measured by consultancy firms like the World Gold Council and Thomson Reuters GFMS. The “surplus” accounts for over 4,000 tonnes. In reality the “surplus” is true gold demand by Chinese individuals and institutional investors directly at the SGE. Some analysts think the huge tonnages in “precious metals assets” on the balance sheets of Chinese commercial banks have anything to do with the “surplus”, but this is not true. And I prefer to explain in detail.
One of the topics about the Chinese gold market that has not been fully illuminated is the “gold” on the 16 Chinese commercial banks’ balance sheets. At the end of 2015 the aggregated “precious metals assets” on the bank balance sheets accounted for 598 billion yuan (RMB), which translates into approximately 2,682 tonnes of gold – if all the precious metals were gold related, which is very likely.
In my previous post on this subject we learned from examining the banks’ annual reports from 2015, that there are at least five gold assets that can appear in the “precious metals” line item on the balance sheets. Namely:
Gold savings that belong to the banks’ customers (Gold Accumulation Plans, GAP)
Gold inventory for the banks’ retail gold bar business
Gold leasing business
Gold held for hedging purposes
Gold held outside China
In this post we’ll examine more thoroughly the (Chinese and English) annual reports from 2007 until 2014 of the 16 banks, to learn more on what these huge tonnages represent. The most significant new finding is that Chinese banks conduct synthetic leases – in other words: swaps. By performing synthetic leases, Chinese banks can show “precious metals assets” but no “precious metals liabilities” on their balance sheets. Then, at the very surface it seems these banks own gold, in reality they own zero gold.
Also note, swaps can be executed with foreign banks, through which gold is subsequently imported into the domestic market. And because the Chinese banks have been importing thousands of tonnes in recent years, it should come as no surprise these trades have influenced the “precious metals” line item on their balance sheets.
More findings that will be addressed in this post are:
Chinese reported lease volume reflects yearly turnover.
Gold stored in Shanghai Gold Exchange (SGE) designated vaults owned by commercial banks does not to appear on the custodial bank’s balance sheet.
More confirmation some gold on the balance sheets is stored outside China.
My conclusion is that the “precious metals” on the Chinese commercial bank balance sheets do not account for the “surplus” gold in the Chinese domestic market Western consultancy firms pretend to be ignorant about. The Chinese banks do not own much gold of themselves, as some analysts have speculated, nor are these banks preparing for a new gold standard designed by the PBOC, according to my sources and analysis.
This post is divided in three segments. The first segment is about accounting, which supports the second segment about swaps and other gold related line items on the Chinese bank balance sheets. The first segment can be skipped if you already posses thorough knowledge on accounting. The third segment displays all the “precious metals” related data of the 16 bank balance sheets from 2007 until 2015.
I Accounting Background
Before we can discuss the details of the “precious metals” mentioned in the financial statements of the annual reports of the 16 banks, we need to do some studying on accounting structures (study the definitions of a financial statement, balance sheet, an income statement, assets/liabilities, financial assets/liabilities and derivative financial assets/liabilities). This study will prove valuable for future posts as well. The bank balance sheets are an important topic in the Chinese gold market; understanding accounting helps us to illuminate the Chinese gold market.
Financial statements of banks are divided in three main segments: abalance sheet, anincome statement and a cash flow statement.
On Investopedia we can read the definition of a balance sheet:
A balance sheet is a financial statement that summarizes a company’s assets, liabilities and shareholders’ equity at a specific point in time. These three balance sheet segments give investors an idea as to what the company owns and owes, as well as the amount invested by shareholders.
The balance sheet adheres to the following formula:
Assets = Liabilities + Shareholders’ Equity
A number of ratios can be derived from the balance sheet, helping investors get a sense of how healthy a company is. These include the debt-to-equity ratio and the acid-test ratio, along with many others. The income statement and statement of cash flows also provide valuable context for assessing a company’s finances, as do any notes or addenda in an earnings report that might refer back to the balance sheet.
An example would be, ICBC holding 1 tonne of gold in small ICBC brand bars as inventory for retail sales. This gold is an asset of ICBC.
Next to a balance sheet, banks disclose an income statement in their annual reports. From Investopedia we read:
An income statement is a financial statement that reports a company’s financial performance over a specific accounting period. Financial performance is assessed by giving a summary of how the business incurs its revenues and expenses …. It also shows the net profit or loss incurred over a specific accounting period.
Unlike the balance sheet, which covers one moment in time, the income statement provides performance information about a time period.
In example, ICBC buys gold at the SGE worth 1,000,000 RMB and has the metal recast in small 200 gram ICBC brand bars. If ICBC subsequently sells the newly casted bars for in total 1,100,000 RMB, then 100,000 RMB is profit and will be included in the income statement.
Cash flow is the net amount of cash … moving into and out of a business.
Total aggregated cash flows are measured over the course of a period, for example one year, as with the income statement. But unlike the income statement, it records all things related to cash flows. For example, if ICBC buys a new building worth 10,000,000 RMB, this will affect the balance sheet (cash decrease, asset increase) and the cash flow statement, but not the income statement.
Article 20 An asset is a resource that is owned or controlled by an enterprise as a result of past transactions or events and is expected to generate economic benefits to the enterprise.
“Past transactions or events” mentioned in preceding paragraph include acquisition, production, construction or other transactions or events. Transactions or events expected to occur in the future do not give rise to assets.
“Owned or controlled by an enterprise” is the right to enjoy the ownership of a particular resource or, although the enterprise may not have the ownership of a particular resource, it can control the resource.
“Expected to generate economic benefits to the enterprise” is the potential to bring inflows of cash and cash equivalents, directly or indirectly, to the enterprise.
Article 21 A resource that satisfies the definition of an asset set out in Article 20 in this standard shall be recognized as an asset when both of the following conditions are met:
(a) it is probable that the economic benefits associated with that resource will flow to the enterprise;
(b) the cost or value of that resource can be measured reliably.
Article 22 An item that satisfies the definition and recognition criteria of an asset shall be included in the balance sheet. An item that satisfies the definition of an asset but fails to meet the recognition criteria shall not be included in the balance sheet.
Financial assets/liabilities can be subdivided in several categories, such as financial assets/liabilities designated at fair value through profit and loss, financial assets/liabilities held for trading and derivative financial assets/liabilities. Financial assets/liabilities are included on the balance sheet and the change in fair value of most financial asset/liabilities will appear in the income statement. Not all banks subdivide financial assets/liabilities in the same manner. For example, ICBC lists “financial assets/liabilities held for trading” parallel to “financial assets/liabilities designated at fair value through profit and loss”. Other banks only disclose “financial assets/liabilities designated at fair value through profit and loss” as a total. The details on accounting are beyond the scope of this post.
Let’s have a look at an example of a financial liability. We’ll use plain gold leasing. Suppose ICBC borrows 1 Kg of gold for 1 year and instantly sells the gold at 280 RMB/gram. ICBC will then record a cash asset of 280,000 RMB and a financial liability held for trading of 280,000 RMB on its balance sheet. Say, after one month the gold price surges to 380 RMB/gram. For ICBC the cash asset remains at 280,000 RMB, but the bank will increase the carrying amount of the financial liability held for trading to 380,000 RMB. The 100,000 RMB, which is a loss, will go into the income statement. In the income statement there is a separate line for this called net profit or loss on financial assets or liabilities designated at fair value through profit and loss.
Derivative financial assets/liabilities on balance sheets must not be commingled with derivative instruments such as futures or forwards, of which the notional values are recorded off-balance sheet. Let me show how derivative financial assets/liabilities are acquired.
We’ll use futures as an example. Suppose ICBC buys long a SHFE gold futures (1,000 grams) contract at 280 RMB/gram on 1 November 2016 that is to expire in June 2017. The futures contract itself (derivative instrument) is recorded off-balance sheet, but the profit or loss arising from it creates a “derivative financial asset/liability” recorded on the balance sheet and the income statement. At 1 November 2016 the fair value of the futures contract is 0 because the future price has not moved yet so there is no profit or loss. The notional value of the futures contract is 280,000 RMB (1,000*280). On 1 November 2016 ICBC’s financial statement would be:
ICBC’s derivative financial asset/liability held for trading on the balance sheet = 0
Fair value ICBC’s derivative financial asset/liability held for trading recorded in the income statement’s “net profit or loss on financial assets or liabilities designated at fair value through profit and loss” = 0 RMB
Notional value of ICBC’s derivative financial instrument recorded off-balance sheet = 280,000 RMB
Suppose one month later, on 1 December 2016, the gold price has surged to 380 RMB/gram. ICBC is long gold so it will have a mark-to-market profit of 100,000 RMB. This profit will go into the income statement in “net profit or loss on financial assets or liabilities designated at fair value through profit and loss”. At the same time ICBC has created a derivative financial asset held for trading worth 100,000 RMB. (If gold would sink below 280 RMB/gram, ICBC would record a derivative financial liability held for trading.) On 1 December 2016 ICBC’s financial statement would be:
Derivative financial asset held for trading on the balance sheet = 100,000 RMB
Fair value ICBC’s derivative financial assets held for trading recorded in the income statement’s “net profit or loss on financial assets or liabilities designated at fair value through profit and loss” = 100,000 RMB
Notional value of ICBC’s derivative financial instrument recorded off-balance sheet = 380,000 RMB
Below you can view a balance sheet and an off-balance sheet account from ICBC’s 2015 annual report.
Having said this, the practice of categorizing precious metals assets and liabilities varies from bank to bank in China. Nevertheless, there are excellent observations to make from the financial statements of the banks. This will be quite complex, if I didn’t explain it properly, please refer to the introduction of this post that serves as a simplified summary.
Banks Do Synthetic Back-To-Back Gold Leasing Through Swaps
From the previous post, we know that gold leasing – mainly back-to-back borrowing and lending – overstates the precious metals assets and liabilities of Chinese banks. However, what was not mentioned in the previous post was that banks do synthetic back-to-back leasing through swaps. This way, it’s possible that banks that are active in the gold lending market, will show precious metals assets on their balance sheet – without precious metals liabilities, while not owning a single gram of metal themselves. The bank will syntheticallyborrow gold through a swap, and lend it out for a few extra basis points. The result is synthetic back-to-back leasing.
From a Chinese bank’s perspective a synthetic gold lease is conducted by borrowing RMB to buy spot gold, lend that metal to a customer, and at the same time sell short a forward contract. When the gold loan to the customer comes due the metal is returned to the bank, which then will be sold through the forward contract to repay the bank’s RMB loan. That’s the definition of a swap: buy spot and sell forward (sell spot and buy forward for the counterparty).
If gold is in contango, and the forward price is higher than spot, the Chinese bank will make a profit on the swap. However, in contango, the costs for the RMB loan transcend the swap profit. The difference between both is the cost equal to the gold lease rate (GLR). In my previous post Understanding GOFO And The Gold Wholesale Market we could read about these relationships (and the exact workings of swaps).
Fiat interest rate – swap rate = GLR
Effectively, by borrowing RMB for a swap the bank pays GLR to synthetically borrow gold.
As the international gold lease rate is likely lower than the gold lease rate in China, Chinese banks can make a profit by (synthetically) borrowing gold abroad, import the metal and lend it through the SGE system at a higher GLR. (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.)
For example, Minsheng Bank can synthetically borrow gold for 3 months from HSBC at GLR in the interbank market. When Minsheng lends the gold for 3 months to a jeweler at GLR + 30 BPs, then Minsheng earns 30 BPs in this trade.
In the real world, this is exactly what banks have been doing. Let’s still use Minsheng Bank as an example.Please view the table above. We can see Minsheng’s gold lease volume jumped from 13 tonnes in 2013 to 101 tonnes in 2014, and the precious metals assets surged from 2,913 million RMB in 2013 (~12 tonnes) to 25,639 million RMB in 2014 (~107 tonnes).The surge in precious metals assets was fully caused by the increment in the gold lease business, as can be seen in the excerpt below from Minsheng Bank’s 2014 annual report. All the numbers are in millions of RMB.
It’s disclosed the precious metals assets jumped from 2,913 million RMB in 2013 to 25,639 million RMB in 2014, due to a 22,726 million “increase in precious metals lease business”.
But note we can only see an increase in “precious metals assets” on Minsheng’s balance sheet (exhibit 4), there are no “precious metals liabilities”. This is because the gold lend by Minsheng was sourced through swaps. Minsheng didn’t literally borrow gold (precious metals liability), it swapped gold for RMB collateral.
This is how it works in Minsheng’s case. When it enters a swap transaction these are the spot and the forward legs to be recorded in the financial statement. Minsheng borrows RMB and buys spot gold to lend out to a customer at GLR plus a few basis points. At that moment a precious metals asset (the gold loan) is recorded on the balance sheet, but not a precious metals liability (the related RMB liability is not disclosed in exhibit 4). Simultaneously, Minsheng sells short a forward contract that is recorded off-balance sheet. In due time the gold loan is repaid, the forward settled, etc.
The off-balance activities are shown in exhibit 4, additionally they’re disclosed in Minsheng’s financial statement to be viewed below. Again all numbers are in millions of RMB.
We can see that the large increase in precious metals derivatives trading from 2013 to 2014 was mainly caused by “3 months to 1 year” “forwards and swaps”, of which most have been swaps used for synthetic back-to-back leasing.
Exhibit 5 shows there was a 22,726 million RMB (~ 94 tonnes) increase in leases from 2013 to 2014. Exhibit 6 shows ~ 24 billion RMB (~ 100 tonnes) in “3 months to 1 year” swaps have been executed in 2014, over zero in 2013. Likely, the majority of the swaps have been in tenors close to 1 year, as by 31 December 2014 roughly 107 tonnes in precious metals assets were on the balance sheet.
In 2014 the “3 months to 1 year” “cash inflow” (Minsheng’s sell forward leg) transcended the “cash outflow” (buy spot leg) because gold was in contango that year in China. (Exhibit 6)
Perhaps you have noticed that Minsheng Bank counts only 1 leg of the gold swap off-balance sheet. Yes, if we compare the total “precious metals forwards and swaps” “cash outflow” 32,865 million RMB with the total notional amount in precious metals derivatives off-balance sheet, 32,844 million RMB, the two numbers are roughly equal.
All in all, at the surface it seems Minsheng Bank holds approximately 100 tonnes in precious metals assets, in reality this is merely reflecting synthetic back-to-back leasing through swaps. More proof there can be little “surplus” gold on the commercial banks balance sheets.
As long as Chinese annual lease volume grows, the commercial bank balance sheets can mushroom as a consequence.
Chinese Lease Volume Reflects Yearly Turnover.
In the past there has been some doubt whether the reported Chinese gold lease volume reflected the total turnover over a certain period, or the gold that has been leased out at a certain point in time. Already in May 2015 I wrote China’s reported gold lease volume reflects turnover – because traders at Chinese banks told me – and now there is more confirmation to be presented. From Minsheng Bank’s financial statements we can understand that the gold lease volume means the lease turnover per annum. Have another look at exhibit 4.
Minsheng bank leased out 116 tonnes of gold in 2015, which was an increase from 2014. But at the end of 2015, the “precious metals assets” wherein gold leasing is recorded, decreased to 83 tonnes. This can only be possible if the lease volume is annual turnover. Apparently, in 2015 Minsheng’s leasing business grew, but it conducted more deals in tenors shorter than 1 year, causing the annual turnover to increase (to 116 tonnes) but the outstanding leases at year-end on the balance sheet to decline from the previous year.
The World Gold Council (WGC) seems the have come to the same conclusion recently. In the Gold Demand Trends Q2 2016 report, it stated (page 15) the gold lease volume “captures the total amount of gold leased in the reporting period, for example, if Commercial Bank A lends 1t to Jeweller B for three months and Jeweller B returns it back for the Commercial Bank A to lend again to Bank C, a total of 2t of leasing volume will be recorded for the period”. This confession by the WGC is remarkable, because from April 2014 until early 2016 the WGC was spreading a myth about the gold involved in the Chinese lease market. From the WGC’s China’s Gold Market Progress And Prospects, April 2014:
No statistics are available on the outstanding amount of gold tied up in financial operations [leases] linked to shadow banking but Precious Metals Insights believes it is feasible that by the end of 2013 this could have reached a cumulative 1,000t.
While at it, the WGC admitted most of the leased gold doesn’t leave the SGE vaults:
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 for cash settlement.
This is what I’ve written since February 2015: gold leasing has little impact on SGE withdrawals, as the vast majority of leases are for financing purposes and are thus settled within the SGE system.
Gold In SGE Vaults Is Not On The Custodian’s Balance Sheets
In China, most of the SGE vaults are actually owned by commercial banks but approved by the SGE as “designated vaults”. In addition there are other types of enterprises that own “SGE designated vaults” – probably jewelry companies in Shenzhen, the heart of China’s jewelry manufacturing industry. In my previous post I shared the possibility that SGE vaulted gold appears on the balance sheets of custodian commercial banks. But further research has pointed out that is not the case. SGE vaulted gold does not appear on the balance sheet of the custodians, only on the balance sheet of the owner.
As has been written at the beginning of this post, in order for a custodian, in this example ICBC, to recognise the gold owned by another entity, in this example BOC, in its SGE-designated vault as an asset, the gold has to be “owned or controlled” by ICBC. In reality ICBC wouldn’t have any ownership of this gold. ICBC would have, to a certain extent, some control over BOC’s gold, but in order for ICBC to recognise the gold as an asset on its balance sheet, it should be “probable that the economic benefits associated with that resource will flow to the enterprise”. In other words, ICBC should be able to sell or lease out BOC’s gold in its vaults to record the metal as asset. Though, an SGE custodian would never go there or its business would collapse promptly.
There is more confirmation. On the balance sheet of Ping’ An Bank, the volume of precious metals holdings for 2011 and 2010 were both nil. At the same time, according to Ping’ An’s annual report of 2010, its total gold withdrawals ranked No. 8 among all SGE designated vaults.
Gold vaulting service keeps increasing and the withdrawal number is listed the eighth among SGE designated vaults.
And in 2011 Ping’ An’s gold deposit and withdrawal total accounted for 10% of all SGE warehouse activity. It is hard to believe that Ping’ An had no gold in its SGE-designated vaults at the end of 2010 and 2011, while Ping’ An’s vaults were such an important part of the SGE system. Concluding, Ping’ An didn’t recognize other SGE clients’ or members’ gold in its vaults as its assets. Hence we have for 0 for Ping’ An’s precious assets in 2010 and 2011.
Some readers may point out the following paragraph in ICBC’s 2015 annual report:
The Group records the precious metals received as an asset. A liability to return the amount of precious metals deposited is also recognised.
The group recognises an asset when the group receives the precious metals deposited by the customer for accumulation, and at the same time recognises the related liability.
Therefore, ICBC was actually referring to the gold in its Gold Accumulation Plan (GAP) and the key information was lost in translation.
Gold in Chinese ETFs is neither recognized by its custodian as an asset.
Some Of Chinese Banks’ Gold Is Indeed Outside China
I mentioned in the previous post that some of Chinese banks’ precious metals holdings could be outside China. ICBC acquired Standard Bank in 2015 and Standard Bank’s precious metals are outside China. However, even some medium-sized Chinese banks hold precious metals outside China. The following table is from Ping’ An’s 2014 annual report (page 196, numbers are in millions of RMB).
What we see is that Ping’ An held gold assets in US dollars worth 2,420 million RMB. The disclosed “foreign exchange equivalent” for Ping’ An’s precious metals would only be mentioned like this if the precious metals are held outside China. If the precious metals would have been located inside China, Ping’ An never would have listed the value of the assets as “USD (in CNY equivalent)”.
We will not extensively analyze every Chinese bank’s financial statement like we’ve done with Minsheng Bank and Ping’ An Bank above, though I do like to share all the data I’ve collected. The practice of categorizing precious metals assets and liabilities varies from bank to bank so readers should pay attention to the notes below the tables and are recommended to read the original annual reports for more information. The derivative instruments are listed according to the notional amount (off balance sheet) instead of the fair value. The notional amount is not comparable between banks because for swaps, some banks only consider one leg while others add both the spot and forward legs, for example Bank of Ningbo, together.
Assuming all precious metals mentioned are gold related.
1. Industrial and Commercial Bank of China (ICBC)
We can observe ICBC precious metals assets started to transcend its financial liabilities related to gold in 2014. The possible causes are increases in ICBC brand gold bar sales (more inventory), customers purchased more options (ICBC would need to buy more gold to hedge), and more synthetic gold leasing.
2. Bank of China (BOC)
“Commodity derivatives and others” were called “precious metals derivatives and other derivatives” before 2010. BOC doesn’t have any significant numbers related to precious metals in financial liabilities designated at fair value through profit and loss.
Noteworthy, at the end of 2007 BOC had 7,982 million RMB (~ 41 tonnes of gold) in precious metals pledged as collateral, and late 2009 this figure had grown into 27,271 million RMB (~ 114 tonnes of gold). The precious metals were used as collateral in swap transactions for financing, according BOC’s accounting practice.
Precious metals swap transactions, based on the transaction nature, are treated as precious metals sales under collateral agreement. The precious metals pledged as collateral are not ceased to be recognized and the related liability is reflected in “borrowings through interbank lending”
3. Bank of Communications
Bank of Communications lists precious metals assets in two separate categories. I’m not sure what is identified with “precious metals contracts”.
Bank of Communications reported in its 2013 annual report that it conducted overseas gold swap business:
[Bank of Communications] successfully conducted overseas gold swap transactions.
In 2013, Bank of Communications conducted gold interbank lending with HSBC and HSBC became the most important source of physical gold for the Bank of Communications:
The two parties [Bank of Communications and HSBC] not only conducted “first deal” cooperation in gold consignment and gold borrowing, but also realized surging cooperation volume. HSBC has become an important import source of physical gold for the bank.
4. China Construction Bank
Not everything in the “other derivatives” category are precious metals.
China Construction Bank (CCB) wrote in its annual reports that the market share of physical sales to the public was No. 1 in 2010, and in the same year the market share of gold leasing was 40 %. From CCB’s 2010 annual report:
The Bank [China Construction Bank] has maintained the rank of No 1 in branded physical gold to individuals. The market share of gold leasing was 40.30 %. The market share of account gold was 37.41 %.
CCB offered physical withdrawal on precious metals accounts since 2013 and its own gold accumulation plan since 2015.
5. Agricultural Bank of China
Before 2014 “precious metals contracts” were called “precious metals lease contracts”. Not sure what “precious metals contracts” can be next to “precious metals lease contracts” – perhaps SGE physical contracts like Au99.99.
Before 2011, precious metals derivatives were reported separately as forwards and swaps. The precious metals lease business was reported to be launched in 2010.
6. Shanghai Pudong Development Bank
The change in “Financial liabilities at fair value through profit and loss” was caused by precious metals shorts (?) according to Shanghai Pudong Development Bank’s annual reports.
7. China Merchants Bank
The increase in “precious metals assets” was caused by the increase in proprietary trading and gold lease according to the annual reports. From China Merchants Bank’s 2014 annual report:
In 2013, China Merchants Bank reported to have conducted precious metals leasing of 60 tonnes, a 203 % increase from 2012.
8. China Minsheng Bank
The fine data was discussed in the previous chapter.
9. Industrial Bank
The 644 million RMB precious metals related liabilities were caused by “gold pledge business” according to Industrial Bank’s 2008 annual report.
“Precious metals shorts and leased precious metals” are a subcategory under “financial liabilities held for trading”.
10. China CITIC Bank
According to the annual reports, the surge in the precious metals and precious metals contracts in 2014 was caused by the increase of precious metals lease and proprietary business.
In the reporting period, the gold lease business and precious metals proprietary trading business all achieved rapid growth.
11. Ping’ An Bank (former Shenzhen Development Bank)
Before 2014 precious metals derivatives were called gold derivatives. Before 2009, Ping’ An only gave a lump sum of all the derivatives. Just in case there were any gold derivatives in this category, I’ve included the lump-sum numbers.
The increase in the “financial liabilities designated at fair value through profit and loss” in 2013 was caused by the increase in “financial liabilities held for trading” related to “gold business”, according to the annual report. Therefore all the numbers in “Financial liabilities designated at fair value through profit and loss” are listed here, although this category may include some liabilities not related to precious metals. From Ping’ An’s 2013 annual report:
12. Huaxia Bank
The precious metals assets in 2007 and 2008 were a result from physical gold sales according to the annual reports.
13. Everbright Bank
According to the annual reports, Everbright Bank started to conduct gold consignment sales and gold leasing in 2013. Therefore, the increase in precious metals holding in 2013 was probably caused by these activities. From to Everbright Bank’s 2013 annual report:
[Everbright Bank] acquired the gold import qualification, started to conduct gold consignment and gold lease business.
14. Bank of Beijing
Clearly the Bank of Beijing participates in back-to-back leasing, as precious metals leased out are exactly equal to precious metals leased in.
15. Bank of Nanjing
The Bank of Nanjing only disclosed 6 million RMB in precious metals assets in 2014 and 7 million RMB in 2015.
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.
My research into the Chinese gold market started in 2013 when I noted the significance of a number published on a weekly basis in the Chinese Market Data Weekly Reports on the website of the Shanghai Gold Exchange (SGE) regarding the amount of physical gold withdrawn from the vaults. It appeared to me the total amount of gold withdrawn from the SGE vaults on a yearly basis exactly equaled total Chinese gold demand as disclosed in the China Gold Market Report. Consequently, weekly SGE withdrawals served us as an interim indicator for total Chinese (wholesale) gold demand. Subsequently, I started publishing SGE withdrawals every Friday, accompanied with an analysis about the Chinese gold market, which gradually exposed the true size of the Chinese physical gold market. By 2015 the whole gold space was focused on SGE withdrawals!
In addition, genuine Chinese gold demand greatly exceeded Chinese gold demand as reported by the World Gold Council, whose supply and demand data is tracked by most investors around the world. The discrepancy stimulated me to thoroughly investigate the Chinese gold market and SGE withdrawals. Throughout the years all evidence I collected pointed in the same direction; Chinese gold demand is roughly twice as much as what was widely assumed across the globe and SGE withdrawals provide a spy-hole to track the Chinese gold market! However, at the same time my findings were spreading through the gold space the Chinese slowly started to cover their tracks.
After the crisis in 2008 it became even more apparent in the higher echelons of the Communist Party that the international fiat monetary system was not sustainable. The development of the Chinese gold market, that has its roots in the late seventies but leaped forward in 2002 when the SGE was erected, had to accelerate to protect the Chinese economy from future turmoil. Being the second largest economy globally but in arrears regarding physical gold reserves – as a result of a closed market since the Communist Party came in power in 1949 – China has a strong motive to buy gold in secret. For, if they would openly buy the volumes they do the gold price would swiftly be affected, damaging China’s window of opportunity in coming on par with Western gold reserves.
And so, the Chinese decided to roll out more measures to hide their insatiable gold demand. On top of being dishonest about their true official gold reserves and eclipsing gold import data in regular customs reports, the Chinese ceased publishing the (English) China Gold Market Reports and SGE Annual Reports – and by 2014 all existing reports were taken offline. The yearly (Chinese) Gold Yearbook by the China Gold Association was no longer digitally published, only in hard copies. When I asked my contact at the SGE last year if I could purchase a copy of the China Gold Market Report I was told, “due to new regulatory measures the reports are not publicly available anymore”. Be aware, in all the aforementioned reports total Chinese gold demand consistently equals SGE withdrawals – confirming the significance of SGE withdrawals – and the reports exactly disclose total Chinese gold import.
SGE Withdrawals Not Disclosed In Most Recent Data
But hiding the reports was not enough for the Chinese gold market architects. Apparently, the publishing of SGE withdrawals had to be discontinued, as it simply attracted too much attention to the true size of the Chinese physical gold market. The (Chinese) Market Data Weekly Reports on the first two trading weeks of 2016 at the SGE listed no withdrawal figures.
In an announcement on the SGE website from 11 January 2016 it stated the giant bourse would henceforth publish its weekly “delivery amount” (total deliveries from both spot deferred products and physical products) and “load-out volume” (withdrawals). Though in week 1 there was no “load-out volume” published and the disclosed “delivery amount” excluded delivery of physical products as I reported last week. The reporting by the SGE in week 1 did not match the announcement.
The 2016 week 2 report is different, now it seems the top left number (247,201.86 Kg) in the overview table indeed resembles total deliveries of all spot deferred products (114,536 Kg) plus total deliveries of all physical products (182,833 Kg). Yet, the sum of both deliveries is 297,359 Kg according to my calculations, not 247,203 Kg. So, I’m probably missing something, in any case SGE withdrawals are not disclosed!
When I called the SGE I was told the “load-out volume” (withdrawals) will not be published anymore, a statement that matches the new reports. This is a disaster for the gold community. SGE withdrawals provided a unique transparent metric for Chinese gold demand and it’s gone. However, the fact the Chinese stopped publishing SGE withdrawals once again strongly confirms the importance of these numbers from the past! Until December 2015 these numbers gave us a direct measure of Chinese wholesale gold demand. The truth became a little uncomfortable for the Chinese.
Ah well, I guess I’ll be focusing more on other gold markets from now on
As China doesn’t publicly disclose how much gold it imports, we have to combine the foreign trade statistics from all large gold exporting nations to figure out how much is flowing to China. The second largest gold producer in the world is Australia with an annual production of 270 tonnes, according the US Geological Survey. The majority of Australia’s mine output is exported.
When it comes to Australia’s net gold export to China we’ll have to do some analysis, simply subtracting import from export won’t work in this case. Strangely, Australia discloses gold shipments as “export to China” even when it’s transferred via Hong Kong. Implying Australia records its gold export by country of destination, not the first stop, which is not common to my knowledge. To offset any double counting – Australia gold export to China plus Hong Kong gold export to China – we need to cross-check foreign trade statistics.
Let’s compare data from COMTRADE on Australia’s gross gold export to Hong Kong with data from the Hong Kong Census And Statistics Department on Hong Kong’s gross gold import from Australia. Normally, these two data sets would be equal. But they’re not. Have a look at the chart below.
Australia reports to export a lot less to Hong Kong than Hong Kong reports to import from Australia. I should mention these mismatches are not unusual in global gold trade, though in this instance there is an obvious explanation.
When we compare data from COMTRADE on Australia’s gross gold export to China with data from the Hong Kong Census And Statistics Department on Hong Kong’s gross gold import from Australia, remarkably we can see matching values in nearly all months until January 2015. Have a look at the chart below (please focus on the months until January 2015 for now).
At this point we can conclude that Australia (COMTRADE) disclosed gold shipments as “export to China” from January 2013 until December 2014 even though these first arrived in Hong Kong. How do we know the exports from Australia to Hong Kong were re-exported to China mainland (the SGE system)? Because Australia does make a difference between Hong Kong and China for its gold export, it just doesn’t reveal the transfer. If Australia’s gold export to Hong Kong wasn’t re-exported to China mainland after its ‘initial arrival’ Australia would not have disclosed the trade as “export to China”, but as “export to Hong Kong” or “export to XXX”.
By the cross-check presented above we have established all gold Australia exported to China from January 2013 until December 2014 was shipped via Hong Kong. Subsequently, if we would add Hong Kong’s “export to China” to Australia’s “export to China”, in order to compute Chinese gold import, this would result in double counting.
At least for the past decades Hong Kong has been the main entry point for (non-monetary) gold into China. This 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 the UK:
The strategic move from Beijing to stimulate direct imports was also mentioned on Chinese state television channel CCTV in early 2014, in the clip below starting from 1:30.
Whenever Australia exported gold to China mainland before 2014 it was shipped via Hong Kong (see exhibit 2). After early 2014 gold exports from Australia to China could travel directly. Tellingly, what Australia (COMTRADE) reported as “export to China” since January 2015 has exceeded what Hong Kong reported as “import from Australia”. According to my analysis the difference reflects what Australia has directly exported to China mainland. In exhibit 2 we can see that for the months after December 2014 Australia’s direct gold export to China increased.
By subtracting Hong Kong’s “import from Australia” from Australia’s “export to China”, what remains is what Australia directly exported to China, which is the figure we were looking for. (By and by, Australia’s gross import from China and Hong Kong is close to nil.)
From the data shown in exhibit 2 we can compute Australia directly net exported 61 tonnes of gold to China mainland In the first 7 months of 2015.
Everything there is to know about the Chinese gold market and the true size of Chinese private and official gold demand. Start here.
This post will guide you through all relevant articles that have been published on BullionStar Blogs over the years that elucidate the mechanics of the Chinese (domestic) gold market and genuine Chinese gold demand. If you are new to the Chinese gold market or like to refresh your memory, this post provides a staring point from where to navigate through all segments of the Chinese gold market you like to study. For example, Chinese gold demand metrics, the Shanghai Gold Exchange (SGE) system, Chinese cross-border gold trade rules, the Chinese gold lease market and official gold reserves held by China’s central bank the People’s Bank Of China (PBOC).
The BullionStar blog posts that collectively clarify all facets of the Chinese gold market are titled Chinese Gold Market Essentials. Whenever the mechanics of the Chinese gold market develop all Chinese Gold Market Essentials will be updated or new ones will be published, as to remain a comprehensive knowledge base on the largest physical gold market in the world at all times. All Chinese Gold Market Essentials have been recently rewritten and the post on PBOC gold purchasescontains many very important new insights.
Topical data such as monthly Chinese gold import numbers will not be updated in the Chinese Gold Market Essentials, however, this data will be published in new blog posts appearing on my BullionStar Blogs homepage, accompanied with a link to this webpage to be complete.
If there is anything unclear, if you have additional information or if you have a suggestion to improve the Chinese Gold Market Essentials, please send me an email at firstname.lastname@example.org.
Understanding The Chinese Gold Market Step By Step
The unique structure of the Chinese domestic gold market, the SGE system, and why the amount of physical gold withdrawn from the vaults of the SGE (published on a weekly basis) can be used as a measure for Chinese wholesale gold demand is explained in part one:The Mechanics Of The Chinese Domestic Gold Market. It also provides a basic understanding of contrasting metrics applied to measure Chinese gold demand, and the difference between SGE withdrawals and Chinese consumer gold demand as disclosed by the World Gold Council, which has aggregated to at least 2,500 tonnes from 2007 until 2015. For whatever reason, the World Gold Council and its affiliates continuously present feeble arguments that should explain the difference. The Chinese Gold Market Essentials debunk these arguments where necessary, back up by facts, and reveal genuine Chinese gold demand.
More detailed rules regarding cross-border gold trade in and out of the Chinese domestic gold market and Free Trade Zones in China are discussed in part two: Chinese Cross-Border Gold Trade Rules.
When fully comprehending the mechanics of the Chinese domestic gold market and Chinese cross-border gold trade rules you can continue reading Workings Of The Shanghai International Gold Exchange about the international subsidiary exchange of the SGE set up to become the major gold trading hub in Asia. Related is SGE Withdrawals In Perspective that discusses how trading activity on the Shanghai International Gold Exchange (SGEI) can potentially blur our view on Chinese wholesale gold demand when measured by SGE withdrawals.
Finally, please read PBOC Gold Purchases: Separating Facts from Speculationfor studying the amount of gold accumulated by China’s central bank in recent years in addition to private reserves. At the end of the post you can find an overview of the estimated amounts of above ground gold in China (privately owned gold and official holdings).This post has collected many new contributions in recent months, a must read!
Not surprisingly there is little official documentation on the recently launched Silk Road Gold Fund. However, the translation below (original article published on ifeng) provides an intriguing insight at what this Fund is about. On May 22 Chinese financial policy makers from the PBOC, Chinese gold industry executives from commercial banks, mining companies, the Shanghai Gold Exchange and the China Gold Association together with representatives of the Western gold industry discussed gold’s future role in finance and how it will serve the New Silk Road Initiative.
Representatives from gold and financial institutions talked freely about bringing gold’s superiority into full play, seizing the historic and strategic opportunity of the “One Belt And One Road”…
The holding of the conference enhanced the communication and cooperation between the western gold industry and countries along the line of the “One Belt And One Road”, clarified the development direction of the gold industry under the economic background of the new normal … and unlocked a new chapter of the gold industry development.
Largest Domestic Special Fund of Silk Road Positioned in Xi’an For Assisting “One Belt And One Road”
In the afternoon of May 22, the “One Belt And One Road” Conference of Promoting Gold Industry Development & Launching Ceremony of Silk Road Gold Fund hosted by Shanghai Gold Exchange and Shaanxi Provincial Government and co-hosted by Shaanxi Gold Group Incorporation Co., Ltd. was held grandly in Xi’an. As an important part of the Investment & Trade Forum for Cooperation between East & West China and the Silk Road International Expo agenda, the conference officially initiated the Silk Road Gold Fund with the subject of “Serve the New Strategy of the Silk Road, Lead the New Development of the Gold”; discussed the innovative thinking and specific measures on grasping the great development opportunities of “One Belt And One Road” and enhancing the synergetic development with the gold industry of the countries and regions along the line of “One Belt And One Road” under the new normal of the economy, and initiated the new era of the gold industry development.
Wei Minzhou, Standing Committee member of Shaanxi Province and municipal party secretary of Xi’an, attended the conference and gave a speech; deputy head of the financial market department of People’s Bank of China Zou Lan gave a speech about the consistent support on the sustainable and healthy development of China’s gold market; vice president of the Shanghai Gold Exchange Song Yuqin made a keynote speech that profoundly analyzed the development direction of China’s gold market and the policies on the gold industry; Sun Feng, chairman of the Shaanxi Gold Group, addressed the development report of the Shaanxi Gold Group; vice president of precious metal department of Industrial and Commercial Bank of China Qiu Yi gave his report on how to adapt to the new normal and how to develop new business. Chairman of Shaanxi Non-ferrous Metal Holding Group Co., Ltd Huang Xiaoping, vice chairman of China Gold Association Cui Jianguo, president of Industrial and Commercial Bank of China Shaanxi Branch Shang Jun, president of Bank of China Shaanxi Branch Li Ruiqiang, Industrial Bank Co., Ltd. Xi’an Branch Guo Qiujun and president of Industrial and Commercial Bank of China Sinkiang Branch Sun Jianyong gave their speech successively; Chen Yumin, general manager of the Shandong Gold Group, introduced the basic information of the Silk Road Gold Fund. Representatives from gold and financial institutions talked freely about bringing gold’s superiority into full play, seizing the historic and strategic opportunity of the “One Belt And One Road”, strengthening the bank-enterprise cooperation and financial-industrial combination, and leading the transformation and upgrading of the gold industry under the economic background of the new normal.
During the conference, vice governor of Shaanxi Provincial Government Wang Lixia and vice president of the Shanghai Gold Exchange Song Yuqin signed the agreement of comprehensively enhancing the strategic cooperation of the gold industry, which indicated promoting the Shaanxi gold industry to be superior and strong by establishing the fixed cooperative mechanism, setting up gold trading center, etc. Shaanxi Gold Group signed the comprehensive strategic cooperation agreement with 8 banks as Shaanxi Branch of ICBC, Sinkiang Branch of ICBC, Shaanxi Branch of CCB, Shaanxi Branch of Bank of China, Shaanxi Branch of Bank of Communications, Xi’an Branch of Industrial Bank Co., Ltd., Bank of Xi’an and Shaanxi Rural Credit Cooperative Union.
As an important agenda of this conference, Shandong Gold Financial Holding Capital Management Co., Ltd., Shaanxi Gold Group Incorporation Co., Ltd., China Industrial Asset Management Limited, China Industrial Wealth Asset Management Limited, Western Capital Investment Co., Ltd. and Shenzhen Gold Information Group Co., Ltd. signed the Sponsorship Agreement of the Xi’an Silk Road Gold Fund Management Co., Ltd. The guests activated the specially designed trigger and initiated the Silk Road Gold Fund in the form of turning stone into gold by touching. The Silk Road Gold Fund, with the Shanghai Gold Exchange as the leading initiator and the win-win cooperation of the Shandong Gold Group with the strongest comprehensive strength in domestic gold industry and the Shaanxi Gold Group with regional advantage, attracted large financial institution to work together on its establishment.“The Silk Road Gold Fund” (hereinafter short as “Fund”) will raise and manage one mother Fund and several sub-Funds, including a Gold ETF Fund, Gold Resource Merger and acquisition Fund, Gold Investment Fund, etc. The Fund will be issued in 3 phases with the first phase as 5 billion yuan, second phase as 30 billion and estimated gross as 100 billion, and it will become the largest gold fund in the domestic gold industry.
The holding of the conference enhanced the communication and cooperation between the western gold industry and countries along the line of the “One Belt And One Road”, clarified the development direction of the gold industry under the economic background of the new normal, and facilitated the western gold industry and gold market to grasp the opportunity under the motivation of the grand pattern of “One Belt And One Road”, it added new vitality and injected new energy to the prosperity of the development of the gold industry and gold market of China, and unlocked a new chapter of the gold industry development.
On April 4, 2014 Alasdair Macleod published an extensive analysis on the Chinese gold market. I felt obligated to respond to it by sharing my point of view and explain where I disagree with his analysis. I think his estimates are largely overstated because he double counts certain demand categories. He states Chinese gold demand in 2013 was 4843 metric tonnes, according to me it was 2197 metric tonnes (my estimate excludes some hidden demand and PBOC purchases on which I have no hard numbers). Setting out our differences was incidentally a good occasion for me to write another in-depth analysis on the Chinese gold market.
I highly respect Macleod, who was probably working in finance when I was in diapers, and I’m very grateful he has been using my findings about SGE withdrawals and the structure of the Chinese gold market. I see very little commentators stepping into this realm, though it’s truly the most important economic event happening in our time. Having said that, my concern is the accuracy of the data being spread. I present my analysis:
For all clarity please note I make a clear distinction between deliveries and withdrawals since a couple of months, as they do not relate to the same data. The SGE uses the term deliveries inconsistently which has caused for confusion.
Let’s go through the aspects of the Chinese gold market in random order; PBOC demand, the SGE, domestic mining, mainland net import and Hong Kong trade.
PBOC Gold Purchases
Macleod states all Chinese domestic mine supply is soaked up by the PBOC, according to my analysis this is not likely to be the case.
The main objectives for the PBOC to accumulate gold are:
– Supporting the renminbi for its internationalization (adding trust and credibility)
– Owning hard currency as the cornerstone of capitalism.
– Owning reserves that protect the Chinese economy from external/internal shocks and inflation.
– Owning reserves that are not controlled by a foreign nation (the US).
– Diversifying its excessively large USD reserves prior to an irrevocable USD devaluation.
– Hedge their exorbitant USD reserves.
In my opinion the PBOC (or its proxies SAFE and CIC) does not purchase gold from domestic mines or from the SGE. The PBOC’s incentive is to exchange USD’s for gold, preferably buying undervalued gold with overvalued dollars. Hence the PBOC buys in utmost secrecy, not to affect the market.
It wouldn’t make sense for the PBOC to buy gold from domestic mines because they would have to pay in RMB. This wouldn’t fit all their objectives mentioned above. Additionally Chinese law dictates all domestic gold mining output is required to be sold through the SGE (page 15). Last, I personally have never come across any evidence the PBOC has bought domestic mine supply in recent years.
Before the liberalization of the Chinese gold market in 2002 the PBOC did buy all domestic mine supply because the PBOC had the monopoly in the Chinese gold market; the PBOC was the Chinese gold market. A brief history lesson from SGE president Wang Zhe in 2004:
In April 2001, the governor of the PBOC announced the abolishment of the gold monopoly with a planning management system. In June of that year, the weekly quotation system for the gold price officially came into operation, which adjusted the domestic gold price in accordance with the price on the international market. The Shanghai Gold Exchange (SGE) officially opened on 30 October 2002, representing an important breakpoint in the revolution of China’s gold system, and reflected the great progress being made.
From chairman of the SGE board, Shen Xiangrong, in 2004:
After the PBOC abolished the monopoly on gold allocation and management, the SGE assumed the basic role of allocation and management of gold resources, stipulating the healthy and orderly development for gold production, circulation and consumption.
When the SGE was launched in 2002, the gold market wasn’t liberalized overnight, as one can imagine. It took a couple of years before the market functioned as the PBOC had intended. The intensions were, inter alia, to let the free market set prices and all imported and mined gold was required to be sold first through the SGE. The reason to channel fresh gold (import and mine supply) through one exchange is to keep track of the gold added to non-government reserves (jewelry, bar hoarding, institutional buying, etc). By requiring all fresh gold to flow through the SGE the PBOC can efficiently supervise the quality and quantity of the gold that enters the Chinese market place. The PBOC wants to know exactly how many grains of fine gold are being held among the people. Additionally scrap gold is allowed to be sold through the SGE, but because this type of supply doesn’t affect reserves, it isn’t required to be sold through the SGE (it doesn’t have to be monitored).
The structure of Chinese physical gold market with the Shanghai Gold Exchange at its core entails SGE withdrawals equal Chinese wholesale demand. This has been published by the SGE Annual Reports, China Gold Market Reports and CGA Gold Yearbooks 2007-2011 (I’ve written and extensive analysis on this theorem which you can read here). Unfortunately only a fraction of all these reports is publically available; if you study the rest and gather all bits and pieces you can make an informed analysis.
Through analysing data from 2002 to 2011, after 2011 the Chinese were reluctant to publish reports as this information became too sensitive, we can clearly see how the SGE and the Chinese gold market have developed.
The next table is from the China Gold Association (CGA) Gold Yearbook 2006.
I made a translated version:
Whilst we can see that SGE withdrawals grew from 2002 to 2006, moreover the table exposes SGE withdrawals grew relative to total supply.
The next table shows SGE withdrawals compared to total demand; the top row shows SGE withdrawals, note another typo, the bottom row is SGE withdrawals relative to (%) total demand. These tables illustrate the PBOC’s intention to match supply, SGE withdrawals and demand. Although they didn’t immediately succeed in 2002 when the gold market started to liberalize, in 2007 the CGA reported for the first time SGE withdrawals equalled demand for 100 %. As mentioned before, in the years after 2007 this continued to match (as I have demonstrated here)
In 2007, the amount of gold withdrawn from the vaults of the Shanghai Gold Exchange, gold demand of that year, was 363.194 tonnes of gold, compared to 2006 increased by 48.02 percent, 8.82 percentage points lower than the growth rate of supply.
Regular readers of my research are familiar with the equation:
In this post I will show/repeat two examples to proof this equation. Example one; this is a quote from the China Gold Market Report 2008:
For the sake of simplicity I left stock carry-over out of my equation. Second example; this is a screen shot from the China Gold Market Report 2010:
It states domestic mining output in 2010 was 340.88 metric tonnes, 40.72 % of total supply, net import (others) was 240 tonnes and total supply was 837.20.
Now let’s have a look at SGE withdrawals in 2010. From The SGE Annual Report 2010:
Exactly 837.2 metric tonnes. Last but not least, total demand as disclosed by the China Gold Market Report 2010:
Also 837.2 metric tonnes! We know this 100 % match has occurred from 2007 to 2011 by reading the reports from those years. There are no signs SGE withdrawals stopped matching total supply and demand ever since. In 2013 total SGE withdrawals accounted for 2197 metric tonnes (boxed in red, Kg – 本年累计交割量)
My point being, I think all this clearly exposes Chinese domestic mine supply is being sold through the SGE, not to the PBOC. Does the PBOC purchase gold on the SGE? I don’t think so because all physical gold on the SGE is quoted in RMB and, again, it wouldn’t fit the PBOC’s objectives mentioned above to exchange RMB for gold. On top of that I have several sources in the mainland, including a teacher in economics and the gold market at the Henan University of Economics and Law in Zhengzhou City, that all tell me the PBOC would never buy gold on the SGE.
Commercial banks like ICBC do offer a few trading products in USD, but these do not incorporate physical delivery/withdrawal. These products merely offer Chinese citizens and businesses more trading flexibility.
The PBOC (or SAFE) is more likely to make gold purchases overseas in exchange for USD; this way they can fulfill all their objectives. It’s not hard for the PBOC to do this without the shipments showing up in global trade data.
The UK net exported 1425 metric tonnes in 2013, most of which ended up in China. When looking at UK trade we should bear in mind these enormous amounts of gold exclude monetary gold.
All data I gather from the SGE, UK customs, Switzerland customs and Hong Kong customs do not relate to any PBOC purchases (click here to see how much gold was exported from the UK, through Switzerland, through Hong Kong to the mainland in 2013). The amount of gold bought by Chinese consumers, investors and institutions I can make fairly good estimates for (it simply equals SGE withdrawals).
My estimates on PBOC official gold holdings are pure guessing, based on common sense and anecdotal stuff (though it doesn’t take a rocket scientist to know the PBOC has increased it gold holdings since 2009, when it was last updated to 1054 metric tonnes). More on that later.
In Macleod’s article there is much emphasis on SGE vaulting, though to my knowledge this amount is currently unknown. This is how the SGE works: SGE members make gold deposits, they sell this gold and the buyers have the option to withdraw the gold from the vaults. From the data I have we know yearly SGE deposits and withdrawals have been approximately the same from 2007 to 2011. Deposits can transcend withdrawals as some SGE account holders purchase Au (T+D) deferred contracts, perhaps later withdrawing the gold. Withdrawals can transcend deposits because there can be stock carry-over from previous years (see exhibit 4).
The SGE does not own its own vaults. There are merely SGE designated vaults owned by, for example, commercial banks. Needless to say, SGE withdrawal data relates to physical gold that leaves SGE designated vaults.
The next table is from Macleod’s article.
First of all he mixes deposit and withdrawal numbers and presents these as vaulted gold numbers (blue boxed numbers are deposits, orange boxed numbers withdrawals). Compare the numbers in the top row with exhibit 13 (and 4, 6, 8, 12 and this). In 2013 the 2197 tonnes were not vaulted, they were withdrawn! One more exhibit from the China Gold Market Report 2008:
According to my analysis Macleod’s vaulted numbers are false and thereby his vaulted gold increase numbers, as presented as demand in the following table I took from his article.
Additionally he adds vaulted scrap and mine supply to Chinese demand, while this is already included in SGE withdrawals (Exhibit 5, 6, 7, and this). This is double counting.
Hong Kong And Mainland Gold Trade
The amount of net exports from Hong Kong to the mainland is clear. Very little of the gold imported by Hong Kong from the mainland was bullion withdrawn from the SGE vaults.
A very long and complicated story short: In the mainland there are two types of trade; general trade and processing trade. General trade can be considered as normal trade. If gold is imported in general trade this is required to be sold through the Shanghai Gold Exchange. Only 12 banks have general trade licenses from the PBOC, though for every shipment they need anew approval.
1. Industrial and Commercial Bank of China
2. Shenzhen Development Bank / Ping An Bank
3. Agricultural Bank of China
4. China Construction Bank
5. Bank of Communications
6. China Minsheng Bank
7. Bank of Shanghai
8. Industrial Bank
9. Bank of China
It’s not likely the PBOC would approve bullion gold to be exported in general trade. Additionally there are a few jewelry companies that have PBOC licenses, but these also have to ask for permission for every trade they conduct. The PBOC has a very firm grip on gold trade.
Processing trade is something else. In this trade form raw materials from abroad are imported, processed into products and then these products are required to be exported again. This processing is usually done (there can be exceptions) in Customs Specially Supervised Areas, or CSSAs. Processing trade doesn’t require a permit from the PBOC, as the gold that is imported will be exported after being processed. To export gold from a CSSA to a non-CSSA (that’s the rest of the mainland) a PBOC license is required. An example for a processing trade would be; gold from Hong Kong is exported to Shenzhen (a CSSA just across the border from Hong Kong and well known for its vast jewelry fabrication industry), then the gold is fabricated into jewelry and imported back into Hong Kong. This trade would show up in Hong Kong’s customs report, but it would not affect Hong Kong net export to the mainland.
Processing trade explains the Hong Kong imports from the mainland. Most of the gold Hong Kong imports from the mainland is balanced by Hong Kong exports or re-exports to the mainland, as the PBOC is not likely to allow the mainland to export gold in general trade.
Macleod states correctly that Hong Kong gold re-exports to the mainland, gold that is virtually not processed in Hong Kong, are all 1 Kg bars refined overseas imported into Hong Kong and sent forward to the mainland. Regarding Hong Kong exports to the mainland, gold that is processed in Hong Kong, he states this refers mainly to jewelry fabricated in Hong Kong which is shipped to the mainland and sold directly without going through the SGE. I disagree:
1) There is no evidence for this. Just because the gold is declared in Hong Kong as export doesn’t say anything about its shape or form. There are many refineries in Hong Kong, all capable of casting 1 kg bars to export to the mainland. Hong Kong gold export to the mainland can also be 1 Kg bars destined for the SGE.
2) In China mainland there is a 22 % tax on jewelry (17 % VAT and 5 % consumption tax), these costs are added to the bullion and fabrication costs of the jewelry. This makes a 24 carat bracelet (most aunties buy 24 carat for investment purposes) of 100 grams much more expensive than the spot price of 100 grams of bullion on the SGE, which is free of VAT and consumption tax. Why would a Chinese jeweler fabricate its products in Hong Kong where wages are at least twice as high and then import them into the mainland? Assuming this company has a PBOC import license. It’s more likely Chinese jewelers buy bullion on the SGE in the mainland, the SGE has no vaults in Hong Kong, fabricate the jewelry and then sell it, all in the mainland.
Macleod adds Hong Kong gold exports to the mainland (211 metric tonnes in 2013) to Chinese demand, I don’t. Additionally he adds total Hong Kong net gold import (597 tonnes in 2013) to Chinese demand. I don’t.
We know some of the gold Hong Kong net imported in 2013 ended up in the hands of mainland citizens. Because in Hong Kong there is zero tax on jewelry, there are many mainland citizens making trips to Hong Kong to purchase jewlery and walk back across the border without being bothered by customs. It’s estimated half of the jewelry sold in Hong Kong is bought by mainland tourists.
There are also mainland citizen that purchase gold in Hong Kong and store it locally in safety deposit boxes at banks or private vaults. Unfortunately I don’t have any hard numbers on this hidden Chinese gold demand (yet). One could take half of the jewelry sales numbers from Hong Kong reported by the World Gold Council, but I have my reasons not to trust those numbers.
Hong Kong net imports can also be explained by the fact many gold brokers in the world offer vaulting services in Hong Kong (GoldSilver, GoldMoney, etc). In 2013 Malca-Amit Global Ltd opened a vault in Hong kong, with a capacity of 1000 metric tonnes, which can be used by investors worldwide. This is why Hong Kong net import isn’t solely Chinese demand.
My Estimate On Chinese Total Gold Reserves Held In The Mainland
Let’s put together some data and try to work out how much gold the Chinese people and the central bank have been accumulating in the past decades. In exhibit 5 we found a clue suggesting China has probably been a net importer since the nineties.
This means we don’t know how much of the gold China domestically mined prior to that period has been exported, but after, lets say, 1995 all domestic mining did not leave the mainland. My best estimate of how much gold was being held among the Chinese population in 1995 is 2500 tonnes, according to Albert Cheng from the World Gold Council (page 55). Starting from that year I will try to make a conservative estimate on how much gold the Chinese have been accumulating.
According to the PBOC their official reserves in 1995 accounted for 394 tonnes, Chinese mines produced 108 tonnes that year; our starting point is 3002 tonnes (2500 + 394 + 108) in 1995. Subsequently I added yearly domestic mining, cumulative, as the Chinese didn’t net export any gold since that year. In 2001 The PBOC announced their official reserves had increased to 500 tonnes and in 2003 they announced having 600 tonnes. Because the gold market wasn’t fully liberalized in those years I have subtracted these gains from cumulative domestic mining. Just to be on the conservative side, also because I have zero trade data from 1995-2001.
The official subsequent update to 1054 tonnes by the PBOC was in 2009, when the gold market was fully liberalized. This gain I didn’t subtract from cumulative domestic mining, as I believe this was imported monetary gold. The increase in PBOC holdings from here on is pure guessing, though I feel comfortable raising their holdings to 3500 tonnes in 2013.
Import I have calculated using Hong Kong net exports to the mainland (my data begins in 2001), net gold imports numbers disclosed by Chinese gold reports (2007-2011) and analysing SGE withdrawals (2007-2013), using the equation:
mine + scrap + import = SGE withdrawals
import = SGE withdrawals – scrap – mine
The end result is this:
The chart above I think is conservative as it excludes hidden demand on which I have no hard numbers (yet):
– Mainland tourist buying jewelry in Hong Kong and storing it locally or bringing it home.
– Potential gold smuggling via tunnels from Hong Kong into the mainland.
In short, some enterprises in China use gold leasing from banks to solve their short-term funding problems in the hope of buying back the gold at lower levels to repay the lease. However they can be short-squeezed when gold moves higher. My source was so kind to do a quick translation for us (the west):
The Gold Bear Market Game: Spread Arbitrage Through Gold Leasing For Individuals
January 20, 2014
By Chen Zhi, Shanghai
It’s Spring Festival time again. A private business owner Chen Qian (Alias) is unhappy with her own investment impulse.
At the beginning of January, she got the 11 million RMB from a due trust product and she wanted to use it as the cushion to pay for the bills for procurement. 2 weeks later, because she couldn’t resist the temptation of a real estate trust product with an annualized rate of 11%, she put her money into this product.
To her surprise, because another sum of sales proceeds was said to be delayed, she now needed some money to pay for business procurement.
In fact, this is not her first time to be in a shortage of funds. In the past, she could pledge trust products at banks to apply for short-term bridge loans. This year, she was told banks didn’t have enough lending capacity so the bridge loan was impossible.
Therefore, she had to try the gold lease business.
Gold lease is like this: eligible businesses can lease gold from banks and pay the same quantity and grade gold when the gold lease is due and pay the relevant gold lease rate. During the lease, businesses can sell the gold to get short-term funding.
However, to her surprise, gold lease is not only a new financing tool but many business owners use it as a modern arbitrage means.
“Among my friends, there are business owners investing tens of millions of RMB and play the gold lease risk-free spread arbitrage.” Chen Qian said. But in her opinion, this kind of risk free arbitrage may have unfathomable risks.
6.7 % Funding Cost: The Involvement Of Individuals
Chen Qian’s first experience with gold lease is from the recommendation of a jewelry manufacturer.
In the past, through gold lease, this jewelry manufacturer could easily get tens of millions yuan of “cheap”funds, even in the time of credit crunch, which made her jealous.
It works like this: the jewellery manufacturer first leases 33kg of gold from a bank and then sells it through the Shanghai Gold Exchange to get around 10 million yuan (at 303 yuan/gram). Then he uses 1.5 million (15% margin rate) to buy 33 kg of gold futures contracts and use the 8.5 million left for the short-term funding of businesses.
Because the finance expenses including the gold lease expense, the brokerage fee for the futures contract are less than 0.55 million yuan, then the effective cost for the gold lease is close to 6.7 %. At the same time, the total finance expenses for bank loans (including loan rate, to cost to buy wealth management products, business audits, etc) are more than 9 %.
But not all businesses are qualified for gold lease as a means to get low rate loans. Chen Qian’s first application for gold lease was turned down. The reason is banks only lease gold to companies involved in gold market, including gold production, fabrication, sales and trade. Gold lease is not available for high net worth individuals.
Under the guide of the jewellery manufacturer, Chen Qian found that high net worth individuals can circumvent rules to get gold lease contracts. Way No. 1: set up an enterprise related to gold business. One only needs to put the phrase “gold jewellery business” into the business license to satisfy the internal compliance needs of banks. Way No 2: use the “tunnel” provided by financial lease companies and gold fabricators. One just needs to ask them to lease gold from banks to re-lease to individuals.
In her opinion, her enterprise’s internal credit rating in banks is B+ and has enough credit limit and funds so leasing gold is simple.
“Some bank insiders say, gold lease is an off-sheet lease activity. When authorities are putting tight controls on on-sheet lending, this kind of off-sheet lease business is flexible” Chen Qian said. The biggest flexibility in her opinion is lack of generalised pricing standards.
At the moment, ICBC, CCB, SPDB, BOC etc all have gold lease businesses. The 3 banks Chen met had the following rates: the lowest 3.5 %, highest 4.2 % and one is 3.8 %
“The pricing (of the lease) is related to banks’ internal pricing of risks” a person working at a Bank’s precious metals dept. This is related to the bank’s cost to deal with future gold volatility, the cost for physical delivery etc. But he emphasized that to prevent enterprises and individuals to use gold lease to get funds for speculation, most banks don’t allow non-gold related enterprises to get involved.
Every rule has loopholes. Chen found in casual chat that gold lease has become a fashionable spread arbitrage game among the enterprise owners around.
Picking Pennies In Front Of A Bulldozer Through Spread Arbitrage.
Spread arbitrage is like this: these business owners, in the background of gold’s 28% pullback in 2013, remain bearish on gold. They “borrow”gold through different ways and sell the gold on the SGE for funds. They hope to buy back the same amount of gold to repay and get the spread when gold falls further to their targets in 2014.
“A business owner signed a 3-month gold lease agreement at the end of last year and sold the gold at $1300/oz. He said he would buy back and return the gold when gold fell to $1150/oz in Q1 2014 and pocket the $150/oz difference.” Chen said. This business owner used tens of thousands of yuan. Because banks had many limitation on gold lease targets, he chose to lease physical gold from gold producers/merchants.
Gold merchants have a lot of physical gold in hand and this gold has no interest. So they would rather lease out the gold for a return.
This method is similar to banks’ gold lease. It needs business owners to put a certain percentage as margin and use real estate as pledge. During the lease, the hedge in the gold futures agreement must be done through the gold merchant’s account to control gold price volatility. But if the gold’s fall is far less than business owner’s target price to buy back the gold at the beginning of the lease, the business owner has to meet margin calls or even suffer losses.
“Gold lease is usually shorter than 1 year because the shortage the tenor, the easier to control price volatility.” The person working at the Bank’s precious metals department said. But there are some radical rich investors.
Recently, some rich people even use the funds through gold lease to invest in high yield real estate trust products to achieve “getting something from nothing”. The spread between the yield on trust products and gold lease rate is risk free in their eyes.
“Is it really risk free?” Chen was suspicious. On the one hand, many real estate investment products are facing default risks and on the other, gold lease arbitrage is facing the volatility of gold price. If these 2 risks occur at the same time, this seemingly risk-free arbitrage could be in fact “picking pennies in front of a bulldozer.”
This post is part of the Chinese Gold Market essentials series. Click here to go to an overview of all Chinese Gold Market Essentials for a comprehensive understanding the largest physical gold market globally.
The main arguments presented by Western consultancy firms, such as GFMS and the World Gold Council (WGC), to explain the difference between SGE withdrawals and Chinese consumer gold demand relate to Chinese Commodity Financing Deals (CCFDs). However, this analysis is incorrect as I will demonstrate in this post.
CCFDs are used by Chinese speculators to acquire cheap funds using commodities as collateral. When it comes to using gold as collateral for CCFDs there are two options: round tripping and gold leasing. First we’ll discuss round tripping.
Goldman Sachs (GS) has properly described the round tripping process in a report dated March 2014. We’ll start by reading a few segments from GS about financing deals [brackets added by me]:
While commodity financing [round tripping] deals are very complicated, the general idea is that arbitrageurs borrow short-term FX loans from onshore banks in the form of LC (letter of credit) to import commodities and then re-export the warrants (a document issued by logistic companies which represent the ownership of the underlying asset) to bring in the low cost foreign capital (hot money) and then circulate the whole process several times per year. As a result, the total outstanding FX loans associated with these commodity financing deals is determined by:
– the volume of physical inventories that is involved
– commodity prices
– the number of circulations
Our understanding is that the commodities that are involved in the financing deals include gold, copper, iron ore, and to a lesser extent, nickel, zinc, aluminum, soybean, palm oil and rubber.
…Chinese gold financing deals are processed in a different way compared with copper financing deals, though both are aimed at facilitating low cost foreign capital inflow to China. Specifically, gold financing deals involve the physical import of gold and export of gold semi-fabricated products to bring the FX into China; as a result, China’s trade data does reflect, at least partially, the scale of China gold financing deals. In contrast, Chinese copper financing deals do not need to physically move the physical copper in and out of China, so it is not shown in trade data published by China customs. In detail, Chinese gold financing deals includes four steps:
Onshore gold manufacturers pay LCs to offshore subsidiaries and import gold from Hong Kong to mainland China – inflating import numbers
offshore subsidiaries borrow USD from offshore banks via collaterizing LCs received
onshore manufacturers get paid by USD from offshore subsidiaries and export the gold semi-fabricated products – inflating export numbers
repeat step 1-3
Important to understand is that gold in round tripping needs to be physically imported into China and then exported, in contrast to copper. The reason for this, which GS fails to mention, is that the cross-border trade rules for gold in China are different than for all other commodities. Only through processing trade gold can be imported into China mainland by enterprises that do not carry a PBOC gold trade license. Round tripping by speculators can only be done through processing trade, as it’s not possible through general trade to ship gold into China without a PBOC license. Consequently, round tripping flows are completely separated from the Chinese domestic gold market where the SGE operates. And hence round tripping cannot inflate SGE withdrawals.
Only by bending the rules – set up a fake jewelry enterprise in a CSSA – speculators can import gold to round trip. By using processing trade in order to import gold into China speculators are required to subsequently export the exact same amount of gold, because these speculators pretend to be jewelry manufacturers importing gold for genuine production, which upon completion must be exported. This is why the gold is round tripped. The requirement for export in processing trade can be read in the official PRC Customs Supervision and Administration of Processing Trade Goods Procedures (2004):
“Processing trade” shall refer to the business activity of import of operating enterprises of all or some raw and auxiliary materials, components, parts, mechanical components and packing materials (Materials and Parts) and the re-export thereof as finished products after processing or assembling.
Now we can understand why GS wrote [brackets added by me]:
Specifically, gold financing deals [round tripping] involve the physical import of gold and export of gold semi-fabricated products to bring the FX into China…
The speculators export semi-fabricated gold products to keep up the appearance they are genuine gold fabricators, for which the gold imported must be processed and exported.
On a side note, the gold used in round tripping can be at most the amount of gold yearly exported from China (to Hong Kong). Though the total exported gold will also contain genuine processing trade, so round tripping will be less than this amount. Round tripping does not inflate net export from Hong Kong to China, only gross trade. The net amount of gold imported into China is shipped through general trade, via the SGE, into the Chinese domestic gold market and is prohibited from being exported.
In the chart above we can see China exported 330 tonnes to Hong Kong in 2013. Let’s guess 200 tonnes of that was genuine processing trade (jewelry manufactured in a Chinese CSSA).
330 – 200 = 130 tonnes
Possibly, there was 130 tonnes imported into China for round tripping and subsequently exported back to Hong Kong. Or, 10 tonnes was imported into China for round tripping and subsequently exported to be round tripped an additional 12 cycles, making 13 rounds in total.
13 x 10 = 130 tonnes
In the latter scenario a lot less physical gold is involved (10 tonnes versus 130 tonnes). In reality it’s more likely a gold batch used in round tripping is making multiple rounds than one round.
The Chinese Gold Lease Market
The other gold financing deal that can be conducted by Chinese speculators is gold leasing (which is the same as gold lending). In general gold leasing is a normal market practice.
I have categorized all potential gold lessees (borrowers) in three groups for us to have a look at examples (with US dollars) of how gold leasing is done in financial markets:
A gold miner needs funds to invest in new production goods. It can borrow dollars from a bank at a 7 % interest rate, or borrow gold at 2 % – the gold lease rate is usuallylower than the dollar interest rate. The miner chooses to borrow 10,000 ounces and sells it spot at $1,500 an ounce. The proceeds are $15,000,000 that can be used to invest in new production goods. In a years time the miner has mined 10,200 ounces to repay the principal debt plus interest (the interest on gold loans can be settled in gold or dollars, depending on the contract). Through gold leasing the miner has acquired cheap funding compared to a dollar loan.
A jeweler needs funds to buy gold stock for production. It can borrow dollars from a bank for 7 %, or borrow gold for 2 %. The jeweler borrows 10,000 ounces of gold, with which it can start fabricating jewelry. To hedge itself against price fluctuations the jeweler can sell spot, for example, 10 % of the 10,000 ounces it has borrowed (1,000 ounces at $1,500 makes $1,500,000) to buy gold futures contracts in order to lock in a future price. After a year the jeweler has sold the 9,000 ounces (as jewelry) for dollars and can take delivery of the long futures contracts to repay the gold loan.
A speculator is looking for cheap funds. It can borrow dollars from a bank for 7 %, or borrow gold for 2 %. He borrows 10,000 ounces and sells it spot at $1,500 an ounce. The proceeds are $15,000,000 and subsequently these newly acquired funds can be used to invest in higher yielding products (> 2 %). If the trader chooses to hedge itself in the futures market is up to him. After a year the 10,000 ounces plus interest need to be repaid, either the trader can purchase gold with the profits made on the higher yielding investment or from delivery of futures contracts.
…the SGE provides a crucial role in gold leasing. The SGE’s block trading system is the trading platform used by gold leasing participants; the SGE also provides transfer and settlement services.
China’s gold leasing does not involve the central bank. Gold leasing takes place between commercial banks and enterprises as well as between commercial banks, the former being key.…
An enterprise that intends to be a lessee approaches a branch office of a commercial bank with a rate request and application.
The commercial bank carries out due diligence and then submits a review to their head office for approval.
Upon approval the head office quotes a lease rate with the international gold lease rate as a benchmark plus additional basis points taking into account the potential lessee’s credit, physical gold management costs and other factors.
If the potential lessee accepts the offer, a commercial bank branch manager will sign a lease contract with the customer including the terms and conditions clearly laid out.
According to the “Shanghai Gold Exchange Lease Transfer Procedure”, after signing the lease, the head office of the commercial bank and lessee, or his agent, shall make a lease application through the exchange’s membership system. After verification, the SGE shall transfer the commercial bank’s gold from its SGE bullion account to the lessee’s SGE bullion account. The lessee can now trade the physical gold that it has leased or withdrawal the gold from the vaults.
Upon expiration of the lease the lessee shall deposit or purchase physical gold through the SGE to repay the gold. Corresponding physical gold will be transferred from the lessee’s SGE bullion account to the commercial bank’s bullion account. Leasing fees involved will be settled in currency. At this point, the lease is completed.
First, I would like to insert a comment supplementing the PBOC’s description of gold leasing in the Chinese domestic gold market. In the paper it says:
“After verification, the SGE shall transfer the commercial bank’s gold from its SGE bullion account to the lessee’s SGE bullion account. The lessee can now trade the physical gold that it has leased or withdrawal the gold from vaults.”
My source at ICBC’s precious metals trading desk told me ICBC has little gold of itself for leasing, most of the gold lend out is sourced from third parties. These parties are either SGE members or overseas banks that supply gold through the Chinese OTC market. ICBC operates in the lease market as an intermediary by connecting supply and demand, it can lease from international banks or local gold owners with SGE Bullion Account and lend the gold to miners, jewelers or speculators. My suspicion is that the international gold lease rate is lower than the Chinese gold lease rate, which can attract gold from the international market into the Chinese domestic gold market.
The Chinese lease market in short: in China all gold leases are settled through the SGE (there can be an off-SGE lease market, but it would be highly illiquid). Both lessor (lender) and lessee are required to have an SGE Account. If a lease is agreed between two parties gold is transferred from one SGE Bullion Account to the other, when the lease comes due the gold is returned. At SGE level it’s as simple as that.
There is a big difference between jewelers that lease gold in contrast to miners and speculators. Jewelers lease gold because they need physical gold for fabrication; miners and speculators lease gold because they are seeking cheap funds, they will always sell spot the leased gold (without withdrawing the metal) at the SGE to use the proceeds. Why would a speculator withdrawal the metal?
Therefor, if SGE withdrawals capture leased gold this is for genuine jewelry fabrication that eventually ends up at retail level. When a jeweler needs to repay the lease it simply buys gold at the SGE to subsequently transfer it from its SGE Bullion Account to the lessor’s SGE Bullion Account. It’s not likely a jeweler would buy gold off-SGE to repay a lease, which then would need to be refined into newly cast bars by an SGE approved refiner to enter the SGE vaults. Gold leasing by jewelers can inflate SGE withdrawals but not so much supply to the SGE.
… No statistics are available on the outstanding amount of gold tied up in financial operations … but Precious Metals Insights [PMI] believes it is feasible that by the end of 2013 this could have reached a cumulative 1,000t…
This 1,000 tonnes figure is based on a misunderstanding regarding the Chinese gold lease market. PMI assumed there was 1,000 tonnes of gold tied up in financing deals based on the yearly lease volume in China, which was 1,070 tonnes in 2013. However, the yearly lease volume is not the gold that is leased out at any point in time, but reflects the aggregated volumes disclosed on all lease contracts that are executed over one year’s time in the Chinese domestic gold market. Meaning, if 100 mining companies lease 2 tonnes of gold for 1 month in 2016 and all leases are rolled over 4 additional months, the yearly lease volume would be 1,000 tonnes (100 x 2 x (1 + 4)), while on 31 December 2016 the total amount of gold leased out could be nil. (It’s impossible there was 1,000 tonnes used in round tripping as gross export from China has never been more than 330 tonnes)
In addition, the WGC used the words ‘tied up‘ for the gold used in financing operations, which sounds as if the market will be flooded when the gold is untied. The words ‘tied up’ can be misleading, let me explain: If a speculator borrows gold he will promptly sell it spot, this gold will not leave the SGE system. During such a lease period there is nothing tied up, there is just a debt to be repaid. When the lease comes due the lessee has to buy gold in the market (SGE) to settle the debt, which is the opposite of what the WGC insinuates what happens when gold is untied. In case a jewelry company leases gold the words tied up are more appropriate, in my view, as the borrowed gold bars are in transit from being processed to being sold as jewelry. Gold involved (tied up) in these leases can only be a share of the total amount of gold leased out in any point in time, because we all agree most leases in China are done for financing. There is only a small percentage of total gold loans tied up by jewelry companies.
… a good part of the withdrawals represent gold that is used purely for financing and other end-uses that are not equivalent to real consumption.
Needless to say I don’t agree for the reasons just mentioned regarding gold leasing and round tripping. Am I the only one? No. When Na Liu of CNC Asset Management Ltd, visited the SGE in May 2014 he spoke to the President of the SGE Transaction Department. From Na:
First, the withdrawal data reflects the actual gold wholesales in China. In 2013, the total gold withdrawal from the SGE vaults amounted to 2,196.96 tonnes. The President of SGE Transaction Department (The President) said: “This 2,200 tonnes of gold, after leaving our vaults, they entered thousands of Chinese households in the form of jewellery and investment purchases.”
… Second, none of the 2,200 tonnes of gold was bought by the Chinese central bank. The President said: “The PBOC does not buy gold through the SGE.”
… Third, the financing deals do not exaggerate SGE’s assessment of China’s gold demand. This is because “the financing deals do not take place after the gold leaves the vaults.”
The President of the SGE’s Transaction Department is clearly stating most leasing happens within the SGE system and this metal is not withdrawn. Therefor, gold leasing by speculators does not inflate SGE withdrawals and thus does not explainthe differencebetween SGE withdrawals and Chinese consumer gold demand as disclosed by the World Gold Council.
Remarkably, when I asked the WGC about the details in 2014 they replied [brackets adde by me]:
Gold leasing: Banks have built up this business to support China’s burgeoning gold industry. Miners, refiners and fabricators all have a requirement to borrow gold from time to time. For example, fabricators borrow gold to transform into jewelry, sell and then repay the bank with the proceeds. It is an effective way for the fabricator to use the bank’s balance sheet to fund its business. Banks have strict policies in place for who they can lend to, and these have been tightened over recent years, but during PMIs field research it identified that, in some instances, organizations other than genuine gold business had used this method to obtain gold, which it would then sell to obtain funding [in this case the gold wouldn’t be withdrawn from the SGE vaults]. It would then hedge its position. According to PMI, this can generate a lower cost of funding than borrowing directly from the bank. Our colleagues in China think this would be a very small part of total gold leasing; the majority of it would be used to meet the demands of genuine gold businesses.
In their email the World Gold Council admits gold leases that are withdrawn from the SGE vaults are used for genuine gold business and being part of true gold demand. This is more confirmation gold leasing cannot explainthe difference.
In conclusion, round tripping gold flows are completely separated from the Chinese domestic gold market (SGE) and therefor cannot have caused the difference. In addition, gold leasing only inflates SGE withdrawals when used for genuine gold business and therefor cannot have caused the difference either.