This post is part one of the Chinese Gold Market essentials series. Click here to go to an overview of all Chinese Gold Market Essentials for a comprehensive understanding of this gigantic physical gold market.
The Shanghai Gold Exchange (SGE) is by far the largest physical gold bourse in the world. China is the largest gold importer and gold mine producer globally and both of these supply channels flow through the SGE. The yearly amount of physical gold withdrawn from the SGE vaults has exceeded 2,100 tonnes since 2013. In reports hidden from public eyes the China Gold Association (CGA) states annual Chinese gold demand equals SGE withdrawals, while Western consultancy firms like the World Gold Council and Thomson Reuters GFMS report Chinese gold demand is roughly half this tonnage. The mysterious difference can only in part can be explained by contrasting metrics. In this post we’ll examine the mechanics of the Chinese domestic gold market and why nearly all physical gold in China flows through the SGE, in order to estimate true Chinese gold demand as precisely as we can.
Kindly note, the definition of SGE withdrawals has changed late 2014. How it was changed can be read in the subsequent posts of the Chinese Gold Market Essentials (Workings Of The Shanghai International Gold Exchange, SGE Withdrawals In Perspective)
According to my analysis the structure of the Chinese domestic gold market with the SGE at its core has been designed by the People’s Bank Of China (PBOC), (i) to provide the Chinese citizenry direct access to the gold wholesale market, (ii) to grant all gold traded in the Chinese wholesale market to be of the highest quality, (iii) to be able to monitor gold traded in the Chinese gold market, (iiii) keep track of the amount of physical gold added to Chinese (non-government) gold reserves. Sprouted from the centrally minded Chinese authorities the SGE system was conceived in 2002 to facilitate the citizenry to buy physical gold, strengthen the Chinese economy and develop the Chinese gold market in order to support China’s internationalization.
For my analysis of the Chinese domestic gold market I’ve relied on Chinese laws, annual reports drafted by the China Gold Association (CGA), SGE, PBOC and Shanghai Futures Exchange (SHFE), next to sources in China at commercial banks and individual traders. The aforementioned reports are:
- China Gold Association (CGA) Gold Yearbook 2006, 2007, 2008, 2013 (Chinese)
- SGE Annual Report 2007, 2008, 2009, 2010, 2011 (English and Chinese)
- China Gold Market Report 2008, 2009, 2010, 2011 (English and Chinese)
Most of these reports have been written in conjunction by the CGA, SGE, PBOC and SHFE.
All the English reports that were available on the SGE website (until 2014), but now have been taken offline. Nowadays most information is only published in Chinese print.
Prior to 2002 the Chinese gold market was practically non-existent. The PBOC had the monopoly in trading gold and Chinese people were only allowed to buy jewelry in designated shops. In 2002 the PBOC erected its subsidiary the SGE to allow the free market to take over the the pricing and allocation of gold. However, the Chinese domestic gold market didn’t change over night.
To a certain extent the Chinese domestic gold market functioned as was planned starting in 2007, as for the first time the amount of physical gold withdrawn from SGE designated vaults equaled Chinese (wholesale) gold demand that year. All supply and demand was matched at the SGE, without the direct interference of the PBOC in 2007. In the CGA Gold Yearbook 2008 we can read:
In 2007, the amount of gold withdrawn from the warehouses of the Shanghai Gold Exchange, the total gold demand of that year, was 363.194 tonnes of gold, …
From 2002 until 2007 Chinese gold demand did not equal SGE withdrawals, to which I conclude the reform of the market wasn’t fully worked out in those years. From 2007 until 2011 SGE withdrawals exactly matched total Chinese gold demand, according to the metrics used by the CGA used in the Gold Yearbooks published in Chinese. From 2012 until present SGE withdrawals by approximation match total Chinese gold demand – the details will be discussed later on.
There are a few basic rules with respect to the Chinese (domestic) gold market that determine why SGE withdrawals equal Chinese (wholesale) gold demand, these rules compound to the mechanics of this market. The first we’ll discuss are import rules.
Chinese Cross-Border Gold Trade Rules
Gold bullion import into the Chinese domestic gold market can be done by banks that enjoy a PBOC gold import license – though for every shipment anew approval must be submitted at the Chinese central bank. Bullion export from the Chinese domestic gold market is prohibited as far as I know. At this stage there are fifteen banks that enjoy a PBOC import license:
- Shenzhen Development Bank / Ping An Bank
- Industrial and Commercial Bank of China
- Shanghai Pudong Development Bank
- Agricultural Bank of China
- China Construction Bank
- Bank of Communications
- China Merchants Bank
- China Minsheng Bank
- Standard Chartered
- Bank of Shanghai
- Industrial Bank
- Bank of China
The Chinese domestic gold market with the SGE at its core is separated from Chinese Free Trade Zones (Customs Specially Supervised Areas) where different cross-border trade rules apply. For more detailed information please read my post Chinese Cross-Border Gold Trade Rules.
All bullion imported into the Chinese domestic gold market by one of the fifteen banks is required to be standard gold and sold first through the SGE before entering the Chinese market place. Standard gold in China is bullion casted by an LBMA or SGE approved refinery in bars of 50g, 100g, 1Kg, 3Kg or 12.5Kg, with a fineness of Au9999, Au9995, Au999 or Au995. Solely standard gold is allowed into SGE designated vaults to be traded through the SGE system. The Chinese gold trade rule book says [brackets added by me]
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.
When standard gold is traded over the SGE or SHFE it’s exempt from Value Added Tax (VAT). When standard gold is not traded over the SGE or SHFE it is not exempt from VAT. In addition, when non-standard gold, like jewelry, powder, ore, and dore, any gold that doesn’t meet standard gold specifications, is traded in the Chinese domestic gold market it is exempt from VAT – although the value added part may be not VAT free. These VAT rules incentivize nearly all wholesale gold supply to be traded in the form of standard gold through the SGE system.
The Chinese Mint has an exception to export golden Panda coins from the Chinese domestic gold market and to my knowledge there are also a few jewelry companies that are allowed to trade non-standard gold in and out of the Chinese domestic market, but this tonnage is insignificant.
Individuals can officially import and export 50 gram when traveling abroad. However, this rule isn’t very stringent on the import side. Many mainland tourists visit Hong Kong to buy jewelry and bring as much bracelets as they like across the border when they return home.
At the LBMA forum in Rome September 30, 2013, Vincent Chow (Chow Sang Sang Jewelry, Hong Kong) showed some interesting slides.
In the slide above we can see that jewelry (non-standard gold) in China enjoys 17.5 % tax on added value and 5 % consumption tax. Whilst, in Hong Kong gold jewelry enjoys no VAT or consumption tax whatsoever. This is why many Chinese women travel to Hong Kong for jewelry bargains.
Chinese Gold Mining
China has the largest domestic gold mine production in the world with an output of roughly 450 tonnes in 2015. The vast majority of this output is sold first through the SGE. All Chinese gold miners are required to sell their standard gold over the SGE. From China Gold International Resources Corp. Ltd. we can read [page 15, brackets added by me]:
On October 30, 2002, the Shanghai Gold Exchange commenced operation under the supervision of the State Council. Thereafter, the PBOC ceased its gold allocation and gold purchase operations. All PRC [People’s Republic of China] gold producers are now required to sell their standard gold bullion through the Shanghai Gold Exchange, and prices of gold on the Shanghai Gold Exchange are determined by market demand and supply, which essentially converge with the price of gold in the international market.
In addition, overseas gold mining output can be imported into the Chinese domestic gold market as non standard gold, subsequently to be refined into standard gold by an SGE approved refinery and traded over the SGE.
Because the SGE has the best liquidity in China, gold mining companies are incentivized to cast their output in standard gold bars and sell it through the SGE. However, in theory miners can sell non-standard gold off-SGE. For example China National Gold Group (China Gold) is a miner that also has its own physical stores to sell bars and ornaments.
Chinese Scrap And Disinvestment Supply
Scrap supply in the Chinese domestic gold market, as defined by old jewelry or industrial products sold, has a strong incentive to flow through the SGE as well because of the VAT rules regarding standard gold. Scrap is not required to be sold through the SGE, yet many refineries cast standard gold, which are the most commonly traded bars and the only bars allowed in the SGE system. Because standard gold traded off-SGE enjoys VAT and the SGE is the most liquid exchange in China most refinery bar production finds its way to the SGE. Below is a picture of a 100 gram standard gold bar:
1. 上海黄金交易所标准金条 SGE Standard Gold Bar.
2. 上海黄金交易所标志 SGE Logo.
3. 品牌标志 Brand Logo.
4. 金条品牌 Bar Brand (泰山 is Mount Tai, which is produced by Shandong Gold).
5. 成色 Fineness.
6. 重量 Weight.
7. 金条编号 Bar Number.
Important for understanding all metrics used to measure Chinese gold demand, there are three kinds of scrap flows that enter the SGE.
- The first is genuine scrap, as defined above, which is old gold products (jewelry or industrial) sold for cash and therefor true supply having an effect on the gold price. These scrap flows are included by GFMS in their scrap numbers.
- The second is disinvestment. Some large and smaller investors in China buy gold directly at the SGE. If the bars are sold back they can be sent directly through a refinery and then making their way to the SGE. An investor wanting to sell 1500 Kg in gold bars is not likely to walk into a jewelry store to sell its material, more likely he will approach a refinery. Disinvestment (in my nomenclature) is not measured by GFMS as scrap.
- The third kind is recycled gold (again, this is my nomenclature). Recycled gold can be for example process scrap, which is metal spill over from jewelry or industrial fabrication. Suppose, a jewelry manufacturer buys 1 tonne of gold at the SGE and starts fabricating jewelry. During production 800 Kg makes it into finished products while 200 Kg is scrap spill over. The spill over, called process scrap, is being sold back from the jewelry manufacturer to a refinery making its way back to the SGE. Effectively the 200 Kg have been recycled through the SGE, being both demand and supply, having no net effect on the price. Process scrap is not included in GFMS data. Next to process scarp there can be other forms of gold being recycled through the SGE, which will label as distortion.
Note, since the inception of the Shanghai International Gold Exchange (SGEI) in 2014, total SGE withdrawals as disclosed in the Chinese Market Data Reports include both withdrawals from SGE vaults in the Chinese domestic market as well as withdrawals from SGEI vaults in the Shanghai Free Trade Zone (SFTZ). The withdrawals from SGEI vaults that are not imported into the Chinese domestic market are also part of distortion.
In the (CGA) Chinese annual gold reports I mentioned at the beginning of this post, scrap, disinvestment and distortion flows are all counted in one category “scrap supply”, in contrast to GFMS data. This partially explains the difference in Chinese gold demand.
As supply and demand are always equal, when CGA metrics measure more supply, logically they measure more demand as well. When, later on, we’ll estimate true Chinese gold demand, we should subtract distortion from SGE withdrawals.
Just like the London Bullion Market Association (LBMA) the SGE respects a chain of integrity. Meaning, only SGE approved refineries can supply bars to the SGE system and once bars are withdrawn from the SGE vaults they leave the chain of integrity. To prevent fraud, hereafter, these bars are not allowed to re-enter the SGE vaults. The only way they can be sold through the SGE is if they’re recast into new bars by an SGE approved refinery. From the SGE rulebook, Detailed Rules for Physical Delivery of the Shanghai Gold Exchange we can read:
Any gold bullion withdrawn by a member or customer shall not be loaded into any Certified Vault in the future.
The same rule is disclosed on the websites of China’s largest banks that offer customers SGE trading accounts. Read point 2 of a considerations segment from an ICBC gold product:
This rule is essential for comprehending the mechanics of the Chinese domestic gold market.
SGE Withdrawals Equal Chinese Wholesale Gold Demand
If we put together the rules mentioned above we can understand the basic formula for the Chinese domestic gold market:
SGE withdrawals = Chinese Wholesale Gold Demand
As import + mine + scrap + disinvestment + distortion is total physical supply to the SGE and everything that is withdrawn is total demand, therefor:
Import + Mine + Scrap + Disinvestment + Distortion = Total Supply = SGE Withdrawals = Wholesale Demand
True Chinese gold demand = Import + Mine + Scrap + Disinvestment
As you can see in the graph above total supply and total demand are exactly equal, this is because one cannot sell gold without a buyer or buy gold without a seller. Consequently we can gauge demand by measuring supply. Please note, in the supply and demand balance shown above, and in our further investigation, two elements are left out. On the supply side I left out stock carry over in SGE vaults from previous years, as this information is not publicly available. On the demand side I left out gold bought at the SGE that was not withdrawn from the vaults, as this information is also unknown.
The formula is supported by reports from the CGA and SGE since 2007, as every year SGE withdrawals equal total (wholesale) gold demand in these documents. Let’s have a look at CGA demand data and SGE withdrawals since 2007:
2007: SGE Withdrawals 363.2 Tonnes
2008: SGE Withdrawals 543.2 Tonnes
2010: SGE Withdrawals 837.2 Tonnes
2013: SGE Withdrawals 2197 Tonnes
In the last screen shots (from the CGA Gold Yearbook 2013) we can see total supply/demand in 2013 was 2,198.84 tonnes, which is 1.88 tonnes higher than SGE withdrawals. This can be explained by jewelry import that was counted as demand, but not sold through the SGE.
Chinese Gold Demand Metrics
Chinese wholesale gold demand as disclosed in Chinese reports by the CGA is the widest measure of demand. Western consultancy firms like GFMS use different metrics, resulting in lower supply and demand figures. Though, contrasting metrics can not explain the full difference, which has aggregated to 5,030 tonnes from 2007 until 2015. In this post we’ll briefly discuss contrasting metrics, which explain the difference in part, a succeeding post is dedicated to an extensive study on these metrics and how we can measure genuine Chinese gold demand.
In the supply and demand tables above we could see the difference was labeled as net investment (in the CGA Gold Yearbook 2013 at 1,022.44 tonnes), which is calculated by the CGA as a residual between what is withdrawn from the SGE vaults and gold sold at retail level (jewelry shops and banks). GFMS does not include net investment on its demand balance, but merely includes the gold sold at retail level. Net investment, which roughly equals the difference, is caused by direct purchases from individual and institutional customers at the SGE that withdraw their metal (also see chart 3 below).
During the first four months of this year, the number of individual investors kept growing rapidly and now has exceeded two million. The Exchange has become the main channel of investment of physical precious metals, fulfilling the needs of domestic residents.
The quote above clearly states that in 2010 direct purchases at the SGE by individual clients (266 tonnes) already exceeded retail bar investment (142 tonnes).
Purchasing gold directly at the SGE is fairly simple in China. Every Chinese citizen can buy gold or trade derivatives at the SGE through a commercial bank. For 50 RMB a client can open an SGE account at his local commercial bank branch. Subsequently, he or she receives a unique 10-digit trading number that gives access to one SGE account, consisting of a Bullion Account and a Margin Account. The 10-digit trading number will stay with an individual forever, even if he or she switches banks. The process is illustrated in the picture below:
When a physical SGE gold contract is exchanged the full amount of funds is transferred from the buyer’s Margin Account to seller’s Margin Account, the gold is transferred from the seller’s Bullion Account to the buyer’s Bullion Account (settlement is T+0). Gold credited to a Bullion Account is allowed to be withdrawn from the vaults at any time.
The SGE has almost 10,000 institutional and over 8.3 million individual clients, next to 183 domestic members and 63 international members such as banks and refineries. Naturally, the metal withdrawn from the SGE vaults by individual and institutional clients is not sold at retail level (jewelry shops and banks).
Since early 2016 there is even an SGE smartphone application called “Yijintong” that allows anyone with an internet connection to open an SGE account and trade directly on the SGE wholesale platform enjoying the lowest spreads in China.
Any individual can buy bullion directly at the SGE, the only reason he or she would buy gold in a jewelry shop is because these bars are decorated and come in all sorts of shapes and sizes. Obviously, large investors would not buy retail gold but prefer relatively cheaper SGE bars.
I should mention, the CGA discloses Chinese gold demand for the English speaking world excluding net investment, to make it appear demand is far lower than it is in reality. From Reuters on Chinese gold demand 2013:
Gold consumption in China grew to 1,176.40 tonnes last year, with jewellery demand climbing 43 percent to 716.50 tonnes and bullion demand soaring 57 percent to 375.73 tonnes, the China Gold Association said on its website.
Jewelry and bar demand is exactly the same as in the screen shot from the CGA Gold Yearbook 2013 above, but net investment is excluded. Why the widest measure of the Chinese gold market is hidden from the English speaking world is left for speculation.
I shall give another example that confirms the more realistic size of Chinese gold demand. Na Liu, from CNC Asset Management Ltd, traveled to China in 2014 and spoke to The President of the SGE Transaction Department. Afterwards Na reported on Chinese gold demand in 2013 [brackets added by me]:
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.”
…when we asked why the China Gold Association’s number is so low [demand disclosed without net investment], the President said: “They mainly cover the gold sales through the gold shops. This is their main source of information. And their number is quite useful in that way. However, our system [SGE withdrawals] has broader coverage.”
Needless to say, the people that run the SGE, CGA, PBOC and SHFE are all related. Depending on the occasion these people choose to disclose net investment, and thus the true size of the Chinese gold market.
Let us briefly have a look at the compositions of the difference. In the chart below we can see apparent Chinese gold supply (import + mine + GFMS scrap = center column) versus SGE withdrawals and GFMS demand. Obviously, what is being supplied in the Chinese gold market is far more than what the GFMS reports as demand.
The gap between the height of the centre columns (apparent supply) and the red columns (SGE withdrawals) is something that will be discussed in a following post.
A legitimate reason that explains part of the difference (SGE withdrawals – GFMS demand) is stock inventory change. There is always gold in transit from being withdrawn from SGE vaults by jewelry and industrial fabricators to being sold at retail level. This is wholesale stock inventory is not being counted by GFMS as demand as this is likely hedged in the futures market and thus has no net effect on the gold price. Stock inventory change can’t make up the full difference between SGE withdrawals and consumer gold demand, but is part of distortion.
In 2013 GFMS wrote me net investment is solely stock inventory change. Of course this can’t be true. When confronting them with all the evidence I had collected they wrote me:
We have checked with our Data Specialist and confirmed that we use a different methodology. Total Chinese demand used by Thomson Reuters GFMS only include jewelry, physical bullion bars/coins and all industrial demand. Any stock movement change (which is essentially the item 6 net investment) will not be included as underlying demand.
So according to you net investment is “stock movement change”? This would be gold added to the stocks from jewelers, the mint, industrial companies, etc? (this is a few hundred tons each year!)
That’s correct based on the resolution provided by our data specialist.
The World Gold Council (WGC) has tried to explain the difference in two reports released in 2014 dedicated to the Chinese gold market, which both contained fallacious and self-contradictory statements. Up until now the WGC and GFMS have presented very weak arguments that should explain the difference.
For this post we’ll wrap it up. In short, there are several metrics to measure Chinese gold demand:
- Gold sold at retail level = GFMS gold demand
- Import + mine = net gold added to Chinese (non-government) reserves
- Import + mine + scrap = the lowest measure of Chinese gold demand
- Import + mine + scrap + disinvestment = true Chinese gold demand
- SGE withdrawals = total wholesale gold demand
SGE chairman, Xu Luode, said at the LBMA conference in 2014 [brackets added by me]
Last year , China imported 1,540 tonnes of gold. Such imports, together with the 430 tonnes of gold we produced ourselves, means that we have, in effect, supplied approximately 2,000 tonnes of gold last year.
The 2,000 tonnes of gold were consumed by consumers in China. Of course, we all know that the Chinese ‘dama’ [middle-aged women] accounts for a significant proportion in purchasing gold. So last year, our gold exchange’s inventory reduced by nearly 2,200 tonnes, of which 200 tonnes was recycled gold.
Typically, Xu likes to measure import + mine as Chinese gold demand as this is the amount of gold added to Chinese (non-government) reserves. I prefer to consider all metrics to have the best understanding of the Chinese domestic gold market and keep track by how much Chinese reserves are increasing.