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 largest physical gold market globally is presently the Chinese domestic gold market. At the core of this market is the Shanghai Gold Exchange.
China is the largest gold importer and mine producer globally, and because nearly all of these supply channels in the domestic market flow through the center bourse, as a consequence the infamous Shanghai Gold Exchange (SGE) is the largest physical gold exchange currently in existence. The yearly amount of physical gold withdrawn from the SGE vaults has exceeded 2,100 tonnes since 2013.
Whilst Western consultancy firms like the World Gold Council and Thomson Reuters GFMS report annual Chinese gold demand is roughly 900 tonnes, we can read in reports by inter alia the China Gold Association (CGA) that annual Chinese gold demand equals SGE withdrawals and is thus more that twice as much as is portrayed in the West. The difference (between GFMS demand and SGE withdrawals) can only in part can be explained by contrasting metrics.
In this post we’ll examine the basic mechanics of the Chinese domestic gold market and how nearly all physical gold in China flows through the SGE in order to achieve the best understanding of the size of this market and the level of true Chinese gold demand.
Kindly note, the definition of SGE withdrawals 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, Why SGE Withdrawals Equal Chinese Gold Demand And Why Not – The Argument List)
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 for teh PBOC to monitor the gold traded in the Chinese market, and (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 this analysis of the Chinese domestic gold market I’ve relied on Chinese laws, annual reports drafted by the 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 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. Back then the PBOC had the monopoly in trading gold in China 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.
By approximation the Chinese domestic gold market functioned as was planned starting in 2007, as in that year for the first time the amount of physical gold withdrawn from SGE 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 2007 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 we 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 roughly match total Chinese gold demand.
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.
Gold Imported Into China
Gold bullion import into the Chinese domestic gold market can be done by banks that enjoy approval by the PBOC, 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 is publicly know. At this stage there are fifteen banks that have been approved by the PBOC (in random order):
- 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
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. 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 9999, 9995, 999 or 995. Solely standard gold is allowed into SGE designated vaults to be traded through the SGE system. The Chinese gold trade rule book states [brackets added]:
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 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 import of doré, ore and jewelry into the domestic market different rules apply than for standard gold; in this form other entities than banks can import the metal, if approved by the PBOC, though export is prohibited.
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’s not exempt from VAT. In addition, when non-standard gold, like 200 gramme bars, is traded in the Chinese domestic gold market it is exempt from VAT. These VAT rules incentivize 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 gold products in and out of the Chinese domestic market, but the tonnage is insignificant.
Individuals can freely import and export 50 gram when traveling abroad. However, the rules aren’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.
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. The next quote is from China Gold International Resources Corp. Ltd. [page 15, brackets added]:
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, subsequently to be refined into standard gold by an SGE approved refinery and traded over the SGE.
Because of the aforementioned rules the SGE has the best liquidity in China, and thus gold mining companies are extra incentivized to cast their output in standard gold bars and sell on the SGE. However, miners are allowed to sell non-standard gold or gold products 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.
Scrap And Disinvestment Supply In China
When it comes to measuring scrap and disinvestment it gets a little more complicated, as our sources (GFMS, CGA) for this data do not use the same nomenclature and metrics. GFMS usually uses term scrap for old jewelry and industrial products, but this excludes disinvestment. The CGA uses the terms recycled gold and scrap supply inconsistently for all other supply flows next to import and mine production. Shortly, we’ll make a distinction between CGA, GFMS and BullionStar metrics.
First, all scrap and disinvestment and alike in the Chinese domestic gold market has a strong incentive to flow through the SGE because of the VAT rules regarding standard gold and liquidity. Scrap and disinvestment is not required to be sold through the SGE, yet many refineries cast standard gold that is exempt from VAT on the SGE, and thus most finds its way to the center bourse.
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.
Now we will establish the significance of differentiating scrap and disinvestment and alike. Because in economics total supply and total demand are exactly equal – one cannot sell gold without a buyer or buy gold without a seller – consequently we can gauge demand by measuring supply. With this knowledge we’ll have a more precise look at this topic.
- 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 both the CGA and GFMS in their “scrap” numbers.
- The second is disinvestment. Individual and institutional investors in China buy gold directly at the SGE. If later in time the bars are sold back they can be send 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) are included by the CGA in their “scrap” numbers, but not by GFMS.
- 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 scrap there can be other forms of gold being recycled through the SGE, which we’ll all label as distortion (distortion is recycled gold).
In the (CGA) Chinese annual gold reports mentioned at the beginning of this post, scrap, disinvestment and distortion flows are all counted in one category, labelled by the CGA as “scrap supply”. In contrast, GFMS only measures scrap and not disinvestment . 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 re-enter the SGE is if they’re recast into new bars by an SGE approved refinery. From the SGE’s 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
Let us use some equations to clear our view of this market. 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:
SGE Withdrawals = Import + Mine + Scrap + Disinvestment + Distortion = Total Supply = Wholesale Demand
But as mentioned before distortion blurs our view of demand (it has no net effect on the price). So distortion has to be subtracted from SGE withdrawals
True Chinese gold demand = Import + Mine + Scrap + Disinvestment
Chinese Wholesale Gold Demand = True Chinese gold demand + Distortion
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.