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Filling the China Cabinet With Gold

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It won’t take a collapse of the dollar or some doomsday scenario to catapult the price of gold well above its September 2011 all-time high of $1,924 an ounce.

A decline in the greenback’s value and international prestige may or may not be in the cards.  So, too, might troublesome inflation, a collapse on world equity markets, or another financial crisis of some sort.  But these are not necessary prerequisites for gold to resume its long-term price ascent.

Indeed, not withstanding the possibility of further gold-price weakness in the next year or so, I am confident China’s insatiable appetite for the yellow metal can single-handedly lift its price well above its historic high.

Recent History

Private gold investment was banned in China and the domestic market was tightly controlled for more than five decades following the Communist Party victory and ascension to power in 1949.  But, ever since the legalization of private gold investment and the gradual liberalization of the market beginning in 2002, China’s appetite for gold - reflecting both pent-up demand and rising prosperity - has been growing steadily year after year.

The government’s continuing liberalization of the domestic market, its support for new channels of distribution, its orderly and measured regulation of spot and futures exchanges, and its encouragement of private gold investment have contributed to the country’s rise in prominence in the world of gold.

Official Purchases Continue Apace

In recent years, China’s central bank, the People’s Bank of China, has very likely also been a significant buyer of gold.  A few years ago, in April 2009, the PBOC revealed it had purchased some 454 tons (about 14.6 million ounces) over the preceding six years - an average of about 75 tons per year.

Since then, there has been no official data or hard evidence of additional acquisitions - but we believe the central bank has continued buying regularly from domestic mine production and scrap refinery output perhaps as much as 50 to 100 tons or more each year.  For its part, the PBOC has said it will “seek diversification in the management of reserve assets,” thus discretely signaling its intention to accumulate gold.

Fueling the PBOC’s interest in building its official gold holdings is their expectation that the U.S. dollar will depreciate against the Chinese yuan and other “strong” currencies in years to come as the dollar’s status and role as the world’s primary official reserve asset gradually diminishes.  At the same time, the PBOC envisions the yuan will enjoy growing stature as an official reserve and trade settlement currency - and it believes ownership of gold will enhance its currency’s future stature and prestige.

A Look at the Numbers

Over the past few years, we have repeatedly expressed the view that China’s actual gold-mine production, secondary supply from old jewelry and industrial scrap, jewelry consumption, investment, imports and central bank purchases have each been more than indicated by the available statistics or generally believed by analysts of the gold scene.

To begin with, the China Mining Association (CMA) estimates the country’s gold production may reach a record 430 tons this year, up about seven percent from their 2012 estimate of 403 tons.   Meanwhile, total gold consumption is expected to rise at least 20 percent from 832 tons last year to over 1,000 tons this year, according to the China Gold Association (CGA).

However, we believe mine production and supply from other domestic sources has year after year run well ahead of “official” estimates - and this year’s total domestic supply will total well over 500 tons, possibly as much as 550 tons or even more.

We understand that the mine production statistics include only output from reporting members of the China Mining Association but exclude output from mines operated by the military as well as the many small rudimentary mines operating in the “underground” economy.

Also omitted from the production data are the significant quantities of recycled gold recovered from electronics and dental scrap, old jewelry, and small investment bars coming back to the market.  In addition, gold contained in copper and other mining concentrates imported from abroad for processing by Chinese smelters and refiners are not reflected in the CMA supply statistics.

Import data is also incomplete.  We do know how much gold enters the Mainland through Hong Kong because the former colony continues to report export statistics - which incidentally have been booming.  Net imports through Hong Kong are running this year through September at an annual rate over 1,100 tons - more than double the rate prevailing in the past few years.   Some gold also enters China through other trade routes imported legally by licensed dealers, but again, there are no published statistics.

Finally, there must be some gold smuggled illegally into China through its long and porous borders by travelers returning from abroad as well as organized smuggling syndicates.  Gold smuggling is a big business in many other Asian nations (Vietnam, Thailand, India, Pakistan to name a few) and there is no reason to believe otherwise for China.

The bottom line is we really don’t have any idea what supplies from all sources add up to.   All we know is that total supply is significantly higher than generally believed!  And, since every ounce of this metal must go somewhere, total gold demand must also be higher than indicated by the available, but incomplete, data.

Truth and Consequences

If annual available supply is actually some 75 to 100 tons more than generally acknowledged, total demand will be underestimated by a like amount - and these are likely very conservative estimates.

Moreover, this excludes gold sourced and stored abroad by the PBOC and, possibly, some too by the country’s sovereign wealth fund.  Many central banks typically hold a significant share of their official gold reserves on deposit with the Bank of England and the New York Fed - and there’s no reason to believe China would not also hold some of its gold abroad.  Therefore, total Chinese gold demand - including purchases by the PBOC - could be still higher than indicated by a domestic supply/demand analysis.

Even if the recent pace of demand - and the high level of monthly imports - proves unsustainable, Chinese gold accumulation will have a long-run bullish consequences that are not fully recognized by most other gold-market analysts and commentators.

Growth in aggregate demand from jewelry buyers, private investors, and the People’s Bank of China will continue to outpace growth in total supplies from mine production and secondary sources.  With both domestic supply and demand relatively price inelastic, a significant volume of imports will be required to balance the market.  And, even though China has become the world’s biggest gold-mining nation, none of its output is exported to the world market.

For the Chinese, as our friends and clients in China attest, gold purchased today is mostly for long-term, quasi-permanent, holdings.  Moreover, exporting of gold is for the most part legally prohibited, except by licensed gold-market dealers for commercial reasons such as refining and re-import.

Simply put, China’s private- and official-sector gold purchases - whether sourced domestically or internationally - are unlikely to flow back into the world gold market any time soon . . . even if prices rise to stratospheric levels.  Indeed, Chinese investors, unlike many of their American and European counterparts, have exceptionally “strong hands” and are unlikely to sell their gold holdings, except under the most dire of economic or political circumstances.