China's gold coup d'etat

Editor's Note: This issue of Review & Outlook is based on a series of posts I made at the USAGOLD blog over the course of the past month. China has imported an unprecedented amount of gold bullion in 2013. So much so, that if it were to maintain the current pace, it would import nearly the equivalent of global production for the year. When the news first filtered out of China on the amounts of gold being mobilized through its Shanghai Gold Exchange, the numbers seemed too large to be believed. The obvious question became "What is the source of this extraordinary amount of gold bullion?" It was only in October when Reuters reported that much of that gold had been shipped from London-based exchange traded funds to Switzerland for refining into smaller Asia-friendly bars and then on to Hong Kong and Shanghai that the full picture came into focus and the extraordinary numbers gained credibility.

Below I detail how the China gold trade mechanism works, the reasons for it, and why China's interest in gold is likely to remain of paramount importance to the global market for many years to come. I have updated the original statistics from recently posted reports at the Koos Jansen website based in the Netherlands -- a research source specializing in the China gold trade. To stay abreast of the China situation as well as other developments in the gold market on a daily basis, I invite you to visit our blog page linked above.

According to a recent Reuters report, the United Kingdom's gold exports to Switzerland jumped from 85 tonnes to 1,016 tonnes in the first eight months of 2013 — a twelve times increase. Some bullion market watchers attribute the huge increase to withdrawals or sales from exchange traded funds (ETFs) — an explanation that covers only half the story…….if that. When one learns where this gold ended up and why it went there, the true importance of this unusually large deployment begins to take shape.

Switzerland, according to the Koos Jansen website, has exported over 600 tonnes of gold to Hong Kong through August, 2013. Hong Kong, in turn, has exported over 700 tonnes of gold to the Chinese mainland over the same period through the Shanghai Gold Exchange. Through August, 2013 Koos Jansen puts the total Chinese gold mobilization through the SGE at a stunning 1672 tonnes. Now, with this report of ramped-up exports from the United Kingdom, another piece of the puzzle falls into place and we begin to get a fairly clear picture what these gold mobilizations entail. Switzerland and Hong Kong are acting as a conduit of western gold on its way to China — and probably, at least in part, to Chinese central bank reserves.

To what extent this gold mobilization is the result of some yet-to-be-identified external pressure on London's bullion banks, or simply business as usual, remains to be determined, but gold movements of this size usually do not occur in a vacuum. Hedge funds have been in the gold ETF liquidation mode since April, at the behest, it seems, of certain bullion banks that have issued generalized ETF sell recommendations to their clientele (which includes the funds). The ETF selling has been blamed repeatedly for the rapid drop in the price. If all of this has been a ploy to drive down the price on paper and channel substantial amounts of physical gold to China, who is the winner in this game and who is the loser? And why is it being done?

The gold market is incurably opaque (no matter how diligent or persistent the arguments to the contrary that it isn't or that it should not be), and that is probably why so many are intrigued by it. Yet, at the same time, those who innocently own gold for asset preservation purposes can rest assured that they will never become collateral damage in these affairs as long as they do not allow themselves to lose patience or forget the reasons why they purchased gold in the first place.

Gold is never sought by those who think all is well with the world. It is sought by those who believe that things could go wrong, or indeed, that things have already gone very badly. That true believer might be someone of incredible private wealth, as was the case with Bernard Baruch in the 1930s, or it might be a great nation-state like Germany or China today. When the sitting Secretary of the Treasury asked Bernard Baruch why he was buying so much gold, the reply came quickly that he "was commencing to have doubts about the currency." China and Germany -- the former by buying gold on the open market and the latter through its gold repatriation program -- no doubt, are acting on doubts of their own. Up until today, we were unaware of the degree to which those doubts had manifested themselves in the hidden corridors of the world gold market. . . .Now we know. In the first eight months of 2013 China produced 270 tonnes of gold from its mines, and theoretically almost four times that amount through its London – Zurich – Hong Kong - Shanghai gold conduit. In future years, China's gold import operations likely will be considered a major financial coup d'etat.

The Telegraph's Andrew Critchlow explains that China's consumption of raw materials makes it "only a matter of time before the renminbi replaces the dollar as the primary currency for trading commodities and resources such as crude oil and iron ore." He comes to an ominous conclusion: "The debt ceiling farce in Washington and China's growing reluctance to continue underwriting the US economy by buying up its bonds and adding to America's near $17 trillion (£10.5 trillion) debt mountain suggests that this tectonic shift in the global trade system could be just around the corner."

While financial markets' attention was riveted on Washington's budget theatrics, the United Kingdom and China quietly entered into a game-changing currency swap arrangement that will allow the two countries to trade for goods and services directly in their own currencies, thus cutting out the dollar middle man. "All of a sudden," says Kathleen Brooks, research director at Forex.com, "there's potentially no dollar risk." The two countries quickly followed the swap arrangement with easier access to Chinese financial markets for British investors, including we might assume London financial firms, and the same for Chinese banks in the United Kingdom. By circumventing the dollar, the UK and China are sending a strong message on the greenback's future as the the world's sole reserve currency -- all toward a "de-Americanized world' as China's state -owned Xinhua news agency put it.

Zhu Baoliang, an economist in China's State Information Center, a research unit of the National Development and Reform Commission, a powerful planning agency, told Financial Times, "We need to continue to diversify. Even without this latest debt debate, it would still be necessary to diversify." With this endeavor, it seems China and Europe have crossed a Rubicon of sorts and shifted the playing field in financial markets. It's one thing for Iran or Libya to challenge the pre-eminence of the dollar, but another thing entirely when China and Europe do it.

In Reuters' initial report on the London-Zurich-Hong Kong-Shanghai gold pipeline, Macquarie gold analyst Matthew Turner speculated that the 1016 metric tonne United Kingdom export was shipped to Switzerland for refining into "smaller bars more attractive to Asian consumers or to be vaulted there instead." Though vaulting cannot be ruled out, the recasting explanation makes considerably more sense given the times and the extraordinary amount of gold being imported by China – over 1500 tonnes so far this year as mentioned above. It is difficult to imagine a scenario in which China would be interested in vaulting gold in the West – particularly at a time when the West is experiencing difficult financial and economic circumstances.

On the other hand, we know that four of the world's top gold refineries are located in Switzerland — Valcambi, Pamp, Argor-Heraeus and Metalor. Roughly 70% of the world's annual gold production is refined in Switzerland and it is considered the center of the world's gold refinery business. Its bars are trusted on the world's gold exchanges by the top banks, bullion dealers, jewelry manufacturers, and nation states alike. If Turner is right about recasting the bars into Asia-friendly units, and I think he is, Switzerland would be the place to do it, particularly in light of the volume reportedly being re-refined. In my view, China intends for this gold to be transported to and remain in the East otherwise it would not have gone to the trouble of having it recast into Asa-friendly bars.

To gain a deeper understanding of what China might be up to, some background is essential. Let's start with the trading units at the two major Chinese exchanges involved in the gold trade – the Hong Kong Gold and Silver Exchange and the Shanghai Gold Exchange (SGE) – because that goes a long toward explaining why the 1016 tonne export made an initial stop in Switzerland before moving on to China.

The tael is the standard unit of weight on the Hong Kong exchange. It equals 1.20337 troy ounces, or 37.4290 grams, fineness in the past has been 99% but this standard has been upgraded to 99.99% to conform to international trading standards. According to gold expert Timothy Green's The Gold Companion (1991), the standard trading sizes on the Hong Kong exchange is five and ten taels. The basic contract is 100 taels, or 120.377 troy ounces, as opposed to the standard 100 troy ounce contract on U.S. futures' exchanges. The Hong Kong Gold Exchange is an outlet for much of Asia and the tael trading units, once again according to The Gold Companion are used in China, Taiwan, South Korea, Thailand and Viet Nam.

The SGE is the only gold exchange in China and its contract-trading unit is the kilo bar (32.15 troy ounces), once again a significant deviation from the western exchange standard. SGE widely publicizes itself as a "delivery market" thus the smaller and familiar kilo bar size as its chief trading unit makes a great deal of sense. Most of the metal moving from London to Asia through Switzerland will more than likely end up in the hands of consumers in the form of jewelry and small bars (See stats below). What few people realize is that all of this activity is fully sanctioned by the Chinese government and the Peoples Bank of China (PBOC). In fact, the Shanghai Gold Exchange is owned by the PBOC. As a result any unallocated gold imported and stored at the exchange for future delivery is, indirectly at least, gold inventory at China's central bank.

Drawing again from the Koos Jansen analysis, the China Gold Market Report – compiled by the key players in China's gold market, including analysts for the SGE – lists the following distribution of physical metal through the Shanghai exchange in 2011:

To offer a measuring stick that might give that total number additional meaning – it equals roughly 40% of annual mine production, one-eighth the U.S. gold reserve, and nearly one-third Germany's reserve. (Keep in mind, too, we are talking 2011 numbers not 2013 numbers after the latest massive imports outlined above.)

It is no secret that the Chinese people have a traditional, transcending attachment to gold. That same attitude, it should be kept in mind, permeates almost the whole of Asia, and as more and more people partake in the fruits of Asia's rise economically the demand for gold is likely to grow with it. As such, the demand we have seen thus far could be just the tip of the iceberg, particularly when you take into consideration China's ambition to build a significant central bank gold reserve. China is likely to take advantage of any drop in the price to load up as it did in the April-August, 2013 time period.

In a recent Financial Times opinion piece, John Dizard explored the burgeoning tension building between the paper and physical gold markets. He pointed to the very situation in the physical gold market we have just covered in depth. He talks about the shortage of kilo bars globally, the recasting of 400 troy ounce ETF bars for shipment to China, and the upside down forward rate on physical gold, a strong indicator of short physical supply. Dizard poses the question, "Could the gold flow back from those kilo bars to recasting as good delivery 400oz bars?" In other words, does the London-Zurich-Hong Kong-Shanghai pipeline run in both directions? An unidentified gold refiner answers: "Much of that has been converted to jewelry. It would be a lengthy process. Those are pretty sticky hands…This could turn into a very violent wake-up call for [screen-traded gold]. People talk about 'fiat currencies', but we also have 'fiat gold.' Volatility is too cheap right now."

One more point of interest before I put this piece of the China analysis to rest: HSBC, the multinational bank headquartered in London, is the chief storage facility for the largest gold ETFs. As mentioned in my previous article, much of the gold transferred to Switzerland by HSBC came out of the ETFs. In addition, HSBC is an important trading member in the daily London Gold Market Fixings. Founded by Sir Thomas Sutherland in the British colony of Hong Kong in 1865, HSBC stands for the Hong Kong Shanghai Banking Corporation.

As Chief Market Strategist for Anglo Far East, the precious metals logistics and custodial services company, Alex Stanczyk travels frequently to China and has extensive knowledge and experience about its attitude towards gold. In the following snippet from a longer interview at the Koos Jansen website, he discusses China's gold strategy and what it might mean for the market in the months and years to come. The interview took place in early September, 2013, and it is reprinted here with permission.

Michael J. Kosares is the founder of USAGOLD and the author of "The ABCs of Gold Investing - How To Protect and Build Your Wealth With Gold." He has over forty years experience in the physical gold business. He is also the editor of Review & Outlook, the firm's newsletter which is offered free of charge and specializes in issues and opinion of importance to owners of gold coins and bullion. If you would like to register for an e-mail alert when the next issue is published, please visit this link.
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