My previous posts (part one, two, three) on the structure of the Chinese gold market I started writing a few years ago and additional information has been published in little bits and pieces all over my blog. The time has come for another comprehensive and updated post on the basic mechanics of the Chinese gold market.
According to my analysis the current structure of the Chinese market with the Shanghai Gold Exchange (SGE), launched in 2002, at its core has been designed by China’s central bank, the People’s Bank Of China (PBOC), (i) to manage the amount of gold added to Chinese (non-government) reserves, (ii) to grant all gold added to Chinese (non-government) reserves and traded in the Chinese wholesale market to be of the highest quality, (ii) to provide the Chinese people direct acces to the wholesale market. Sprouted from the centrally minded Chinese authorities, the SGE system was implemented to stimulate the citizenry to buy physical gold and to develop the Chinese gold market in order to support the internationalization of the renminbi.
The reports that provided the base on which I’ve analyzed the structure of the Chinese market are:
China Gold Association (CGA) Gold Yearbook 2006, 2007, 2008, 2013 (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 Shanghai Futures Exchange (SHFE).
Screenshot from the China Gold Market Report 2011
In my research I’ve also been helped by sources in China mainland with expertise of the Chinese domestic market and global market. Much information is only written in Chinese, which I never could have used without without proper translations.
When the SGE was launched in 2002 the Chinese market didn’t change over night. Prior to 2002 the PBOC had the monopoly on gold and silver trade in China, the people were only allowed to purchase jewelry in designated shops. The inception of the SGE slowly started to liberalize the market; individuals were allowed to invest in gold in 2004.
In 2007 the gold market fully functioned as was planned, for the first time SGE withdrawals equaled Chinese wholesale demand that year. From the CGA Gold Yearbook 2007:
In 2007, the amount of gold withdrawn from the warehouses of the Shanghai Gold Exchange, total gold demand of that year, was 363.194 tonnes of gold, compared to 2006 increased by 48.02 percent,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.
From 2002 until 2007 Chinese gold demand did not match SGE withdrawals; the reform of the market wasn’t fully worked out in those years.
There are a few basic rules 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 Gold Trade
Bullion import into the Chinese domestic gold market can only be done by banks that carry a PBOC gold import license, though, for every shipment anew approval must be submitted. Bullion export from the Chinese domestic gold market is prohibited. 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
Bank of Shanghai
Bank of China
The Chinese domestic gold market is separated from Chinese Free Trade Zones (read this and this post for more information on Free Trade Zones).
All bullion imported into the Chinese domestic gold market is required to be sold first through the SGE before entering the Chinese market place. Only standard gold is allowed into SGE designated vaults; this is gold casted by an SGE approved refinery that meets the following specifications: bars of 50g, 100g, 1Kg, 3Kg or 12.5Kg, with a purity of Au9999, Au9995, Au999 and Au995. When standard gold is traded in the Chinese domestic gold market over the SGE or SHFE it’s exempt from VAT.
The Chinese Mint has an exception to export golden Panda coins and to my knowledge there are also a couple jewelry companies that are allowed to trade non-standard gold (jewelry) 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 is not very stringent on the import side. Many mainland tourists visit Hong Kong to buy jewelry and bring as much 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. While, 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. Some travel agencies even offer jewelry trips.
Vincent Chow estimates about half of all jewelry in Hong Kong is purchased by mainland tourists. Some gold purchased by mainland tourists is stored in safety deposit boxes in Hong Kong; this is hidden demand from China mainland. On the other hand it’s likely some gold is smuggled from the Chinese domestic market to India – unfortunately, it’s impossible to know how much.
Chinese Gold Mining
All domestic mining output in China is required to be sold first through the SGE before entering the Chinese market place. Overseas mining can be imported and sold through the SGE as well. In 2013 overseas mining accounted for 17.25 tonnes.
From China Gold International Resources Corp. Ltd. (page 15):
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.
Chinese Recycled Gold
Scrap supply has a strong incentive to flow through the SGE because of the VAT rules regarding standard gold. Scrap gold is not required to be sold through the SGE, though many refineries cast standard gold, as these sizes are most commonly traded, and thus most refinery bar production finds its way to the SGE.
1. 上海黄金交易所标准金条 Shanghai Gold Exchange Standard Gold Bar. 2. 上海黄金交易所标志 Shanghai Gold Exchange Logo. 3. 品牌标志 Brand Logo. 4. 金条品牌 Gold 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 Gold Bar Number.
Important for understanding all metrics used to measure Chinese gold demand, there are two kinds of scrap flows that enter the SGE. The first is gold-for-cash scrap; gold sold for cash forming a part of the supply side in the market and, therefor, having an effect on the price. The second is gold-for-gold scrap; this can be scrap spill over from jewelry or industrial fabricators that sell the scrap to a refinery, while at the same time buying bars at the SGE to continue production. Because gold-for-gold is supply as well as demand it has no net effect on the price of gold, for which this type of scrap is not counted by GFMS as supply.
In the Chinese reports I mentioned at the beginning of this post – that use an alternate metric for Chinese gold supply & demand than GFMS – both scrap flows are counted as supply.
Just like the LBMA, the SGE respects a chain of integrity. Only approved refineries can supply bars to the SGE system, once bars are withdrawn from the 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:
Any gold bullion withdrawn by a member or customer shall not be loaded into any Certified Vault in the future.
This rule is essential for comprehending the mechanics of the Chinese gold market.
SGE Withdrawals Equal Chinese Wholesale Gold Demand
If we put together the rules mentioned above we can understand the basic equation for the Chinese gold market, SGE withdrawals equal wholesale demand. As import + mine + scrap is total physical supply to the SGE and everything that is withdrawn is total demand, therefor:
The equation is supported by data from the CGA and SGE since 2007. Note, for every year SGE withdrawals equal total demand.
2007 SGE Withdrawals 363.2 Tonnes
CGA Gold Yearbook 2007: framed in red is total demand
2008 SGE Withdrawals 543.2 Tonnes
CGA Gold Yearbook 2008: framed in red is total demand 2008 in tonnes
2010 SGE Withdrawals 873.2 Tonnes
China Gold Market Report 2010, total demand in tonnes
2013 SGE Withdrawals 2197 Tonnes
CGA Gold Yearbook 2013: framed in black is total demand 2013 in tonnes. (Red = jewelry manufacturing, blue = small gold bar production, purple = industrial material, turquoise = gold coin manufacturing, yellow = other, green = net investment)
In the last screen shots (from the CGA Gold Yearbook 2013) we can see total supply/demand in 2013 was 2198.84 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. Another reason why SGE withdrawals lost their accuracy to measure demand in 2014, is because of the launch of Shanghai International Gold Exchange (SGEI). No significant disturbances as of yet though. I’ll shortly write a comprehensive post on the relationship between SGE withdrawals and SGEI activity.
The next flow chart of the Chinese gold market drawn by the WGC is quite helpful. Although I don’t think there is any/much jewelry exported from the Jewelry Sector after the SGE; this has to do with different rules in the Chinese domestic gold market (SGE) and Free Trade Zones, read this post for information.
Chinese Gold Demand Metrics
Wholesale demand (SGE withdrawals) as disclosed in Chinese reports is the widest measure of demand. Western consultancy firms like GFMS and the World Gold Council (WGC) use different metrics, resulting in substantially lower supply and demand figures. As I just pointed out GFMS doesn’t count gold-for-gold on the supply side, on the demand side they don’t count much of net investment (1,022 tonnes in 2013). GFMS only measures what is being sold at retail level.
However, every Chinese citizen can buy gold or trade derivatives at the SGE through a commercial bank. For 50 RMB a client receives a unique 10-digit trading number – this number will stay with an individual forever, even if he or she switches banks – that provides access to one SGE account, consisting of a Bullion Account and a Margin Account.
When a physical gold contract – like Au99.99 – is traded the full amount of funds equal to the value of the contract 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. Needless to say, gold can only be withdrawn from a Bullion Account.
According to the chairman of the SGE, his exchange has over 5 million individual clients and 8,000 institutional clients, next to all its members such as banks and refineries. Gold can be withdrawn from SGE vaults by banks, jewelers, industrial manufacturers, the mint, individuals, institutional investors and refineries, naturally not all this gold is sold at retail level. Banks cast their own bars, jewelry companies manufacture jewelry and industrial companies produce chips; a lot ends up at retail level, not all.
There is always some gold is in transit between SGE withdrawals and retail level in wholesalers stock inventory, GFMS doesn’t count stock inventory (purchases) as demand as this is hedged in the futures market and thus has no net effect on the price of gold. But stock inventory can’t make up the difference between SGE withdrawals and retail demand. In reality the residual flows to private vaults.
Gold withdrawn by individual or institutional investors directly from the SGE vaults cannot be measured at retail level, but this is most certainly gold demand. In previous posts (one, two) I’ve expressed why I think the GFMS & WGC are deliberately understating Chinese physical gold demand to not shock the global gold market. To the Western world the CGA also presents Chinese gold demand measured at retail level, only in the reports mentioned above, that are currently all taken of-line, the true size of the Chinese gold market is disclosed. The China Gold Market Report hasn’t been published after 2011 and the CGA Gold Yearbook 2013 was only published in Chinese hard copies. This is all done to hide China’s gold hunger; for an orderly transfer of gold from West to East.
In the above chart we can see that when we subtract gold-for-gold supply from SGE withdrawals there is still a huge discrepancy between apparent total supply and WGC demand. The gap has cumulated to an astonishing 2,400 tonnes from 2007 to 2014.
In this last chart we can see all supply and demand categories disclosed in the CGA Gold Yearbook 2013, next to WGC demand that was recently revised upwards. The SGE has confirmed to me net investment is simply a residual between what is withdrawn from the SGE vaults and gold sold at retail level; thus containing stock inventory change, but far more purchases by individual and institutional clients directly at the SGE.
GFMS states net investment is solely stock inventory change, they told me by email back in 2013. When confronting them with the matter they replied:
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.
At the time aggregated net investment was only 1,000 tonnes, by now it’s more than 2,500 tonnes (calculated as SGE withdrawals minus gold-for gold minus WGC demand). Pretending this is all stock movement severely hurts GFMS’ credibility. The WGC has tried to explain the gap in two reports released in 2014 dedicated to the Chinese gold market that both contained inaccurate and self-contradictory statements. Remarkably the WGC wrote in Understanding China’s Gold Market, there is about 125 tonnes of gold in stock inventory. That’s not much for a gap of 2,500 tonnes.
In my opinion there can be four different metrics used:
Gold sold at retail level = WGC data
Import plus mine = net gold added to Chinese (non-government) reserves
SGE withdrawals minus gold-for-gold scrap = total demand including stock movement change
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.
Apparently Xu likes to measure import + mine as Chinese consumer gold demand as this is the amount of gold added to Chinese non-government reserves. I like to consider all metrics to have the best understanding of the Chinese gold market and keep track by how much Chinese (non-government) reserves are growing.
This post is part of the Chinese gold market essentials series. Other parts previously published are:
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