This post is an overview of all arguments presented by Western consultancy firms that should explain the difference between SGE Withdrawals and WGC Chinese gold demand. Once again we’ll examine to what degree divers metrics can cause the difference.
Since my first post on SGE Withdrawals Equal Chinese Wholesale Gold Demand Western consultancy firms have kept repeating my analysis is false, in response I’ve continued to clarify the metrics used in the China Gold Association (CGA) Gold Yearbooks. Not to get confused in this debate, this blog will keep track of all arguments ever presented and new ones that surface. This is the list so far in chronological order:
stock movement change
In 2014 the World Gold Council (WGC) came out with two special reports about the Chinese gold market that should have shine a light on the difference. However, the reports contained numerous false statements and the segments on the difference failed miserably, as I’ve pointed out in several posts (one, two, three, four, five, six). Subsequently, Western consultancy firms came up with new arguments! Kindly note the shift in arguments; when the old ones failed, the firms impudently moved on and came up with new ones. The fact the list of arguments is constantly changing confirms the weakness of the arguments.
Please make sure you have read this post, about the basic mechanics of the Chinese gold market with the SGE at its core.
First let’s go through all the arguments to investigate which ones make any sense, at the end of the post we’ll do some number crunching.
1) INDUSTRIAL DEMAND. The first argument ever presented was by the World Gold Council (WGC). In August 2013 I’ve asked the Council what their explanation was for the difference between WGC demand and demand disclosed in the China Gold Market Report 2011, co-written by the PBOC, which exactly equaled SGE withdrawals. They wrote me by email:
The data that we publish in Gold Demand Trends are collected for us by Thomson Reuters GFMS. Our data represent jewelry and bar & coin demand and do not incorporate any industrial demand or fabrication, which is included in the PBoC figures. As I am sure you will appreciate, data collection of this sort relies on a number of proprietary sources and these will not necessarily be the same for both GFMS and PBOC. It is, therefore, perhaps not surprising that the estimates of demand differ somewhat.
Industrial demand couldn’t make up the 263 tonnes difference in 2011, nor could it have caused the 3,354 tonnes total difference from 2007 until 2014.
Though being small, Chinese industrial demand isn’t captured in WGC Chinese gold demand, and thus partially explains the difference from a different metrics point of view. Industrial demand is demand, of course, but the WGC doesn’t count it.
2) STOCK MOVEMENT CHANGE. When I asked GFMS in August 2013 about net investment – which is how the difference was titled in the China Gold Market Reports – they wrote me by email:
We have checked with our Data Specialist and confirmed that we use a different methodology. Total Chinese demand used by Thomson Reuters GFMS only includes 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.
Because SGE withdrawals capture wholesale demand the difference is partially what jewelry companies and the mint have purchased at the SGE, but not yet sold in retail. The amount of gold in stock can never be 3,354 tonnes though. According to an estimate by the WGC as much as 125 tonnes of gold can be held as inventory in the mainland:
… It is, however, indicative that as jewelers expanded, so too did their inventory levels and it is our judgment that across the industry between 75t to 125t may have been absorbed in the supply chain since 2009.
Although we don’t hear much of this argument these days, it’s partially legitimate.
3) ROUND TRIPPING. In April 2014 the WGC published a report on China titled China’s Gold Market: Progress and Prospects. It certainly was not the first WGC report on China, in 2010 China Gold Report was released, but it was the first time the Council described the structure of the Chinese gold market, the Shanghai Gold Exchange and the ‘supply surplus’ in the Chinese gold market. The Council had some explaining to do, as it was clear China imported substantially more gold than what they disclosed as demand.
For the first time Chinese Commodity Financing Deals (CCFD) were introduced to the Council’s wide reader base. This type of financing is pursued to acquire cheap funds. It can be done trough round tripping or leasing. The Council wrote:
These operations fall into two broad categories, although there is some overlap between the two. Firstly, there is the use of gold via loans and through letters of credit (LCs) as a form of financing. Secondly, there is the use of gold for financial arbitrage operations that will also be based upon gold loans or LCs. In most cases the gold is quickly re-exported to Hong Kong, often as very crude jewellery or ornaments to get round tight controls on bullion exports. (This is the practise commonly referred to as ‘round-tripping’. Moreover, because nearly all gold flowing into China goes through the SGE, round-tripping can inflate the SGE delivery figures.) In other cases the metal is stockpiled in vaults in China or Hong Kong.
This is not true. Basically, round tripping gold flows are separated from the Chinese domestic gold market and the SGE system; they do not inflate SGE delivery or withdrawals. Round tripping is done through trade between Chinese Free Trade Zones and (usually) Hong Kong. Therefor, it can’t be an argument, as the difference we’re after is between SGE withdrawals and WGC demand within the Chinese domestic gold market. For further reference you can read my post on round tripping Chinese Gold Trading Rules & Financing Deals Explained.
Keep in mind gold can only be exported from China through Free Trade Zones (FTZs). This is called processing trade (round tripping is always done through processing trade). Gold is imported into FTZs, processed into jewelry and then exported, that’s how processing trade works. This gold cannot be imported from a FTZ into the rest of the mainland without a PBOC license for general trade. If standard gold is imported into the mainland in general trade it’s required to be sold fist through the SGE and is not allowed to be exported. (The exact rules are explained in this and this post.)
Round tripping is not a legitimate argument. To my understanding the WGC has dropped this argument all together, though GFMS still thinks round tripping inflates SGE withdrawals. In their Gold Survey 2015 it’s written (page 78):
…the round tripping flows between Hong Kong and the Chinese mainland, which also inflates the SGE turnover and withdrawal figures…
4) GOLD LEASING. The other CCFD is leasing. In the WGC report from April 2014 it was stated:
No statistics are available on the outstanding amount of gold tied up in financial operations linked to shadow banking but Precious Metals Insights [PMI] believes it is feasible that by the end of 2013 this could have reached a cumulative 1,000t…
PMI insinuated 1,000 tonnes is tied up in CCFD. We’ve just concluded round tripping has got nothing to do with the difference, that leaves leasing.
Yes, gold is leased in the Chinese domestic gold market (on the SGE) to acquire cheap funds. Occasionally numbers are published about the yearly lease volume. In April this year ICBC published this chart:
No doubt PMI used the total lending volume in 2013 (1,070 tonnes) to come up with, “the outstanding amount of gold tied up in financial operations … by the end of 2013 could have reached a cumulative 1,000t”. There is one problem; the lease data is not the amount of gold on lease at any point in time, but it resembles all leases yearly conducted (turnover). For example, if a miner borrows 20 tonnes of gold for 1 month and the loan is rolled over 9 months, total lease volume is 200 tonnes. The essence is, there was no 1,000 tonnes tied up in gold leasing in 2013, nor was 1,600 tonnes tied up in gold leasing in 2014. Too bad virtually all mainstream media copied the statement from the WGC report, which spread misleading information through the financial industry.
In addition, we don’t know how much of the leases are withdrawn from the SGE vaults. Only a refinery or jewelry company would withdraw, a mining company or speculator would sell it spot at the SGE for the proceeds (read this post for a detailed explanation of gold leasing) and most of what refiners and jewelers withdraw is for genuine gold business. My point being; according to my analysis SGE withdrawals are not likely to capture shadow banking in the form of gold leasing, just genuine gold business.
Furthermore, when a lease has to be repaid it would be most efficient for a lessee to buy physical on the SGE, not off-SGE to subsequently load it into SGE vaults. The latter would be a waste of capital. Concluding, it’s not likely gold leasing inflates withdrawals from the SGE or scrap supply towards the SGE. Though technically it’s possible.
5) OFFICIAL PURCHASES. Often it’s being thought in the gold space SGE withdrawals end up in the vaults from the People’s Bank Of China. In my post PBOC Gold Purchases: Separating Facts from Speculation I’ve laid out why it doesn’t make sense for the PBOC to purchase gold through the SGE.
Early 2013 the WGC speculated the difference could be explained by official purchases, later that year the Council changed its mind. From the July 2014 WGC report on China, Understanding China’s Gold Market:
China’s authorities have a range of options when purchasing gold. They may acquire some of the gold which flows into China; there has been no shortage of that. But there are reasons why they may prefer to buy gold on international markets: gold sold on the SGE is priced in yuan and prospective buyers – for example, the PBoC with large multi-currency reserves – may rather use US dollars than purchasing domestically-priced gold. The international market would have a lot more liquidity too.
The firms will agree the PBOC is not likely to buy gold through the SGE and thus official purchases cannot make up the difference we’re after.
6) RECYCLED GOLD. The most obvious argument to explain elevated SGE withdrawals, one would think, is recycled gold through the bourse, counted over and over as withdrawn. However, SGE rules dictate bars withdrawn are not permitted to re-enter the vaults before being remelted and assayed by an SGE approved refinery. Which is not say it doesn’t happen.
Arguments presented by the firms regarding recycled gold must be divided in subcategories.
In Understanding China’s Gold Market the WGC was correct in pointing out there are two sorts of scrap flows going through the SGE; gold-for-cash and gold-for-gold.
Gold can be sold for cash, thereby increasing supply, while gold can also be sold for gold, increasing both supply and demand. Gold-for-gold does not affect the supply-demand balance, hence it’s not counted as supply in WGC metrics, nor is the matching demand side.
6.1) Process scrap. This argument is from CPM Group. In short, CPM states industrial companies produce 50 – 70 % scrap supply of the gold used in manufacturing. The scrap spillover flows back to the SGE. Process scrap thus inflates SGE supply and demand, because the gold was bought at the SGE (demand), but flows back for a significant part (supply). Although, it’s unknown how much of this gold actually flows back to the SGE or is brought to a refinery for toll refining (a refinery producing bars or wire from the process scrap for the industrial company in return for a fee).
Process scrap, described in detail by Jeffrey Christian at the very end of this post, is a form of gold-for-gold scrap supply.
6.2) Arbitrage refining. This argument is relatively new and was brought forward by GFMS on February 17, 2015, at the Reuters Global Gold Forum when Jan Harvey interviewed Samson Li (GFMS).
Some people see withdrawals on the Shanghai Gold Exchange as a proxy for Chinese demand. Do you think this is valid?
It depends on the methodology used. For example there are refiners that would, at times, withdraw 9995 gold bars from the SGE, refine it into 9999 bars whenever there is profitable opportunity, and then deposit it back into SGE vault……
Presumably there can be an arbitrage opportunity at the SGE if Au99.95 gold is an X percentage cheaper than Au99.99 gold. Such a spread would be a classic example of one of the contracts being under or overvalued relative to the other.
I’m not a trader, but I can imagine a way to close the arbitrage – through lease. This is my theory: if a spread occurs Au99.95 is bought, concurrently Au99.99 (LAu99.99) is borrowed and immediately sold. Then the Au99.95 is withdrawn, refined into Au99.99 and returned to the lender.
So how much is Process scrap and arbitrage refining? It can be measured and I will tell you how. Every year the Chinese publish the composition of the supply and demand side of the Chinese wholesale market. Have a look:
By knowing, (i) SGE withdrawals, (ii) Import, (iii), Mine production and (iiii) Gold-for-cash (labeled as GFMS scrap in the chart) we can calculate gold-for-gold scrap, which by approximation captures both process scrap and arbitrage refining.
It may be difficult to track process scrap and arbitrage refining directly, indirectly the Chinese disclose the volume of both flows as gold-for-gold. Eventually we’re told what was Import and we can fill in the equation.
To come to a thorough understanding of Chinese gold supply/demand metrics gold-for-gold scrap flows are very much worth measuring. Especially because since 2014 this supply category has grown.
7) EXPORT. This argument is also relatively new, brought forward by PMI. On a conference in London Phillip Klapwijk, Managing Director of Precious Metals Insights Limited (PMI), stated China exports about 1,000 tonnes a year (from the domestic gold market). However, at this stage the rules prohibit gold export from the Chinese domestic gold market. Recently I’ve written an extensive analysis on Klapwijk’s presentation (click to read), no need to go over this again here. The export argument is not legitimate.
There is one argument the firms haven’t brought up, which is withdrawals from the Shanghai International Gold Exchange (SGEI). Although, this only could have influenced total SGE withdrawals starting from 2015.
What Is The Difference?
The difference between SGE withdrawals and WGC Chinese gold demand from 2007 until 2014 is a whopping 3,354 tonnes. What can we subtract from this number from differences in metrics? Let’s put to work the legitimate arguments and see what happens.
1) Data on Chinese industrial demand wildly varies. We’ll use 200 tonnes: 3,354 minus 200 is 3,154 tonnes.
2) For wholesale inventory we’ll use 125 tonnes: 3,154 minus 125 is 3,029 tonnes.
6) Gold-for-gold scrap from 2007 – 2014 accounted for 951 tonnes: 3,029 minus 951 is 2,078 tonnes.
When we subtract the tonnage from all legitimate arguments we’re still left with a difference of 2,078 tonnes of gold, which the firms refuse to label as demand. In my opinion it cannot be labeled as anything else and many Chinese gold industry executives have publicly disclosed to wholeheartedly agree. (This post expands on where the residual withdrawals end up.)
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