Make Way for China Gold Buying Frenzy

“The beginning of gold trading by individual investors on the Shanghai Gold Exchange (SGE) later this month is expected to provide a welcome alternative at a time of high stock market volatility.”
China Daily July 4, 2007 (Happy birthday, America; bad news for the redcoats!)

After launching the Shanghai Gold Exchange in October 2002, the exchange’s principals announced a three-part plan to liberalize trading: 1) establish a deferred delivery service (as physical transactions are settled pretty much the same day); 2) create gold-related investment products in order to promote domestic investment demand and create liquidity; 3) integrate the exchange into international markets – which includes expanding import/export licenses and allowing foreign entities to become members.

All 3 Steps Nearly Complete

Since then, the exchange has flourished in the spot and forward markets, with volumes surpassing the Hong Kong Gold and Silver Exchange and the Istanbul Gold Exchange in its first year (2003). Since 2003, transaction volumes on the Shanghai Gold Exchange have grown fivefold, to over 1,000 tons in 2006 (cumulative volume through the end of May 2007 was 3,910 tons) – and are on track for 1,500 tons in 2007. That is one-tenth of the annual transaction volume of the Tokyo Commodity Exchange, just 3% of Comex trading volumes, and but one-hundredth of the London Bullion Market’s annual OTC clearing volumes . However, the growth of China’s only gold bourse in just five years has been nothing short of spectacular, given that participation by the retail public has scarcely been tapped. Last month, the central bank, which founded the SGE, approved two landmark changes for the gold exchange: 1)The trading of gold and silver futures on the SGE and 2)Foreign banks operating in China could be enrolled as members of the SGE (in principle).

Local newspapers cited HSBC, Standard Chartered, UBS, Societe Generale and the Bank of Nova Scotia as front-runners for membership. Thus, the exchange has step three of its plan to liberalize trading on the SGE within sight and is in the mature phases of step two – mobilizing the launch of the kinds of products that will attract domestic investment demand. While the central bank will continue to regulate trade in physical gold, the country’s securities regulator, CSRC (China Securities Regulatory Commission), regulates futures and derivatives trading and must still approve the exchange’s trading in gold and silver futures. However, no one anticipates any roadblocks.

Exchange Preps for Launch of Derivatives and Gold Bonds to Draw Retail Business

There is talk that the Shanghai Futures Exchange is also going to introduce trading in gold and silver futures, and that the two exchanges will work together on that objective. Moreover, the chairman of the SGE said on June 7 that it was studying several additional products for the exchange, such as gold bonds, gold ETFs, and precious metals index futures – a few weeks later, the local newspapers reported that the exchange was working with gold producers, securities firms and banks in preparation for the launch of the “gold bonds,” a derivative product “issued by gold mining firms and guaranteed by a certain amount of gold they produce within a certain period of time in the future. The interest rate of gold bonds is made up of a basic rate and a floating one. The latter is linked with the gold price of the date of maturity. The maturation of the bonds can be three years, five years, or 10 years” (China Daily).

There is little more information at this time, but the securities seem to contain elements of the niche business that is done by merchant bankers like Investec, Nedbank, and Macquarie, which offer project loan facilities to precious metal miners, which are covered by future gold production (sold forward).

If so, it is a cutting-edge financial innovation. It effectively securitizes a highly profitable business – at least during bull markets – making it widely accessible to the investing public…it is a coup that the newest gold exchange on the beat will be the first to have standardized and listed such a product. Kudos!

Initiatives like this will draw liquidity to the exchange, whose membership recently added its first broker to the roster (which happens to be the one that co-developed this product), and which has increasingly enhanced its retail trading logistics to make it more inviting for the public to trade in gold. Indeed, until recently, the minimum transaction size was still too big for the retail public. But now, with the launch of the aforementioned products, the largest retail population in the world is about to have access to free trading in precious metals for the first time in centuries. Maybe it will go on a buying spree. At its current rate of growth, the SGE could rival Tokyo in less than five years, and the Comex in 10.

Although it may be another generation before it rivals the LBMA in size and scope, given the size of its prospective retail population and the progress of China’s gold market initiatives, the gold market could be on the verge of an enormous bullish shift in investment demand…possibly even official demand.

Bears Obviously Not in the Loop

On May 18, 2007, amid the concerted selling of gold by central banks during a seasonally weak period – probably in order to tame the spike in bond yields – a New York Sun article by Dan Dorfman conveyed the strange rumor that the Chinese were going to sell gold. Nothing else was said, and no premises were offered in the article. He just put it out there. How this could be, I thought, after they’ve been telegraphing the opposite intent for several years. Just nine days earlier, in fact, Reuters wrote: “Chinese economists are urging Beijing to quadruple its gold reserves to 2,500 tonnes from the current 600 tonnes, because the country foreign exchange reserves had become the world’s largest, an official industry newspaper reported on Tuesday.”

Everyone knows that China’s reserves are underweight gold, and that China’s not that interested in dollars or Treasuries any longer. And why go to all the trouble of launching its very own gold exchange (the Shanghai Gold Exchange) if it’s not interested in gold whatsoever, since one of the goals of creating the exchange, ostensibly, is to encourage growth in domestic gold production without immediately losing that output (gold) to foreign buyers? Prior to the launch of the SGE in 2002, gold producers had to sell their gold to the central bank, which would allocate it for processing because the government did not want them to export it. The absence of a free flexible market that set prices was no doubt somewhat of a deterrent to growth in mine production, which stagnated during the ’90s.

But since 2000, China’s annual mine output has grown 40% to about 220 metric tons, even as world mine production has seen absolutely no growth since 1998 (stagnant at around 2,500 tons).

China has probably just overtaken Australia as the world’s third largest gold producer and is likely to overtake the United States and South Africa, where production has been falling precipitously for years.

Still, the rumor continued to perplex me. Doesn’t Dorfman know all this stuff? How come I had never heard it, other than in his article? What don’t I know? Well, that’s a Pandora’s box if I ever saw one, but fortunately, I ran into an article at that painted the SGE’s innovation with a bearish brush – and it occurred to me that this may be the source of the rumor. The author interpreted the coming issuance of gold bonds on the Shanghai Gold Exchange as a bearish factor, which would entice producers to sell their gold production forward (more than they would otherwise presumably)… thereby depressing gold prices in a repeat of the 1998-1999 competitive devaluation by the hedgers.

But this is really a “glass is half full/half empty” quagmire, because the bulls simply see another way for investment demand to proliferate. In fact, the pieces seem to fit this idea better. As already outlined, these bonds were designed as a tool to invite retail demand, which has been hampered up until now by the lack of retail friendly access to the gold market. Clearly, the bears don’t have a leg to stand on!

Chinese Treasury to Buy Gold Bonds?!

I’m just speculating here, but the problem China faced in adding substantially to its gold reserves was that with over a trillion dollars in foreign exchange reserves, it was going to be the bull in a fine China shop – the dollar would collapse, bond yields would soar. Since China follows a mercantilist economic policy, and America is one of China’s largest consumers, it never made a heck of a lot of sense for China to upset the U.S. dollar and Treasury market if it could be avoided, despite threats.

On the other hand, it doesn’t make much sense to be overweight so many dollars, either.

We know that the country is ready to launch its state-owned investment company, financed with a $200 billion stake from Treasury that will be used to diversify its dollar holdings. No one expects China to be buying gold with it, especially since news of the $3 billion investment in private equity firm Blackstone.

Maybe that was a diversion. Maybe China was patiently waiting for the SGE to get its act together?

That way, China could just accumulate gold-related products on the domestic market once it has attained an acceptable degree of liquidity and leave the international markets in the dark.

Additional Negatives for U.S. Dollar and Treasury Market

An increase in gold demand, however, is not the only threat to the U.S. dollar and Treasury markets – China’s stock and bond markets have developed to become the ninth and eight largest markets by capitalization in the world, respectively. As with the gold exchange, the regulators have been slow to open these markets to foreign investment, but full integration is not far away, and China’s capital markets have probably progressed too far to turn back. They may one day rival American markets.

Perhaps, if they buy enough gold, the yuan may even become a world reserve currency.

Edmond J. Bugos

For more articles that cover the gold arena, visit these links:

7/25/2007 – Gold Carry TradeBy Nick Jones

6/20/2007 – A Gold Nuggest from AlaskaBy Byron King

3/28/2007 – Golden Rule: Looking for Profits in All the Right PlacesBy Kevin Kerr

Additional Gold Resources:

Gold Bulls’ Three Stages

Behold the Gold Bull

Got Gold Report

Gold Bull 70’s Vs. Today

Gold Bull Seasonals

The Daily Reckoning