Chinese Physical Gold Demand Surges; Americans Pile Into Stock & Crypto Bubbles
Chinese demand for physical gold investment surged in the first three-quarters of 2017 while Americans ditched the shiny yellow metal for increased bets in the crypto mania and stock market bubble market. Even though China’s Hang Seng Stock Market outperformed the Dow Jones Index last year, Chinese citizens purchased the most gold bar and coin products Q1-Q3 2017 since the same period in 2013, when they took advantage of huge gold market price selloff.
According to the World Gold Council, Chinese gold bar and coin demand increased to 233 metric tons (mt) in the first three-quarters of 2017 compared to 162 mt in the same period last year. Furthermore, if we include Indian gold bar and coin demand, China and India consumed nearly half of the world’s total:
As we can see, China and India consumed 338 mt of gold bar and coin products which accounted for 47% of the total 715 mt Q1-Q3 2017. German gold bar and coin demand of 81 mt took the third highest spot followed by Thailand (49 mt), Turkey (47 mt), Switzerland (31 mt) and the United States (30 mt). Chinese gold bar and coin demand of 233 mt nearly equaled the total demand by German, Thailand, Turkey, Switzerland and the United States of 238 mt.
If we compare gold bar and coin demand by these countries in the same period last year, we can see some interesting changes:
While the increase in Chinese gold bar and coin demand was the big winner (162 mt to 233 mt), Turkish demand nearly doubled from 24 mt in 2016 to 47 mt this year. However, the biggest loser in the group was in the United States. U.S. Gold bar and coin demand fell substantially to 30 mt Q1-Q3 2017 from 66 mt during the same period last year.
As I mentioned at the beginning of the article, Americans shunned gold to make it RICH in the rapidly rising Stock and Crypto Markets. We can see this quite clearly as investors choose to bet on the Dow Jones Index as it surged by 30% last year versus a mere 13.5% for gold:
So, as the Dow Jones Index increased nearly 6,000 points, or 30% since the beginning of 2017, U.S. demand for gold bar and coins fell 55% (Q1-Q3 2017). Also, it makes perfect sense that American investors ditched gold for much larger 1,000+% gains in cryptocurrencies.
The stunning performance in the stock and crypto markets has frustrated precious metals investors to no end. Not only do I see this all over the internet, but I also receive a lot of emails and comments on my blog. And, it doesn’t help that some precious metals investors, now turned crypto specialists and aficionados, are only happy discussing assets that make 10-20 baggers. Forget about old fashion work and taking the time and money to build something real, we have now moved into a new investment strategy that to be successful, one must make 6-7 figure returns by clicking on a mouse.
All I can say is this… enjoy the Crypto fun while it lasts, because the forces of Gravity will once again bring us back down to earth where making a real living takes a lot of sweat and labor. While some followers sense that I am negative about the cryptocurrencies, I am. However, it is for a good reason. Even though the Blockchain technology offers interesting solutions, the speculative mania is a different story entirely. And, yes.. let’s not forget the tremendous amount of fraud and corruption in the crypto markets. If you don’t believe me, just wait around a while… LOL.
Regardless, while the Dow Jones Index jumped by 30% last year, the Chinese Hang Seng market did one better by surging 43%:
Even with their Hang Seng Index up higher than the Dow Jones, Chinese gold bar and coin demand increased by 44% while U.S. physical gold investment demand fell by 55%. Now, some may believe that the increase in Chinese gold and bar and coin purchases were partly due to the Chinese government banning the trading on cryptocurrency exchanges in the country. However, the crypto exchange ban did not take place until the last quarter of 2017. So, the 44% increase in Chinese gold bar and coin demand occurred before the banning of their cryptocurrency exchanges. Because of the crypto exchange ban, we may see a spike in Chinese gold bar and coin demand during Q4 2017 when the statistics are released.
For whatever reason, Chinese physical gold investment demand increased significantly Q1-Q3 2017 while U.S. demand dropped like a rock. It will be interesting to see how 2018 unfolds and if the extreme leverage in the stock and crypto markets finally unravels. You see, it’s not a matter of if, it’s only a matter of time. And, while many believe the Dow Jones will continue higher forever, all markets have to correct. However, the next correction may turn out to be one heck of a crash.
This post is part of the Chinese Gold Market essentials series. Click here to go to an overview of all Chinese Gold Market Essentials for a comprehensive understanding the largest physical gold market globally.
The main arguments presented by Western consultancy firms, such as GFMS and the World Gold Council (WGC), to explain the difference between SGE withdrawals and Chinese consumer gold demand relate to Chinese Commodity Financing Deals (CCFDs). However, this analysis is incorrect as I will demonstrate in this post.
CCFDs are used by Chinese speculators to acquire cheap funds using commodities as collateral. When it comes to using gold as collateral for CCFDs there are two options: round tripping and gold leasing. First we’ll discuss round tripping.
Goldman Sachs (GS) has properly described the round tripping process in a report dated March 2014. We’ll start by reading a few segments from GS about financing deals [brackets added by me]:
While commodity financing [round tripping] deals are very complicated, the general idea is that arbitrageurs borrow short-term FX loans from onshore banks in the form of LC (letter of credit) to import commodities and then re-export the warrants (a document issued by logistic companies which represent the ownership of the underlying asset) to bring in the low cost foreign capital (hot money) and then circulate the whole process several times per year. As a result, the total outstanding FX loans associated with these commodity financing deals is determined by:
– the volume of physical inventories that is involved
– commodity prices
– the number of circulations
Our understanding is that the commodities that are involved in the financing deals include gold, copper, iron ore, and to a lesser extent, nickel, zinc, aluminum, soybean, palm oil and rubber.
…Chinese gold financing deals are processed in a different way compared with copper financing deals, though both are aimed at facilitating low cost foreign capital inflow to China. Specifically, gold financing deals involve the physical import of gold and export of gold semi-fabricated products to bring the FX into China; as a result, China’s trade data does reflect, at least partially, the scale of China gold financing deals. In contrast, Chinese copper financing deals do not need to physically move the physical copper in and out of China, so it is not shown in trade data published by China customs. In detail, Chinese gold financing deals includes four steps:
Onshore gold manufacturers pay LCs to offshore subsidiaries and import gold from Hong Kong to mainland China – inflating import numbers
offshore subsidiaries borrow USD from offshore banks via collaterizing LCs received
onshore manufacturers get paid by USD from offshore subsidiaries and export the gold semi-fabricated products – inflating export numbers
repeat step 1-3
Important to understand is that gold in round tripping needs to be physically imported into China and then exported, in contrast to copper. The reason for this, which GS fails to mention, is that the cross-border trade rules for gold in China are different than for all other commodities. Only through processing trade gold can be imported into China mainland by enterprises that do not carry a PBOC gold trade license. Round tripping by speculators can only be done through processing trade, as it’s not possible through general trade to ship gold into China without a PBOC license. Consequently, round tripping flows are completely separated from the Chinese domestic gold market where the SGE operates. And hence round tripping cannot inflate SGE withdrawals.
Only by bending the rules – set up a fake jewelry enterprise in a CSSA – speculators can import gold to round trip. By using processing trade in order to import gold into China speculators are required to subsequently export the exact same amount of gold, because these speculators pretend to be jewelry manufacturers importing gold for genuine production, which upon completion must be exported. This is why the gold is round tripped. The requirement for export in processing trade can be read in the official PRC Customs Supervision and Administration of Processing Trade Goods Procedures (2004):
“Processing trade” shall refer to the business activity of import of operating enterprises of all or some raw and auxiliary materials, components, parts, mechanical components and packing materials (Materials and Parts) and the re-export thereof as finished products after processing or assembling.
Now we can understand why GS wrote [brackets added by me]:
Specifically, gold financing deals [round tripping] involve the physical import of gold and export of gold semi-fabricated products to bring the FX into China…
The speculators export semi-fabricated gold products to keep up the appearance they are genuine gold fabricators, for which the gold imported must be processed and exported.
On a side note, the gold used in round tripping can be at most the amount of gold yearly exported from China (to Hong Kong). Though the total exported gold will also contain genuine processing trade, so round tripping will be less than this amount. Round tripping does not inflate net export from Hong Kong to China, only gross trade. The net amount of gold imported into China is shipped through general trade, via the SGE, into the Chinese domestic gold market and is prohibited from being exported.
In the chart above we can see China exported 330 tonnes to Hong Kong in 2013. Let’s guess 200 tonnes of that was genuine processing trade (jewelry manufactured in a Chinese CSSA).
330 – 200 = 130 tonnes
Possibly, there was 130 tonnes imported into China for round tripping and subsequently exported back to Hong Kong. Or, 10 tonnes was imported into China for round tripping and subsequently exported to be round tripped an additional 12 cycles, making 13 rounds in total.
13 x 10 = 130 tonnes
In the latter scenario a lot less physical gold is involved (10 tonnes versus 130 tonnes). In reality it’s more likely a gold batch used in round tripping is making multiple rounds than one round.
The Chinese Gold Lease Market
The other gold financing deal that can be conducted by Chinese speculators is gold leasing (which is the same as gold lending). In general gold leasing is a normal market practice.
I have categorized all potential gold lessees (borrowers) in three groups for us to have a look at examples (with US dollars) of how gold leasing is done in financial markets:
A gold miner needs funds to invest in new production goods. It can borrow dollars from a bank at a 7 % interest rate, or borrow gold at 2 % – the gold lease rate is usuallylower than the dollar interest rate. The miner chooses to borrow 10,000 ounces and sells it spot at $ 1,500 an ounce. The proceeds are $ 15,000,000 that can be used to invest in new production goods. In a years time the miner has mined 10,200 ounces to repay the principal debt plus interest (the interest on gold loans can be settled in gold or dollars, depending on the contract). Through gold leasing the miner has acquired cheap funding compared to a dollar loan.
A jeweler needs funds to buy gold stock for production. It can borrow dollars from a bank for 7 %, or borrow gold for 2 %. The jeweler borrows 10,000 ounces of gold, with which it can start fabricating jewelry. To hedge itself against price fluctuations the jeweler can sell spot, for example, 10 % of the 10,000 ounces it has borrowed (1,000 ounces at $ 1,500 makes $ 1,500,000) to buy gold futures contracts in order to lock in a future price. After a year the jeweler has sold the 9,000 ounces (as jewelry) for dollars and can take delivery of the long futures contracts to repay the gold loan.
A speculator is looking for cheap funds. It can borrow dollars from a bank for 7 %, or borrow gold for 2 %. He borrows 10,000 ounces and sells it spot at $ 1,500 an ounce. The proceeds are $ 15,000,000 and subsequently these newly acquired funds can be used to invest in higher yielding products (> 2 %). If the trader chooses to hedge itself in the futures market is up to him. After a year the 10,000 ounces plus interest need to be repaid, either the trader can purchase gold with the profits made on the higher yielding investment or from delivery of futures contracts.
…the SGE provides a crucial role in gold leasing. The SGE’s block trading system is the trading platform used by gold leasing participants; the SGE also provides transfer and settlement services.
China’s gold leasing does not involve the central bank. Gold leasing takes place between commercial banks and enterprises as well as between commercial banks, the former being key.…
An enterprise that intends to be a lessee approaches a branch office of a commercial bank with a rate request and application.
The commercial bank carries out due diligence and then submits a review to their head office for approval.
Upon approval the head office quotes a lease rate with the international gold lease rate as a benchmark plus additional basis points taking into account the potential lessee’s credit, physical gold management costs and other factors.
If the potential lessee accepts the offer, a commercial bank branch manager will sign a lease contract with the customer including the terms and conditions clearly laid out.
According to the “Shanghai Gold Exchange Lease Transfer Procedure”, after signing the lease, the head office of the commercial bank and lessee, or his agent, shall make a lease application through the exchange’s membership system. After verification, the SGE shall transfer the commercial bank’s gold from its SGE bullion account to the lessee’s SGE bullion account. The lessee can now trade the physical gold that it has leased or withdrawal the gold from the vaults.
Upon expiration of the lease the lessee shall deposit or purchase physical gold through the SGE to repay the gold. Corresponding physical gold will be transferred from the lessee’s SGE bullion account to the commercial bank’s bullion account. Leasing fees involved will be settled in currency. At this point, the lease is completed.
First, I would like to insert a comment supplementing the PBOC’s description of gold leasing in the Chinese domestic gold market. In the paper it says:
“After verification, the SGE shall transfer the commercial bank’s gold from its SGE bullion account to the lessee’s SGE bullion account. The lessee can now trade the physical gold that it has leased or withdrawal the gold from vaults.”
My source at ICBC’s precious metals trading desk told me ICBC has little gold of itself for leasing, most of the gold lend out is sourced from third parties. These parties are either SGE members or overseas banks that supply gold through the Chinese OTC market. ICBC operates in the lease market as an intermediary by connecting supply and demand, it can lease from international banks or local gold owners with SGE Bullion Account and lend the gold to miners, jewelers or speculators. My suspicion is that the international gold lease rate is lower than the Chinese gold lease rate, which can attract gold from the international market into the Chinese domestic gold market.
The Chinese lease market in short: in China all gold leases are settled through the SGE (there can be an off-SGE lease market, but it would be highly illiquid). Both lessor (lender) and lessee (borrower) are required to have an SGE Account. If a lease is agreed between two parties gold is transferred from one SGE Bullion Account to the other, when the lease comes due the gold is returned. At SGE level it’s as simple as that.
There is a big difference between jewelers that lease gold in contrast to miners and speculators. Jewelers lease gold because they need physical gold for fabrication; miners and speculators lease gold because they are seeking cheap funds, they will always sell spot the leased gold (without withdrawing the metal) at the SGE to use the proceeds. Why would a speculator withdrawal the metal?
Therefor, if SGE withdrawals capture leased gold this is for genuine jewelry fabrication that eventually ends up at retail level. When a jeweler needs to repay the lease it simply buys gold at the SGE to subsequently transfer it from its SGE Bullion Account to the lessor’s SGE Bullion Account. It’s not likely a jeweler would buy gold off-SGE to repay a lease, which then would need to be refined into newly cast bars by an SGE approved refiner to enter the SGE vaults. Gold leasing by jewelers can inflate SGE withdrawals but not so much supply to the SGE.
… No statistics are available on the outstanding amount of gold tied up in financial operations … but Precious Metals Insights [PMI] believes it is feasible that by the end of 2013 this could have reached a cumulative 1,000t…
This 1,000 tonnes figure is based on a misunderstanding regarding the Chinese gold lease market. PMI assumed there was 1,000 tonnes of gold tied up in financing deals based on the yearly lease volume in China, which was 1,070 tonnes in 2013. However, the yearly lease volume is not the gold that is leased out at any point in time, but reflects the aggregated volumes disclosed on all lease contracts that are executed over one year’s time in the Chinese domestic gold market (turnover). Meaning, if 100 mining companies lease 2 tonnes of gold for 1 month in 2016 and all leases are rolled over 4 additional months, the yearly lease volume would be 1,000 tonnes (100 x 2 x (1 + 4)), while on 31 December 2016 the total amount of gold leased out could be nil. (It’s impossible there was 1,000 tonnes used in round tripping as gross export from China has never been more than 330 tonnes)
In addition, the WGC used the words ‘tied up‘ for the gold used in financing operations, which sounds as if the market will be flooded when the gold is untied. The words ‘tied up’ can be misleading, let me explain: If a speculator borrows gold he will promptly sell it spot, this gold will not leave the SGE system. During such a lease period there is nothing tied up, there is just a debt to be repaid. When the lease comes due the lessee has to buy gold in the market (SGE) to settle the debt, which is the opposite of what the WGC insinuates what happens when gold is untied. In case a jewelry company leases gold the words tied up are more appropriate, in my view, as the borrowed gold bars are in transit from being processed to being sold as jewelry. Gold involved (tied up) in these leases can only be a share of the total amount of gold leased out in any point in time, because we all agree most leases in China are done for financing. There is only a small percentage of total gold loans tied up by jewelry companies.
… a good part of the withdrawals represent gold that is used purely for financing and other end-uses that are not equivalent to real consumption.
Needless to say I don’t agree for the reasons just mentioned regarding gold leasing and round tripping. Am I the only one? No. When Na Liu of CNC Asset Management Ltd, visited the SGE in May 2014 he spoke to the President of the SGE Transaction Department. From Na:
First, the withdrawal data reflects the actual gold wholesales in China. In 2013, the total gold withdrawal from the SGE vaults amounted to 2,196.96 tonnes. The President of SGE Transaction Department (The President) said: “This 2,200 tonnes of gold, after leaving our vaults, they entered thousands of Chinese households in the form of jewellery and investment purchases.”
… Second, none of the 2,200 tonnes of gold was bought by the Chinese central bank. The President said: “The PBOC does not buy gold through the SGE.”
… Third, the financing deals do not exaggerate SGE’s assessment of China’s gold demand. This is because “the financing deals do not take place after the gold leaves the vaults.”
The President of the SGE’s Transaction Department is clearly stating most leasing happens within the SGE system and this metal is not withdrawn. Therefor, gold leasing by speculators does not inflate SGE withdrawals and thus does not explain the difference between SGE withdrawals and Chinese consumer gold demand as disclosed by the World Gold Council.
Remarkably, when I asked the WGC about the details in 2014 they replied [brackets adde by Koos Jansen]:
Gold leasing: Banks have built up this business to support China’s burgeoning gold industry. Miners, refiners and fabricators all have a requirement to borrow gold from time to time. For example, fabricators borrow gold to transform into jewelry, sell and then repay the bank with the proceeds. It is an effective way for the fabricator to use the bank’s balance sheet to fund its business. Banks have strict policies in place for who they can lend to, and these have been tightened over recent years, but during PMIs field research it identified that, in some instances, organizations other than genuine gold business had used this method to obtain gold, which it would then sell to obtain funding [in this case the gold wouldn’t be withdrawn from the SGE vaults]. It would then hedge its position. According to PMI, this can generate a lower cost of funding than borrowing directly from the bank. Our colleagues in China think this would be a very small part of total gold leasing; the majority of it would be used to meet the demands of genuine gold businesses.
In their email the World Gold Council admits gold leases that are withdrawn from the SGE vaults are used for genuine gold business and being part of true gold demand. This is more confirmation gold leasing cannot explain the difference.
In conclusion, round tripping gold flows are completely separated from the Chinese domestic gold market (SGE) and therefor cannot have caused the difference. In addition, gold leasing only inflates SGE withdrawals when used for genuine gold business and therefor cannot have caused the difference either.
Sam Zell, the man known as the “Grave Dancer” since he’s made a fortune in the distressed debt market was interviewed by the CFA institute. Zell is as sharp as they come and has been in the game for a few decades now, so it’s always informative to hear his thoughts on the market and economy (link here).
He discusses commercial real estate (he thinks it’s oversupplied and near bubble territory), how he views the world through the basic lens of supply and demand, and where he thinks the next crisis will come from. Here’s’ an excerpt.
Zell has never seen a period in his lifetime with more headwinds or more questions without answers than today. He believes conventional wisdom is mistaken by looking at geopolitical risks one at a time. He tries to view each as part of a whole. “We have a different world today and there are lots of players with different values. There is enormous unsettledness,” he said, noting that this manifests itself in a lower global growth rate.
He also recently wrote a book titledAm I Being Too Subtle?. I haven’t read it myself but if any of you have, let me know if it’s worth picking up.
This week I revisited an old white paper put out by Michael Mauboussin titled Expectations Investing: Reading Stock Prices for Better Returns. Here’s the abstract and link.
Investing relies on expectations, and revisions in expectations trigger changes in stock prices. Accurately measuring expectations, therefore, is the key to improving stock selection. Expectations investing requires (1) the development of a conceptual framework, (2) a clear understanding of valuation, including cash flow, the cost of capital, and the forecast horizon, and (3) accurate estimations of price-implied expectations and expectations gaps.
It’s a good short read (only 10 pages) and talks about a very important investing concept. Not truly understanding the pricing mechanism and the embedded expectations within these prices is one of the more common errors that I see traders and investors make.
I don’t necessarily think one needs to get as granular or technical in teasing out these expectations as Michael does. But I do know that trying to suss out the embedded expectations in the market you’re analyzing is essential to winning in this game.
He also wrote a pretty good book on the topic for those of you who want to dive into it more. It’s got the same title as the article.
Video I’m watching —
Ray Dalio has been on a media blitz promoting his new book Principles.
He recently sat down with Bloomberg for a 45 minute interview where they discuss everything from his book, to the building of Bridgewater, to his economic framework and so on. Here’s the link if ya feel like watching.
I had read the old white paper on their site of the same title a number of times and figured this would be just a book version of that. But I’m happy to find that there’s been quite a bit added to the material.
The book is about, as the title suggests, Dalio’s principles. Over the last 30 years he has codified the rules that he’s used to find success on a personal level, as well as those he has used to build and run the most successful hedge fund in history.
I’m a big fan of the philosophy and highly suggest picking up the book if you’re at all interested in this type of stuff.
Here’s the intro that gives you a bit of the flavor of the book.
Before I begin telling you what I think, I want to establish that I’m a “dumb shit” who doesn’t know much relative to what I need to know. Whatever success I’ve had in life has had more to do with my knowing how to deal with my not knowing than anything I know. The most important thing I learned is an approach to life based on principles that helps me find out what’s true and what to do about it.
You see this type of radical humility amongst many of the great traders. Soros often attributed his money making powers to the fact that he fully embraced his own fallibility. He often said:
My approach works not by making valid predictions but by allowing me to correct false one.
This way of thinking is no easy habit which is why most traders get caught up playing the game of “being right” versus the one of “making money”. The first game you’re serving your ego, in the second you’re serving your capital.
Chart I’m looking at —
We have now gone 222 days without a 3% or more correction in the S&P, making it the second longest such market streak since 95’ (chart via NDR).
That’s pretty impressive stuff. There’s a good chance that we take out the record, too. We’re only 34 days away and with liquidity flush and the credit market humming along there’s no discernible catalyst for a move lower. Though it’s not like there needs to be for a tiny 3% move.
However, we do need to keep an eye on the Nasdaq which recently broke out to the downside of an ascending wedge and is at risk of forming a major topping pattern.
Trade I’m looking at —
JD.com (JD) is China’s version of AMZN. And unlike BABA, which is mostly a platform for outside merchants to sell their wares, kind of like an EBAY, JD owns and operates its entire supply chain.
To give you a sense of the scale, the company operates over 210 warehouses in over 50 cities with an aggregate floor space of approximately four million square meters. It employs more than 120,000 employees and manages over 5,370 delivery stations and pickup stations in approximately 2,350 counties and districts across China. It’s big.
The company did over $ 310B in revenue over the last year which makes it the third-largest internet company, in terms of sales, right behind AMZN and GOOG.
The chart below shows the stock price (orange), annual revenues (green), TTM EPS (grey), and JD’s price to cash flow per share (blue).
The company has averaged annual revenue growth of 65% over the last 5 years but only trades at 1.3 times sales and 15x cash flow per share.
When digging into potential long-term plays, investments that I call “coffee can” trades because there’s enough of a flywheel there that you could potentially hold for 5+years, I spend a lot of time looking into who the CEO is and what kind of competitor he/she is.
They’re the ones who make the big capital allocation decisions which either widen or narrow their competitive moats. Most companies have average to sub-par leaders. CEO’s who are just there to cash out stock options and parade around their title.
But every once in awhile you come across a maniacally competitive visionary type. Think Henry Ford, Jobs, Bezos etc…
I think JD has one of these types of leaders in its Founder/CEO Liu Qiangdong.
Take a few minutes and read this recent FT interview with him (link here). He and the company have an awesome origins story. Here’s an excerpt where Liu is describing the early days of JD when it was just him operating an online retail message board and electronics stall.
“I bought an old traditional alarm clock and I put it on a wooden floor so it was like an earthquake waking me every two hours — I’d get up and answer questions online and then sleep for another two hours and then get up again,” he says. “In the first four years it was just me doing customer service and it was very good for me because I learned every detail of what our customers wanted.” He has literally lived in his offices for a decade — even as they have become increasingly luxurious.
We have no position in the company and still have plenty of digging to do. Technically the stock looks vulnerable to a selloff at the moment. This would be great as we could then buy at a much better price. We’re looking into some long-term deep OTM calls on the stock which are priced attractively.
On a somewhat related note here’s a great business/stock analysis diagram shared on twitter by @toddwenning.
Quote I’m pondering —
The world is a very complex place, and if taken as anything more than guideposts, ideologies — be them free-market, socialist, or theological — are simply an impediment to understanding, a convenient excuse for the refusal to think rationally about complex questions. ~ Eric Kraus
An area of trouble for market players is when they apply a faulty precept of how they think the world should be to how it really is. They torture reality to fit their biases and ideologies and this leads to pain, not to mention loss of capital.
We all suffer from this exercise in faulty thinking on some level. God knows I have and do.
For example, I used to apply a moral judgement to central bankers and that affected my analysis of their actions and the market’s response. I see other traders, especially on fintwit, making this same mistake.
Think about how ridiculous that is. It’s illogical, right?
As traders why should we care about applying moral judgements to our “Game Masters”or market valuations sans context? We just want to defend our capital and make money. It all goes back to playing the game of being right versus making money. We should always be striving to focus on the latter and attempt to view the world and play the game of markets as ruthlessly unattached and objectively cold and calculating as possible.
So think… what are some ideas that you have about how the world is, that maybe you haven’t stress-tested against reality and perhaps aren’t serving you well?
Lastly, do yourself a favor and scroll through this excellent slidedeck that serves as a good case study on how to analyze “management” (link here).
In the fall of 1993, I was sitting in class in grad school. We were using case studies to explore business management decisions. My professor walked through the history of Otis Elevators, noting that the company had reached market saturation and had choices to make.
I was sort of paying attention… sort of not.
Then he called on me.
“Rodney! What should a company do when it reaches market saturation?!”
I fumbled. “Develop a new product or service?”
He thundered back, “Find another market!”
His point was that Otis Elevators had saturated the U.S. market, but had all of Europe to explore. It would be much easier to exploit untapped markets with a product they already provided than it would be to introduce a new product or service they’d need to develop.
I think the Chinese took the same class.
In 2013, the Chinese government introduced the Silk Road Economic Belt and 21st Century Maritime Silk Road initiative, which has been shortened to One Belt, One Road.
The plan was to develop infrastructure to facilitate trade among many players in Eurasia and Northern Africa. Or so that’s what the Chinese government told everyone. The details indicated other immediate goals, with trade as a long-term, add-on benefit.
After the financial crisis, China poured on the monetary coals to propel its economic engine. The county expanded credit at a torrid pace, fueling an unprecedented building boom. Roads, bridges, and condominiums sprung from the ground.
China produced and used more cement between 2011 and 2013 than the United States did in all of the 20th century.
That’s a lot of concrete.
But even in a land of 1.3 billion people, that pace of building couldn’t last.
Eventually, there would be a dramatic slowdown.
China now has empty cities. Not because everyone left, but because they built them and no one came.
Now, as their domestic expansion slows down, the Chinese have created an outlet for all of their resources and construction know-how…
Under the One Belt, One Road Initiative, the Chinese provide the resources, expertise, and much of the labor to build roads, bridges, ports, and other infrastructure in Pakistan, Kenya, India, Malaysia, and even Russia and Greece.
The initiative is expected to touch 68 countries and billions of people.
Of course, many of those countries can’t pay for expensive new ports and roads, but that’s not an obstacle, it’s an opportunity, if you’re the Chinese.
China will not only provide the materials, expertise, and labor, but also the funding! Through the Asian Development Bank and other entities, China is loaning money to foreign nations that then use the capital to buy stuff from China.
And once those projects are completed, guess which country will have a claim on the assets to repay the loans, and also have priority status when it comes to trade?
And the strategy doesn’t end there.
China has another issue that it’s turning into an opportunity.
The country is pretty good at building coal-fired electric plants. But, as one of the vocal members of the Paris Climate Accord, building a bunch of new coal plants creates bad optics. At least, when you build them at home.
The country also already has a lot of electricity generation capacity, and a fair amount of renewable energy. So as with their other spare capacity, they went looking elsewhere.
Over the next 10 years, China expects to build 700 new coal-fired electric plants, but 20% of the capacity will be overseas. While the new plants (with all of the environmental issues that come with them) will benefit the local populations, they’ll also support operations along the trade routes that will carry Chinese goods.
And I’m guessing that the plants in foreign countries will buy their coal from the Chinese.
The strategy is bold, but not without risks. What happens when locals in Pakistan get annoyed with Chinese workers? What happens when a friendly foreign government is toppled by a political foe that doesn’t want to honor previous arrangements?
These legacy issues will be interesting to watch. Will China be better at dealing with them than, say, every other nation in history that’s tried the same thing? We’ll see.
For now, it’s impressive to watch the Chinese implement their plans in so many locations, providing a much-needed outlet for their overcapacity at home.
For anyone interested, the Chinese are touting the initiatives as some sort of global, hand-holding, kumbaya thing that will unite the planet.
They’ve even released videos and songs to promote it, like this one. That way, people can feel good about helping the Chinese cement their hold on global trade for decades to come.
My best estimate as of June 2017 with respect to total above ground gold reserves within the Chinese domestic market is 20,193 tonnes. The majority of these reserves are held by the citizenry, an estimated 16,193 tonnes; the residual 4,000 tonnes, which is a speculative yet conservative estimate, is held by the Chinese central bank the People’s Bank of China.
To substantiate my estimates on above ground gold reserves in China mainland, we’ll first discuss private gold accumulation in China through the Shanghai Gold Exchange (SGE), after which we’ll address official purchases by the People’s Bank of China (PBOC) and its proxies that operate in the international over-the-counter market.
The amount of SGE withdrawals provides a fairly good proxy for Chinese wholesale gold demand, although not all gold passing through the SGE adds to above ground reserves. In China, most scrap supply and disinvestment flows through the Shanghai bourse as well, next to mine output and imports. Needless to say, recycling gold within China doesn’t change the volume of above ground reserves. So, simply using SGE withdrawals won’t fly for calculating above ground reserves. What we’re interested in are net imports and mine production in the Chinese domestic gold market.
There is one region that is importing significant amounts of gold from China, which is Hong Kong, though, this likely isn’t exported from the SFTZ but from the Shenzhen Free Trade Zone. The vast majority of China’s jewellery manufacturers are in Shenzhen, and for quite some years gold jewellery, ornaments, industrial and semi-manufactured parts are being exported from this Chinese fabrication base to Hong Kong. These events haven’t got anything to do with the SGEI in my opinion. Thereby, Hong Kong exports far more gold to China than vice versa.
For computing net gold export from Hong Kong to China we’ll subtract “imports into Hong Kong from China” from “exports and re-exports from Hong Kong to China” (as you know China doesn’t disclose gold trade statistics itself). Imports into Hong Kong accounted for 23 tonnes, while exports and re-exports to China accounted for 333 tonnes. Accordingly, China net imported 311 tonnes from Hong Kong in the first five months of 2017.
If we apply the same math to Switzerland’s customs data, it shows China net imported 172 tonnes from the Swiss in the first six months of this year.
Most definitely Australia has exported gold bullion directly to China in 2017 as well, but the Australian Bureau of Statistics (ABS) has changed its methodology regarding this data somewhere in 2016 and is reluctant to share the details with me. Using my old way to compute Australia’s export directly to China results in 23 tonnes (this number is provisional and will be amended).
The UK, a large gold exporter directly to China in 2014 and 2015, hasn’t shipped any gold directly to China year to date, according to Eurostat.
What’s remarkable is that Chinese true gold demand is far greater than what the World Gold Council (WGC) and GFMS are reporting as “Chinese consumer gold demand”. This is due to incomplete metrics applied by the WGC and GFMS. The immense tonnages imported by China have been waived in previous years, by the aforementioned Western consultancy firms, with dishonest arguments. (If you like to study the details regarding gold demand metrics read this.) In reality, thousands of tonnes are being imported into China and this metal is not coming back in the foreseeable future; causing a bull run on steroids if institutional interest for gold rebounds in the West. Ascending above ground reserves within China imply declining above ground reserves in the rest of the world. And the more scarce the metal in the West, the higher price when demand revives. I’ve described this phenomenon in my previous post How The West Has Been Selling Gold Into A Black Hole. In a forthcoming posts I will add more texture to my analysis.
Domestic mine production in China is not allowed to be exported, effectively all output can be added to above ground reserves. The China Gold Association (CGA) wrote on April 28, 2017, that Chinese domestic mine output in the first quarter accounted for 101 tonnes. Lacking the data for the second quarter, makes me estimate mine production from January until June by doubling 101, which is 202 tonnes. By the way, the CGA added:
Gold is a special product with the dual attribute of general commodity and currency. It is the cornerstone of important global strategic assets and the national financial reserve system. It plays an irreplaceable role in safeguarding national financial stability and economic security.
Based on data publicly available, in the first six months of 2017 China net imported at least 506 tonnes into the domestic market and mined 202 tonnes. An addition of 707 tonnes to Chinese private gold reserves.
Chinese Official Gold Purchases
I can be short on PBOC gold purchases: the Chinese central bank does not buy any gold through the SGE – its increments must be treated in addition to all visible flows – and it buys in secret not to disturb the global market. I’ve shared my analysis regarding the PBOC buying gold through proxies in the international over-the-counter (OTC) market for several years on these pages. Although, my reasoning has been confirmed countless times, it’s worth noting it was affirmed once more not long ago.
Early 2017 world renowned gold analyst Jim Rickards was in a meeting with the three heads of the precious metals trading desks of largest Chinese bullion banks. These gold dealers told Rickards that indeed the PBOC does not buy any gold through the SGE. Rickards stated in the Gold Chronicles podcast published January 17, 2017 (at 25:00) [brackets added by Koos Jansen]:
What I [J. Rickards] don’t know is about the Shanghai Gold Exchange sales, they’re pretty transparent, how much of that is private and how much of that is the government [PBOC]. And I was sort of guessing 50/50, 70/30, whatever. What they told me, and these guys are the dealers [the three heads of the precious metals trading desks], it’s 100 % private. Meaning, the government operates through completely separate channels. The government does not operate through the Shanghai Gold Exchange. … None of what’s going on on the Shanghai Gold Exchange is going to the People’s Bank Of China.
In fact, the PBOC uses Chinese banks as proxies to buy gold in countries like the UK, Switzerland and South-Africa after which the metal is transhipped to Beijing. Note, monetary gold shipments do not show up in customs reports of any country.
I haven’t come across any clues in the past months that have changed my estimate on the PBOC’s true official gold reserves. My best substantiated guess still is 4,000 tonnes (in contrast, the PBOC publicly discloses it holds about 1,840 tonnes). For more information on how and when the PBOC stacked up to 4,000 tonnes, continue reading at the BullionStar Gold University by clicking here.
Estimated Total Gold Reserves China 20,000 Tonnes
Let us put the pieces of the puzzle together. We know the PBOC doesn’t buy gold though the SGE, but prior to 2007 the Chinese gold market wasn’t fully liberalized and back then the PBOC was primary dealer in the domestic market. Any PBOC purchases prior to 2007 could have been from Chinese gold mines. What else do we know? China is said to be a gold importer since the 1990s, suggesting domestically mined gold was not exported after, say, 1994. In the next screen shot from the China Gold Market Report 2010 we can read “China has been a gold importer since the 1990s”.
For the sake of simplicity, we’ll calculate from 1994 onwards. Precious Metals Insights (PMI) has estimated that 2,500 tonnes of gold jewellery were held by the Chinese population in 1994. Furthermore, I have data on Chinese non-monetary gold import starting in 2001 – which started slowly but ramped up in 2010 (exhibit 2).
In 1994 PBOC official reserves accounted for 394 tonnes and Chinese domestic mine output accounted for 90 tonnes. So, our starting point in 1994 is:
From here, we can aggregate domestic mine output and net imports for every succeeding year. As stated above, my assumption is that the PBOC sourced its official gold from domestic mines prior to 2007, but shifted these acquisitions to the international market after 2007. The official gold increments in 2001 (105 tonnes) and 2003 (100 tonnes) I’ve subtracted from “aggregate domestic mine output”, the increments in 2009 (454 tonnes) and onwards I did not subtract from “aggregate domestic mine output”.
The previous calculation has resulted in the following chart:
In the chart the green, blue and grey bars represent private gold reserves, and summed up account for an estimated 16,193 tonnes at the time of writing. The red bars reflect the PBOC’s official gold reserves – I would like to stress this number is speculative – and currently account for 4,000 tonnes. My best estimate as of June 2017 for total above ground gold reserves within the Chinese domestic market is 20,193 tonnes.
From the moment Donald J. Trump got elected as the next President of the United States, on November 8, 2016, the price of gold tumbled 8 % in the remainder of the month – from $ 1,282 USD/oz to $ 1,178 USD/oz. Usually these cascades in the gold price go hand in hand with physical sell-offs in the West and strong demand Asia. It appears November has been no exception. The volume of physical gold withdrawn from vaults of the Shanghai Gold Exchange (SGE) in November accounted for 215 tonnes, the highest amount in ten months. Year to date SGE withdrawals have reached 1,774 tonnes.
There have been rumours in the gold space about the People’s Bank Of China (the PBOC) curbing gold import into the Chinese domestic market in response to capital flight. Although my sources have confirmed these rumours, Chinese gold import in November was still very strong at an estimated 140 tonnes. I don’t expect the PBOC will halt gold import all together.
The first mention of the rumour was by Reuters on November 25. By then the premium on physical gold trading at the SGE, which more or less reflects the strength of local demand versus international supply, had reached 2 % (from ~ 0.2 % on November 1). Reuters wrote:
“While we don’t have the exact numbers, we hear that they (Chinese government) have limited the number of importers,” said Dick Poon, general manager at Heraeus Precious Metals in Hong Kong.
In a previous blog post I stated the quote from Poon was not likely to be accurate, because there are 15 banks that have PBOC approval to import gold, but for every shipment a new License must be requested at the central bank. This protocol is referred to as “one batch one License”. Bullion cannot cross the Chinese border without a License. From the PBOC:
There shall be one Import … License of the People’s Bank of China for Gold … for each batch … and the License shall be used within 40 work days since the issuing date.
If the PBOC desires to curb gold import it can simply hand out less Licenses to approved banks, instead of deleting banks from the approved list. The former has happened as far as I can see. The next mention was by the Financial Times on November 30 [brackets added]:
Some banks with licences [approval] have recently had difficulty obtaining approval [Licenses] to import gold, they said — a move tied to China’s attempts to stop a weakening renminbi by tightening outflows of dollars, the banks added.
Although the Financial Times exchanged the terms “approval” and “License”, this is what I thought that was happening: banks are obtaining less import Licenses from the PBOC, which is obstructing supply, pushing up the SGE premium.
Either way the PBOC effort has not severely impacted the volume of Chinese gold demand as SGE withdrawals set a ten-month record at 215 tonnes in November, up 40 % from October. Premium or no premium the Chinese still ‘accumulate on the dips’. Additionally, mainlanders buy gold in Hong Kong where jewelry is cheaper as it doesn’t enjoy VAT. From Live Trading News we read:
“Gold sellers in Hong Kong, where mainland Chinese often buy gold, report an increase in purchases, …” according to published reports. “Some of the buying is also because of the Lunar New Year period next month, a time when buying normally picks up.”
How much of SGE withdrawals were supplied by import? Let’s make an educated guess. In the first nine months of 2016 SGE withdrawals accounted for 1,407 tonnes and China net imported 908 tonnes over this period, implying 65 % of SGE withdrawals was imported. If we use the past months as a reference China imported 140 tonnes of gold in November (=0.65*215). Year to date (-November) China has imported and estimated 1,147 tonnes.
An other possibility would be that elevated SGE withdrawals in November were supplied by scrap and disinvestment from within China (domestic mine output is fairly constant at 38 tonnes per month). Though this is not very plausible because the renminbi gold price went down in November (red line in exhibit 1). Normally scrap supply increases on a rising gold price. And hence, I assume the majority of SGE withdrawals in November were supplied by imports.
There have been concerns in the gold community with respect to a full stop on Chinese gold import. In my humble opinion the PBOC will not completely block imports for a number of reasons:
Despite the rumours of obstructed imports SGE withdrawals were strong in November.
The PBOC hasn’t released an official statement to curb imports.
The PBOC has just spent decades to develop the Chinese gold market in order to strengthen the Chinese economy and internationalize the renminbi. Why cancel the project for problems that can be solved differently?
Curbing gold imports would improve China’s current account. But China has a current account surplus; the capital account is in deficit. Why doesn’t the Chinese government tighten the capital account? In Q3 2016 China’s capital flow was minus 71 billion US dollars. In the same quarter gold import was valued at an estimated 13 billion US dollars. The problem is in the capital account.
SGE premiums started to rise on November 8 exactly when the gold price went down (which SGE premiums often do when the price goes down, exhibit 5). So are these elevated premiums of late fully caused by curbed imports, or simply strong demand? It’s probably a mix of both; in any case there is no full stop on imports. What probably happened is that imports exploded when the price tanked after November 8. As a result the PBOC decided to block shipments.
In the next chart we can see SGE premiums move inversely to the price of gold. When the price of gold goes down the Chinese ramp up purchases and SGE premiums rise.
The PBOC has added zero ounces of gold to its monetary reserves in November. It’s total monetary gold reserves currently account for 1,843 tonnes.
More proof the “precious metals assets” on Chinese commercial bank balance sheets have little to do with the “surplus” gold in China’s domestic market.
One of the topics about the Chinese gold market that has not been fully illuminated is the “gold” on the 16 Chinese commercial banks’ balance sheets. At the end of 2015 the aggregated “precious metals assets” on the bank balance sheets accounted for 598 billion yuan (RMB), which translates into approximately 2,682 tonnes of gold – if all the precious metals were gold related, which is very likely.
In my previous post on this subject we learned from examining the banks’ annual reports from 2015, that there are at least five gold assets that can appear in the “precious metals” line item on the balance sheets. Namely:
Gold savings that belong to the banks’ customers (Gold Accumulation Plans, GAP)
Gold inventory for the banks’ retail gold bar business
Gold leasing business
Gold held for hedging purposes
Gold held outside China
In this post we’ll examine more thoroughly the (Chinese and English) annual reports from 2007 until 2014 of the 16 banks, to learn more on what these huge tonnages represent. The most significant new finding is that Chinese banks conduct synthetic leases – in other words: swaps. By performing synthetic leases, Chinese banks can show “precious metals assets” but no “precious metals liabilities” on their balance sheets. Then, at the very surface it appears these banks own gold, in reality they own zero gold.
Also note, swaps can be executed with foreign banks, through which gold is subsequently imported into the domestic market. And because the Chinese banks have been importing thousands of tonnes in recent years, it should come as no surprise these trades have influenced the “precious metals” line item on their balance sheets.
More findings that will be addressed in this post are:
Chinese reported lease volume reflects yearly turnover.
Gold stored in Shanghai Gold Exchange (SGE) designated vaults owned by commercial banks does not to appear on the custodial bank’s balance sheet.
More confirmation some gold on the balance sheets is stored outside China.
My conclusion is that the “precious metals” on the Chinese commercial bank balance sheets do not account for the “surplus” gold in the Chinese domestic market Western consultancy firms pretend to be ignorant about. The Chinese banks do not own much gold of themselves, as some analysts have speculated, nor are these banks preparing for a new gold standard designed by the PBOC, according to my sources and analysis.
This post is divided in three segments. The first segment is about accounting, which supports the second segment about swaps and other gold related line items on the Chinese bank balance sheets. The first segment can be skipped if you already posses thorough knowledge on accounting. The third segment displays all the “precious metals” related data of the 16 bank balance sheets from 2007 until 2015.
I Accounting Background
Before we can discuss the details of the “precious metals” mentioned in the financial statements of the annual reports of the 16 banks, we need to do some studying on accounting structures (study the definitions of a financial statement, balance sheet, an income statement, assets/liabilities, financial assets/liabilities and derivative financial assets/liabilities). This study will prove valuable for future posts as well. The bank balance sheets are an important topic in the Chinese gold market; understanding accounting helps us to illuminate the Chinese gold market.
Financial statements of banks are divided in three main segments: abalance sheet, anincome statement and a cash flow statement.
On Investopedia we can read the definition of a balance sheet:
A balance sheet is a financial statement that summarizes a company’s assets, liabilities and shareholders’ equity at a specific point in time. These three balance sheet segments give investors an idea as to what the company owns and owes, as well as the amount invested by shareholders.
The balance sheet adheres to the following formula:
Assets = Liabilities + Shareholders’ Equity
A number of ratios can be derived from the balance sheet, helping investors get a sense of how healthy a company is. These include the debt-to-equity ratio and the acid-test ratio, along with many others. The income statement and statement of cash flows also provide valuable context for assessing a company’s finances, as do any notes or addenda in an earnings report that might refer back to the balance sheet.
An example would be, ICBC holding 1 tonne of gold in small ICBC brand bars as inventory for retail sales. This gold is an asset of ICBC.
Next to a balance sheet, banks disclose an income statement in their annual reports. From Investopedia we read:
An income statement is a financial statement that reports a company’s financial performance over a specific accounting period. Financial performance is assessed by giving a summary of how the business incurs its revenues and expenses …. It also shows the net profit or loss incurred over a specific accounting period.
Unlike the balance sheet, which covers one moment in time, the income statement provides performance information about a time period.
In example, ICBC buys gold at the SGE worth 1,000,000 RMB and has the metal recast in small 200 gram ICBC brand bars. If ICBC subsequently sells the newly casted bars for in total 1,100,000 RMB, then 100,000 RMB is profit and will be included in the income statement.
Cash flow is the net amount of cash … moving into and out of a business.
Total aggregated cash flows are measured over the course of a period, for example one year, as with the income statement. But unlike the income statement, it records all things related to cash flows. For example, if ICBC buys a new building worth 10,000,000 RMB, this will affect the balance sheet (cash decrease, asset increase) and the cash flow statement, but not the income statement.
Article 20 An asset is a resource that is owned or controlled by an enterprise as a result of past transactions or events and is expected to generate economic benefits to the enterprise.
“Past transactions or events” mentioned in preceding paragraph include acquisition, production, construction or other transactions or events. Transactions or events expected to occur in the future do not give rise to assets.
“Owned or controlled by an enterprise” is the right to enjoy the ownership of a particular resource or, although the enterprise may not have the ownership of a particular resource, it can control the resource.
“Expected to generate economic benefits to the enterprise” is the potential to bring inflows of cash and cash equivalents, directly or indirectly, to the enterprise.
Article 21 A resource that satisfies the definition of an asset set out in Article 20 in this standard shall be recognized as an asset when both of the following conditions are met:
(a) it is probable that the economic benefits associated with that resource will flow to the
(b) the cost or value of that resource can be measured reliably.
Article 22 An item that satisfies the definition and recognition criteria of an asset shall be included in the balance sheet. An item that satisfies the definition of an asset but fails to meet the recognition criteria shall not be included in the balance sheet.
Financial assets/liabilities can be subdivided in several categories, such as financial assets/liabilities designated at fair value through profit and loss, financial assets/liabilities held for trading and derivative financial assets/liabilities. Financial assets/liabilities are included on the balance sheet and the change in fair value of most financial asset/liabilities will appear in the income statement. Not all banks subdivide financial assets/liabilities in the same manner. For example, ICBC lists “financial assets/liabilities held for trading” parallel to “financial assets/liabilities designated at fair value through profit and loss”. Other banks only disclose “financial assets/liabilities designated at fair value through profit and loss” as a total. The details on accounting are beyond the scope of this post.
Let’s have a look at an example of a financial liability. We’ll use plain gold leasing. Suppose ICBC borrows 1 Kg of gold for 1 year and instantly sells the gold at 280 RMB/gram. ICBC will then record a cash asset of 280,000 RMB and a financial liability held for trading of 280,000 RMB on its balance sheet. Say, after one month the gold price surges to 380 RMB/gram. For ICBC the cash asset remains at 280,000 RMB, but the bank will increase the carrying amount of the financial liability held for trading to 380,000 RMB. The 100,000 RMB, which is a loss, will go into the income statement. In the income statement there is a separate line for this called net profit or loss on financial assets or liabilities designated at fair value through profit and loss.
Derivative financial assets/liabilities on balance sheets must not be commingled with derivative instruments such as futures or forwards, of which the notional values are recorded off-balance sheet. Let me show how derivative financial assets/liabilities are acquired.
We’ll use futures as an example. Suppose ICBC buys long a SHFE gold futures (1,000 grams) contract at 280 RMB/gram on 1 November 2016 that is to expire in June 2017. The futures contract itself (derivative instrument) is recorded off-balance sheet, but the profit or loss arising from it creates a “derivative financial asset/liability” recorded on the balance sheet and the income statement. At 1 November 2016 the fair value of the futures contract is 0 because the future price has not moved yet so there is no profit or loss. The notional value of the futures contract is 280,000 RMB (1,000*280). On 1 November 2016 ICBC’s financial statement would be:
ICBC’s derivative financial asset/liability held for trading on the balance sheet = 0
Fair value ICBC’s derivative financial asset/liability held for trading recorded in the income statement’s “net profit or loss on financial assets or liabilities designated at fair value through profit and loss” = 0 RMB
Notional value of ICBC’s derivative financial instrument recorded off-balance sheet = 280,000 RMB
Suppose one month later, on 1 December 2016, the gold price has surged to 380 RMB/gram. ICBC is long gold so it will have a mark-to-market profit of 100,000 RMB. This profit will go into the income statement in “net profit or loss on financial assets or liabilities designated at fair value through profit and loss”. At the same time ICBC has created a derivative financial asset held for trading worth 100,000 RMB. (If gold would sink below 280 RMB/gram, ICBC would record a derivative financial liability held for trading.) On 1 December 2016 ICBC’s financial statement would be:
Derivative financial asset held for trading on the balance sheet = 100,000 RMB
Fair value ICBC’s derivative financial assets held for trading recorded in the income statement’s “net profit or loss on financial assets or liabilities designated at fair value through profit and loss” = 100,000 RMB
Notional value of ICBC’s derivative financial instrument recorded off-balance sheet = 380,000 RMB
Below you can view a balance sheet and an off-balance sheet account from ICBC’s 2015 annual report.
Having said this, the practice of categorizing precious metals assets and liabilities varies from bank to bank in China. Nevertheless, there are excellent observations to make from the financial statements of the banks. This will be quite complex, if I didn’t explain it properly, please refer to the introduction of this post that serves as a simplified summary.
Banks Do Synthetic Back-To-Back Gold Leasing Through Swaps
From the previous post, we know that gold leasing – mainly back-to-back borrowing and lending – overstates the precious metals assets and liabilities of Chinese banks. However, what was not mentioned in the previous post was that banks do synthetic back-to-back leasing through swaps. This way, it’s possible that banks that are active in the gold lending market, will show precious metals assets on their balance sheet – without precious metals liabilities, while not owning a single gram of metal themselves. The bank will syntheticallyborrow gold through a swap, and lend it out for a few extra basis points. The result is synthetic back-to-back leasing.
From a Chinese bank’s perspective a synthetic gold lease is conducted by borrowing RMB to buy spot gold, lend that metal to a customer, and at the same time sell short a forward contract. When the gold loan to the customer comes due the metal is returned to the bank, which then will be sold through the forward contract to repay the bank’s RMB loan. That’s the definition of a swap: buy spot and sell forward (sell spot and buy forward for the counterparty).
If gold is in contango, and the forward price is higher than spot, the Chinese bank will make a profit on the swap. However, in contango, the costs for the RMB loan transcend the swap profit. The difference between both is the cost equal to the gold lease rate (GLR). In my previous post Understanding GOFO And The Gold Wholesale Market we could read about these relationships (and the exact workings of swaps).
Fiat interest rate – swap rate = GLR
Effectively, by borrowing RMB for a swap the bank pays GLR to synthetically borrow gold.
As the international gold lease rate is likely lower than the gold lease rate in China, Chinese banks can make a profit by (synthetically) borrowing gold abroad, import the metal and lend it through the SGE system at a higher GLR. (Whenever a gold loan is to be repaid from the Chinese domestic gold market to an international lender, not the physical metal is exported, but funds cross the Chinese border, as physical gold export is prohibited from the Chinese domestic gold market.)
For example, Minsheng Bank can synthetically borrow gold for 3 months from HSBC at GLR in the interbank market. When Minsheng lends the gold for 3 months to a jeweler at GLR + 30 BPs, then Minsheng earns 30 BPs in this trade.
In the real world, this is exactly what banks have been doing. Let’s still use Minsheng Bank as an example.Please view the table above. We can see Minsheng’s gold lease volume jumped from 13 tonnes in 2013 to 101 tonnes in 2014, and the precious metals assets surged from 2,913 million RMB in 2013 (~12 tonnes) to 25,639 million RMB in 2014 (~107 tonnes).The surge in precious metals assets was fully caused by the increment in the gold lease business, as can be seen in the excerpt below from Minsheng Bank’s 2014 annual report. All the numbers are in millions of RMB.
It’s disclosed the precious metals assets jumped from 2,913 million RMB in 2013 to 25,639 million RMB in 2014, due to a 22,726 million “increase in precious metals lease business”.
But note we can only see an increase in “precious metals assets” on Minsheng’s balance sheet (exhibit 4), there are no “precious metals liabilities”. This is because the gold lend by Minsheng was sourced through swaps. Minsheng didn’t literally borrow gold (precious metals liability), it swapped gold for RMB collateral.
This is how it works in Minsheng’s case. When it enters a swap transaction these are the spot and the forward legs to be recorded in the financial statement. Minsheng borrows RMB and buys spot gold to lend out to a customer at GLR plus a few basis points. At that moment a precious metals asset (the gold loan) is recorded on the balance sheet, but not a precious metals liability (the related RMB liability is not disclosed in exhibit 4). Simultaneously, Minsheng sells short a forward contract that is recorded off-balance sheet. In due time the gold loan is repaid, the forward settled, etc.
The off-balance activities are shown in exhibit 4, additionally they’re disclosed in Minsheng’s financial statement to be viewed below. Again all numbers are in millions of RMB.
We can see that the large increase in precious metals derivatives trading from 2013 to 2014 was mainly caused by “3 months to 1 year” “forwards and swaps”, of which most have been swaps used for synthetic back-to-back leasing.
Exhibit 5 shows there was a 22,726 million RMB (~ 94 tonnes) increase in leases from 2013 to 2014. Exhibit 6 shows ~ 24 billion RMB (~ 100 tonnes) in “3 months to 1 year” swaps have been executed in 2014, over zero in 2013. Likely, the majority of the swaps have been in tenors close to 1 year, as by 31 December 2014 roughly 107 tonnes in precious metals assets were on the balance sheet.
In 2014 the “3 months to 1 year” “cash inflow” (Minsheng’s sell forward leg) transcended the “cash outflow” (buy spot leg) because gold was in contango that year in China. (Exhibit 6)
Perhaps you have noticed that Minsheng Bank counts only 1 leg of the gold swap off-balance sheet. Yes, if we compare the total “precious metals forwards and swaps” “cash outflow” 32,865 million RMB with the total notional amount in precious metals derivatives off-balance sheet, 32,844 million RMB, the two numbers are roughly equal.
All in all, at the surface it appears Minsheng Bank holds approximately 100 tonnes in precious metals assets, in reality this is merely reflecting synthetic back-to-back leasing through swaps. More proof there can be little “surplus” gold on the commercial banks balance sheets.
As long as Chinese annual lease volume grows, the commercial bank balance sheets can mushroom as a consequence.
Chinese Lease Volume Reflects Yearly Turnover.
In the past there has been some doubt whether the reported Chinese gold lease volume reflected the total turnover over a certain period, or the gold that has been leased out at a certain point in time. Already in May 2015 I wrote China’s reported gold lease volume reflects turnover – because traders at Chinese banks told me – and now there is more confirmation to be presented. From Minsheng Bank’s financial statements we can understand that the gold lease volume means the lease turnover per annum. Have another look at exhibit 4.
Minsheng bank leased out 116 tonnes of gold in 2015, which was an increase from 2014. But at the end of 2015, the “precious metals assets” wherein gold leasing is recorded, decreased to 83 tonnes. This can only be possible if the lease volume is annual turnover. Apparently, in 2015 Minsheng’s leasing business grew, but it conducted more deals in tenors shorter than 1 year, causing the annual turnover to increase (to 116 tonnes) but the outstanding leases at year-end on the balance sheet to decline from the previous year.
The World Gold Council (WGC) seems the have come to the same conclusion recently. In the Gold Demand Trends Q2 2016 report, it stated (page 15) the gold lease volume “captures the total amount of gold leased in the reporting period, for example, if Commercial Bank A lends 1t to Jeweller B for three months and Jeweller B returns it back for the Commercial Bank A to lend again to Bank C, a total of 2t of leasing volume will be recorded for the period”. This confession by the WGC is remarkable, because from April 2014 until early 2016 the WGC was spreading a myth about the gold involved in the Chinese lease market. From the WGC’s China’s Gold Market Progress And Prospects, April 2014:
No statistics are available on the outstanding amount of gold tied up in financial operations [leases] linked to shadow banking but Precious Metals Insights believes it is feasible that by the end of 2013 this could have reached a cumulative 1,000t.
While at it, the WGC admitted most of the leased gold doesn’t leave the SGE vaults:
It’s estimated that around 10 % of the leased gold leaves the SGE’s vaults. The majority is for financing purposes and is sold at the SGE for cash settlement.
This is what I’ve written since February 2015: gold leasing has little impact on SGE withdrawals, as the vast majority of leases are for financing purposes and are thus settled within the SGE system.
Gold In SGE Vaults Is Not On The Custodian’s Balance Sheets
In China, most of the SGE vaults are actually owned by commercial banks but approved by the SGE as “designated vaults”. In addition there are other types of enterprises that own “SGE designated vaults” – probably jewelry companies in Shenzhen, the heart of China’s jewelry manufacturing industry. In my previous post I shared the possibility that SGE vaulted gold appears on the balance sheets of custodian commercial banks. But further research has pointed out that is not the case. SGE vaulted gold does not appear on the balance sheet of the custodians, only on the balance sheet of the owner.
As has been written at the beginning of this post, in order for a custodian, in this example ICBC, to recognise the gold owned by another entity, in this example BOC, in its SGE-designated vault as an asset, the gold has to be “owned or controlled” by ICBC. In reality ICBC wouldn’t have any ownership of this gold. ICBC would have, to a certain extent, some control over BOC’s gold, but in order for ICBC to recognise the gold as an asset on its balance sheet, it should be “probable that the economic benefits associated with that resource will flow to the enterprise”. In other words, ICBC should be able to sell or lease out BOC’s gold in its vaults to record the metal as asset. Though, an SGE custodian would never go there or its business would collapse promptly.
There is more confirmation. On the balance sheet of Ping’ An Bank, the volume of precious metals holdings for 2011 and 2010 were both nil. At the same time, according to Ping’ An’s annual report of 2010, its total gold withdrawals ranked No. 8 among all SGE designated vaults.
Gold vaulting service keeps increasing and the withdrawal number is listed the eighth among SGE designated vaults.
And in 2011 Ping’ An’s gold deposit and withdrawal total accounted for 10% of all SGE warehouse activity. It is hard to believe that Ping’ An had no gold in its SGE-designated vaults at the end of 2010 and 2011, while Ping’ An’s vaults were such an important part of the SGE system. Concluding, Ping’ An didn’t recognize other SGE clients’ or members’ gold in its vaults as its assets. Hence we have for 0 for Ping’ An’s precious assets in 2010 and 2011.
Some readers may point out the following paragraph in ICBC’s 2015 annual report:
The Group records the precious metals received as an asset. A liability to return the amount of precious metals deposited is also recognised.
The group recognises an asset when the group receives the precious metals deposited by the customer for accumulation, and at the same time recognises the related liability.
Therefore, ICBC was actually referring to the gold in its Gold Accumulation Plan (GAP) and the key information was lost in translation.
Gold is Chinese ETFs is neither recognized by its custodian as an asset.
Some Of Chinese Banks’ Gold Is Indeed Outside China
I mentioned in the previous post that some of Chinese banks’ precious metals holdings could be outside China. ICBC acquired Standard Bank in 2015 and Standard Bank’s precious metals are outside China. However, even some medium-sized Chinese banks hold precious metals outside China. The following table is from Ping’ An’s 2014 annual report (page 196, numbers are in millions of RMB).
What we see is that Ping’ An held gold assets in US dollars worth 2,420 million RMB. The disclosed “foreign exchange equivalent” for Ping’ An’s precious metals would only be mentioned like this if the precious metals are held outside China. If the precious metals would have been located inside China, Ping’ An never would have listed the value of the assets as “USD (in CNY equivalent)”.
We will not extensively analyze every Chinese bank’s financial statement like we’ve done with Minsheng Bank and Ping’ An Bank above, though I do like to share all the data I’ve collected. The practice of categorizing precious metals assets and liabilities varies from bank to bank so readers should pay attention to the notes below the tables and are recommended to read the original annual reports for more information. The derivative instruments are listed according to the notional amount (off balance sheet) instead of the fair value. The notional amount is not comparable between banks because for swaps, some banks only consider one leg while others add both the spot and forward legs, for example Bank of Ningbo, together.
Assuming all precious metals mentioned are gold related.
1. Industrial and Commercial Bank of China (ICBC)
We can observe ICBC precious metals assets started to transcend its financial liabilities related to gold in 2014. The possible causes are increases in ICBC brand gold bar sales (more inventory), customers purchased more options (ICBC would need to buy more gold to hedge), and more synthetic gold leasing.
2. Bank of China (BOC)
“Commodity derivatives and others” were called “precious metals derivatives and other derivatives” before 2010. BOC doesn’t have any significant numbers related to precious metals in financial liabilities designated at fair value through profit and loss.
Noteworthy, at the end of 2007 BOC had 7,982 million RMB (~ 41 tonnes of gold) in precious metals pledged as collateral, and late 2009 this figure had grown into 27,271 million RMB (~ 114 tonnes of gold). The precious metals were used as collateral in swap transactions for financing, according BOC’s accounting practice.
Precious metals swap transactions, based on the transaction nature, are treated as precious metals sales under collateral agreement. The precious metals pledged as collateral are not ceased to be recognized and the related liability is reflected in “borrowings through interbank lending”
3. Bank of Communications
Bank of Communications lists precious metals assets in two separate categories. I’m not sure what is identified with “precious metals contracts”.
Bank of Communications reported in its 2013 annual report that it conducted overseas gold swap business:
[Bank of Communications] successfully conducted overseas gold swap transactions.
In 2013, Bank of Communications conducted gold interbank lending with HSBC and HSBC became the most important source of physical gold for the Bank of Communications:
The two parties [Bank of Communications and HSBC] not only conducted “first deal” cooperation in gold consignment and gold borrowing, but also realized surging cooperation volume. HSBC has become an important import source of physical gold for the bank.
4. China Construction Bank
Not everything in the “other derivatives” category are precious metals.
China Construction Bank (CCB) wrote in its annual reports that the market share of physical sales to the public was No. 1 in 2010, and in the same year the market share of gold leasing was 40 %. From CCB’s 2010 annual report:
The Bank [China Construction Bank] has maintained the rank of No 1 in branded physical gold to individuals. The market share of gold leasing was 40.30 %. The market share of account gold was 37.41 %.
CCB offered physical withdrawal on precious metals accounts since 2013 and its own gold accumulation plan since 2015.
5. Agricultural Bank of China
Before 2014 “precious metals contracts” were called “precious metals lease contracts”. Not sure what “precious metals contracts” can be next to “precious metals lease contracts” – perhaps SGE physical contracts like Au99.99.
Before 2011, precious metals derivatives were reported separately as forwards and swaps. The precious metals lease business was reported to be launched in 2010.
6. Shanghai Pudong Development Bank
The change in “Financial liabilities at fair value through profit and loss” was caused by precious metals shorts according to Shanghai Pudong Development Bank’s annual reports.
7. China Merchants Bank
The increase in “precious metals assets” was caused by the increase in proprietary trading and gold lease according to the annual reports. From China Merchants Bank’s 2014 annual report:
In 2013, China Merchants Bank reported to have conducted precious metals leasing of 60 tonnes, a 203 % increase from 2012.
8. China Minsheng Bank
The fine data was discussed in the previous chapter.
9. Industrial Bank
The 644 million RMB precious metals related liabilities were caused by “gold pledge business” according to Industrial Bank’s 2008 annual report.
“Precious metals shorts and leased precious metals” are a subcategory under “financial liabilities held for trading”.
10. China CITIC Bank
According to the annual reports, the surge in the precious metals and precious metals contracts in 2014 was caused by the increase of precious metals lease and proprietary business.
In the reporting period, the gold lease business and precious metals proprietary trading business all achieved rapid growth.
11. Ping’ An Bank (former Shenzhen Development Bank)
Before 2014 precious metals derivatives were called gold derivatives. Before 2009, Ping’ An only gave a lump sum of all the derivatives. Just in case there were any gold derivatives in this category, I’ve included the lump-sum numbers.
The increase in the “financial liabilities designated at fair value through profit and loss” in 2013 was caused by the increase in “financial liabilities held for trading” related to “gold business”, according to the annual report. Therefore all the numbers in “Financial liabilities designated at fair value through profit and loss” are listed here, although this category may include some liabilities not related to precious metals. From Ping’ An’s 2013 annual report:
12. Huaxia Bank
The precious metals assets in 2007 and 2008 were a result from physical gold sales according to the annual reports.
13. Everbright Bank
China Everbright Bank doesn’t report the liability related to precious metals separately.
According to the annual reports, Everbright Bank started to conduct gold consignment sales and gold leasing in 2013. Therefore, the increase in precious metals holding in 2013 was probably caused by these activities. From to Everbright Bank’s 2013 annual report:
[Everbright Bank] acquired the gold import qualification, started to conduct gold consignment and gold lease business.
14. Bank of Beijing
Clearly the Bank of Beijing participates in back-to-back leasing, as precious metals leased out are exactly equal to precious metals leased in.
15. Bank of Nanjing
The Bank of Nanjing only disclosed 6 million RMB in precious metals assets in 2014 and 7 million RMB in 2015.
Every market cycle has 1 to 2 macro drivers at the heart of its regime. We call these the fulcrum points. Keep an eye on the fulcrum and you’ll know when a major cyclic turn is underfoot.
The fulcrum point for the current cycle is without a doubt the US dollar (UUP). The dollar is sitting on top of a $ 9-$ 11 trillion powder keg of foreign carry trades — essentially short dollar positions. And the torch that’s likely to set off this powder keg of deflation is the Chinese yuan (FXI).
A depreciating yuan equals a stronger dollar. A stronger dollar increases downside pressure on a depreciating yuan. This is called a feedback loop. Once the loop picks up momentum, it will rip until it has completely exhausted itself.
If (when) this loop starts up, the current market cycle will be over. We’ll enter a new bear regime. And if it’s anything like past devaluations, the shift will be painful and dramatic.
With that said, investors should be concerned. The yuan has been on a relentless march lower against the dollar (when yuan falls the USDCNY pair rises). It’s been hitting new six year lows almost daily and showing no sign of abating.
The yuan has fallen even further against other countries, over 30% just this year against currencies it competes with for exports. This is akin to a massive tectonic plate shift under the ocean. At the epicenter, things are hardly noticeable. But under the surface, powerful waves are barreling toward distant shores.
We’re seeing ripples of this move in the dollar now. It’s been strengthening the last two months and looks set to break out of its 18-month trading range.
Capital flows out of China have been picking up steam. Much of it is being disguised under other cross-border flows in an attempt by the Chinese Communist Party to hide the severity of the situation.
It’s no surprise the Chinese “smart money”, the wealthy and politically connected, are transferring their savings out of the country by going on an unprecedented acquisition spree of foreign companies.
The irony is that a devaluing yuan, once at the front of investors concerns at the beginning of the year, has now faded to little more than an afterthought. But as the saying goes, the big moves happen when nobody is looking.
Fed Worries of “Eroding Credibility”; Gordon Chang on the Chinese Economy
Welcome to this week’s Market Wrap Podcast, I’m Mike Gleason.
There’s been some big news out of China lately, and today we’ll dive deeper into the discussion when we hear a recent interview I did with Gordon Chang. Mr. Chang is one of the foremost experts on the Chinese economy and has written a book titled The Coming Collapse of China. He’ll tell us why he believes an epic collapse is imminent and what it all means for the Western financial world and why he believes there is what he calls a Chinese floor on the gold price. Don’t miss an incredibly eye opening and enlightening conversation with Gordon Chang, coming up after this week’s market update.
After being hit with a barrage of heavy selling during the first few days of October, gold and silver markets have stabilized.
Precious metals traders largely shrugged off this past Wednesday’s release of the Federal Open Market Committee’s latest meeting notes. The most notable Fedspeak to come out of the September meeting was the term “relatively soon” – as in the central bank intends to hike interest rates at some undefined point in the future. Perhaps in December if market conditions are favorable. However, if markets suffer a severe drawdown after the election, then perhaps “relatively soon” will carry over into 2017 or even beyond.
A few meeting participants dissented from the Fed’s decision in September to refrain from hiking. They specifically expressed concerns that the FOMC “risked eroding its credibility.” They talked as if the Fed hasn’t already eroded its credibility. Saying one thing and doing another month after month has consequences. Fed officials offer various excuses each month about the economy not quite performing as well as they had hoped. But there is now a widespread perception that the Fed isn’t hiking ahead of the election for political reasons.
This is an election like no other in recent memory – one in which most organs of the mainstream media have abandoned even the pretense of objectivity. Hillary Clinton and her media and Beltway allies portray Donald Trump as not merely wrong on the issues, but unfit as a person to be president. Trump and his supporters say Hillary Clinton’s actions as Secretary of State make her unfit to be president. It’s quite likely that if she were just a lower level State Department bureaucrat, she would be facing prosecution over her mishandling of classified material. She certainly wouldn’t be deserving of a promotion. Whoever ends up winning will be among the most disliked and least trusted new presidents ever to be inaugurated.
Well, when it comes to investing, the best values often emerge from the least liked assets. When a market is hated by the public, or viewed with doubt even by bulls, it’s usually a good time to buy. Right now the gold and silver markets face a lot of doubters who aren’t convinced the rally seen in the first half of the year puts the metals in a major bull market.
We’ve certainly seen a sharp pullback in precious metals prices. Both gold and silver are still holding above their 50-week moving averages. Until proven otherwise, the long term trends remain positive.
As of this Friday recording, gold prices come in at $ 1,254 an ounce after a small 0.4% decline this week. Silver, meanwhile, is off 0.9% since last Friday’s close to trade at $ 17.46.
The gold to silver ratio has moved up in favor of gold over the past month. That’s normal during market downturns, as silver is the more volatile metal. For the year, though, silver is still outshining gold in terms of price performance. And when the next big rally hits the sector, you can expect silver to outperform the yellow metal.
For silver investors who want to own low cost legal tender coins, Money Metals is pleased to announce that we have just been designated as the only dealer worldwide for the stunning new 2017 “HMS Bounty.” This .999 pure silver coin from the New Zealand Mint is the lowest priced 1 oz legal tender silver coin in the world.
The content and purity of the New Zealand Bounty are identical to those of silver American Eagles, yet premiums are MUCH lower.
The Bounty is not only an outstanding value in legal tender silver, it’s also a spectacular coin. The reverse depicts Her Majesty’s Ship The Bounty under sail, circumscribed by an eight-point compass. The obverse features Queen Elizabeth II and bears the coin’s $ 2 legal tender denomination.
The New Zealand Mint has been producing legal tender coins, bullion, and collectible medallions for more than four decades. It prides itself on high quality designs and production.
Money Metals is offering the 2017 Bounty at only $ 1.99 over spot for smaller orders, and as low as $ 1.69 over spot if you buy 500 or more, making it the lowest price on any 1 oz government minted coin. Its weight, purity, and legal tender status are backed by the Reserve Bank of New Zealand.
In addition to their primary value as a store of wealth against the fickle nature and uncertain future of fiat currencies, these beautiful coins will make outstanding Christmas gifts and stocking stuffers, helping instruct others on the wisdom of owning sound money and investing in precious metals.
As always, all orders over $ 1,000 ship free at Money Metals – that’s about 50 1 oz New Zealand Bounty coins. There is no order limit, so feel free to buy as many as you want.
Well now, without further delay let’s get right to this week’s exclusive interview.
Mike Gleason: It is my privilege now to welcome in author, lawyer, television pundit, and Forbes columnist Gordon Chang. Gordon is a frequent guest on Fox News, CNBC, and CNN and is one of the foremost experts on the Chinese economy and its geopolitics and has written a book on the subject called The Coming Collapse of China.
Gordon, it’s a real honor to have you on with us today. Thank you very much for taking the time, and welcome.
Gordon Chang: Thank you, and it’s a real honor to be on your podcast.
Mike Gleason: Before we dig into some specifics here, Gordon, China’s economy is now the second largest in the world. They’ve been reporting GDP growth at 7% to 10% per year for decades, and we’ve all heard stories about their booming economy. But few Americans have been there and probably don’t really know what’s going on. The Chinese government is notorious for managing statistics and controlling information, so it can be difficult for U.S. investors to get the real story. That’s why we’re very excited to get your insights today. You’ve spent time in China, you are of Chinese descent, and you’ve been studying their economy for decades, so you have a unique perspective on what is really happening there.
So to start out here, talk about the current state of the Chinese economy as you see it and where it might be headed. As people listening have probably already gathered, based on the title of the book you wrote, you aren’t all that optimistic about what’s going to happen there. Tell us about that as we set the stage here.
Gordon Chang: The official National Bureau of Statistics says that the Chinese economy grew 6.7% in the first quarter of this year, 6.9% in 2015. I think that those numbers are over-statements. So for instance, in Q1 they might have been growing 3% or 4%, but maybe even less than that. In 2015, it was a tragic story because you start looking at some of the indicators, you see the contraction of the important manufacturing sector. You see consumption growing a little bit, but not that much.
And still, the most reliable indicator of Chinese economic activity is the consumption of electricity, and in 2015, electricity consumption grew but only by 0.5%. The country was in deflation in 2015 with nominal GDP at 6.4% and real at 6.9. That’s really difficult to reconcile with an economy growing in the higher single digits. So I think China has got a problem right now because essentially, Chinese leaders no longer have the ability to create growth. This is an economy that’s trying to trend down, and eventually, it will start to contract.
Mike Gleason: The Chinese have made some large trade deals with nations such as Russia and Brazil to buy oil and gas and make payments in yuan rather than U.S. dollars. In addition, China is growing its reserves of both gold and silver. Now you told me off-air that you don’t think a currency war is something China should even consider engaging in based on all of their economic issues, but you have to wonder if they’re trying to position the yuan as an alternative to the dollar nonetheless. Heaven knows, there may be an opportunity there.
The U.S. dollar looks less and less like a bastion of strength. Kenneth Austin, an economist at our own Treasury Department, wrote a 2014 op-ed in the New York Times declaring that the burden of the dollar’s reserve currency status is one we can no longer afford to bear. Maybe a currency war won’t be necessary and officials here will willingly step aside. What are your thoughts? Should we expect a major push by China to supplant the dollar with the yuan any time soon? Maybe it will be a failed attempt, but is that something they’re positioning themselves for, Gordon?
Gordon Chang: Well clearly, the Chinese want the renminbi to be the world’s reserve currency. They’d like to shove the dollar aside. The problem, though, is that it is a weak currency right now. Donald Trump might be right that they’re currency manipulators, but they’re not manipulating the currency down to gain an export advantage. What we have seen, especially since August of last year, is that they are supporting their currency.
So this is a problem for China because the last thing that they should be trying to do right now is to internationalize the renminbi. And the reason is when they internationalize it, they start to lose control over it, and that’s exactly the wrong strategy when you have an economy in distress. They have had a lot of money, and they’ve lost actually a lot of money out of their reserves, much more than I think that they’re willing to admit. This is the wrong thing for them to do, at least at this particular time.
Mike Gleason: It’s often discussed how the Chinese are culturally more forward-looking. They plan decades ahead, not just a few months or years. If that is true, one might think that they would have an advantage and avoid some of the traps Western governments have fallen into, but they seem to be making many of the same mistakes. Markets are anything but free. Last summer, officials attempted to prevent a collapse of their stock markets by threatening to arrest anyone selling shares, the antithesis of free-market conditions there. They’ve accrued massive debts and they have an activist Central Bank printing, monetizing debt, et cetera. Are Chinese officials really better at strategic planning and longer-term thinking, Gordon?
Gordon Chang: I actually don’t think so, especially what we saw starting in the second week of July (of last year) when they started to introduce their support measures for the equity markets. And then, of course, the still inexplicable devaluation of the renminbi, starting August 11 (of 2015). Chinese technocrats show themselves to be less than fearsome and less than competent. So I think that we sort of attribute to them mythic qualities which they don’t really deserve. Eventually, they will be able, I think, to stabilize their economy, and they’ve been trying to do that right now, but as they do that, they incur a lot of debt. They’re still experiencing large capital outflows. So right now, although it looks like they were able to at least staunch the problems, they have some challenges I don’t think that they can meet.
Mike Gleason: Certainly, the information that comes out from the Chinese government is very controlled. I think now, I’ve heard just even recently that if you speak ill of the government’s provided statistics that they’ll send you to prison or try to prosecute you in some way. This is just the opposite of what a free market looks like. What are your thoughts on that? I know this is something that’s been going on for a long time, but they don’t appreciate dissenters, do they Gordon?
Gordon Chang: No, they certainly don’t. The Wall Street Journal report that you referred to where they’re trying to infuse a little positive energy into analysts. As we all know, beginning July of last year they criminalized many forms of trading. They did a lot to prohibit institutions from selling. They just at this point, that’s sort of like the last refuge of a technocrat, where they’re trying to browbeat market participants and analysts. So I think that that’s an indication that the end is quite near because they’ve just run out of solutions.
Monetary policy just hasn’t worked. Fiscal stimulus is adding to their debt woes. They do all of these things and you still have the large capital outflows, perhaps as much as $ 1 trillion last year, according to Bloomberg. So I think these are desperate technocrats and desperate leaders who at this point don’t know what to do and are just playing for time. As they play for time, they make matters worse, because we saw that extraordinary increase in credit in March. It had very little effect on the economy. It’s a dead panda bounce. Now, I don’t think that they know what to do except to try to imprison people who don’t say nice things about China’s economic potential.
Mike Gleason: I’m curious. How do the Chinese view the American political system as a whole and also the Obama Administration? And how do you think they view Hillary and Trump, since it appears that one of them will be succeeding Obama later this year? What’s the general mood about American politics in China?
Gordon Chang: Well there are a lot of Chinese, so maybe there’s no general view. Of course, the Communist Party is extremely negative about all things American. So you’re not going to hear nice things about the American political system from an authoritarian one like China’s. Chinese people, though, are very interested. They have means of information. They can climb over what’s called the great firewall. There is a lot of discussion all the time about what goes on in the American political system. Right now, as you point out, people are talking about both Secretary Clinton and Donald Trump, and it seems to be pretty evenly divided about what they think in terms of who they favor to be the next American president.
There’s a lot that’s going on there. Donald Trump, as you’d expect, has a lot of detractors in China, but he also has a lot of supporters. The thing that I just take away, and this is a general thing … my wife and I went to my dad’s hometown in early 2008 because we wanted to know about what people thought on the Olympics. But people didn’t want to talk to us about that, which they derided as the “Government’s Games”, which really surprised me.
What they wanted to talk about was who was John McCain, who was Barack Obama, and how, this is really surprising, how did the concept of balance of powers work in the American Constitution. So people there are really focused in on the United States as an alternate model for China. And although the Communist Party will never want that, nonetheless, I think the Chinese people certainly want more say in their lives and they’re willing to learn from others, which I think is a very important sign of a vibrant society.
Mike Gleason: The Chinese government does seem to maybe nudge their citizens to purchase gold and silver as a way to protect themselves. Does that resonate with the citizenry there? Are they accumulating precious metals at a personal level just because there’s an affinity for it, or are they just going along with what the government is telling them to do? What can you say there?
Gordon Chang: Yeah, I think the Chinese people are acquiring precious metals, but especially gold. But it’s not because they’re nudged by the government. I think they’re doing it because there’s concern about their currency, about their economy, and also about the signs of discord in the political system. So you have people buying gold. This is an easy way of capital flight, in effect, because if people can’t set up a tax haven company in Panama, for instance, just to take an example, the one way to protect your assets is to buy hard metals. So therefore people buy gold.
Now, of course, the Chinese have an affinity for gold, have had for centuries, but now I think the demands are actually much higher. There’s a lot of gold-buying by China. Some of it must be from the Central Bank, but I think a lot of it is by individuals who are concerned about the trajectory of their economy and, indeed, of their country.
Mike Gleason: Are we to believe the reports, Gordon, about how much gold the People’s Bank of China is accumulating? And if not, do you think they’re under-reporting it or over-reporting it? What do you think about China’s gold hoard and what they’ve been telling the world about those figures?
Gordon Chang: For a very long time, the People’s Bank of China was telling us that there was no change in China’s gold position. Then about a year or so ago, they announced a big increase all in one month. So obviously, their reporting is inaccurate and unreliable. I don’t know exactly, but my sense is that they are under-reporting their acquisition of gold. I can’t point you to anything, but it’s just a sense of where Chinese government policy is going. I don’t know what purpose that is for.
People talk about eventually a gold-backed renminbi. I don’t think that they’re thinking about that, but nonetheless, when gold dipped in price, they saw a buying opportunity and so, therefore, they did stock up on gold. And we can expect them to do that at other opportunities when gold declines. So there’s going to be essentially a Chinese floor to gold, largely because of central government buying. But also, as I mentioned, just Chinese individuals will rush in to buy the precious yellow metal when they see that it’s cheap.
Mike Gleason: The Shanghai Gold and Silver Exchange was introduced. It provides an alternative to the COMEX and other Western exchanges, which many believe are massively over-leveraged and highly controlled by the banks, some of whom have recently admitted to rigging prices. But investors need to be careful assuming the Shanghai Exchange won’t be subject to problems of its own. What do you think the ramifications of the new exchange in Shanghai might be for the metals markets, and what do you think was behind the decision for the Chinese government to launch this competing exchange?
Gordon Chang: I think the decision behind the launch is what you talked about before, and that is a general attempt to internationalize the renminbi and also to increase China’s influence in markets generally. As I mentioned, I’m not so sure how long that they’ll be able to continue with this initiative, largely because of severe problems in their own economy, but, as you say, they are long-term thinkers, so that’s what they’re trying to do. As I mentioned, this is probably the wrong time for them to do that, and so therefore, they’re increasing volatility in their own currency and in their own markets. So this really is maybe a good move strategically, but tactically, couldn’t be a worse time to do it than now.
Mike Gleason: As we begin to close here, Gordon, what should the key takeaway here be, because I know you’re expecting not only a collapse of the Chinese economy and their current way of life, but an epic collapse? China is now a major player in the global economy, but if the bubble bursts like you expect and in such an incredibly disruptive way like you expect, what are some of the ramifications of that happening? And more importantly for those of us listening today, how might that collapse affect those of us in the Western world as well as the global financial markets?
Gordon Chang: We saw, for instance, last August where essentially unimportant news out of the Chinese economy, which was news out of a private survey of the manufacturing sector, how that erased something like $ 2.1 trillion in value off the Dow within six trading days. So you can imagine what a big failure in China is going to look like as it rolls through the global financial system and the global economy. China actually is less important to the world than most people think, but nonetheless, with an image of it as being so large, then, of course, it is going to bring down most everything else with it.
I think the important thing is to understand China’s role in that economy so that we will be prepared when it occurs. We know that the Chinese are, for instance, accumulating debt at least four times faster than nominal GDP, probably a lot faster than that. That’s completely unsustainable. There will be a crisis. We don’t know when that crisis will occur, but we also know at some point, China will not be what it is today.
Mike Gleason: How about the future of the Chinese Communist Party? I think I’ve seen you say somewhere where you’re expecting mass riots and so forth as things unfold there in China. What do you think the ramifications are there?
Gordon Chang: I don’t think the Communist Party will survive the economic crisis in China, largely because for about 35 years, the primary basis of its legitimacy has been the continual delivery of prosperity. And without prosperity, the Communist Party is going to have a hard time navigating that. Right now, Chinese technocrats don’t seem to be doing a terribly good job. We see fighting between Xi Jinping, the General Secretary of the Communist Party, in other words, China’s ruler, and Li Keqiang, who is the Premier, who is supposed to be the economic czar.
This is, I think, an early indication of what things will look like as the economy tends to trend down, as it has to. Although Chinese technocrats can postpone the application of the laws of economics, they have not been able to repeal them, and because of that, we know that there’s got to be some adjustment. That adjustment will be large because the imbalances in China are large, and because of that, the Communist Party, I believe, will not survive the coming crisis.
Mike Gleason: It’s certainly going to be interesting to watch this play out. China gets a lot of attention throughout the world, as you mentioned, and if we do see an implosion of that economy, there’s going to be a lot of shock waves, I think, throughout the rest of the world.
Well Gordon, it’s been a truly fascinating conversation, and I really enjoyed it. We’ve been talking a lot about what’s been going on with China of late, and it’s great to have had a chance to speak to an expert like yourself about these matters. We wish you continued success with the book and would love to have you back on in the future as all this unfolds. Thank you again and hope you have a great weekend.
Gordon Chang: Thank you so much, Michael.
Mike Gleason: Well that will do for this week. Thanks again to Gordon Chang, author of the book The Coming Collapse of China. Be sure to check that out.
There has been much conjecture since 2014 about the increasing numbers in the “precious metals” category on the balance sheets of listed Chinese commercial banks. By the end of 2015 China’s largest banks were holding RMB 598 billion in precious metals.
Some analysts think that the precious metals on Chinese commercial bank balance sheets are gold reserves purchased on behalf of the Chinese central bank, while others surmise that Chinese banks buy gold at the Shanghai Gold Exchange (SGE) and then lend it out so the precious metals on the balance sheets solely represent leased gold. In latter analysis it’s then assumed the leasing inflates the amount of gold withdrawn from SGE designated vaults. Most certainly there is leased gold on Chinese banks’ balance sheets, but this can hardly influence SGE withdrawals, as I have previously explained. Read this and this article for more information.
What do we know beyond the gossip about the precious metals holdings on Chinese commercial bank balance sheets?
From studying the annual reports of the respective banks and additional documentation we know the precious metals can be at least the following things (if I find more clues this post will be updated):
Gold savings that belong to the banks’ customers
Gold inventory for the banks’ retail gold business
Gold leasing business
Gold held for hedging purposes
Since the Chinese silver market was liberalized much earlier than gold I don’t think there is any edge for Chinese commercial banks to have a predominant role in the silver market. So, probably most of the precious metals on the balance sheets in question are gold related.
Below is an overview of the precious metals holdings of listed Chinese commercial banks as of 31 December 2015, measured in yuan (RMB). There are 16 listed Chinese commercial banks on China’s A-share market but Huaxia Bank didn’t disclose its precious metals holding in its annual report. If all aggregated precious metals holdings relate to gold, the upper bound is approximately 2,682 tonnes of gold.
1. Customers’ Gold Savings
A substantial amount of the precious metals reflect (fully backed) customers’ gold deposits in the form of Gold Accumulation Plans (GAP), recorded as an asset and a liability on the balance sheets of the banks. However, to me it’s unknown how much gold is exactly accumulated in China through GAPs.
Let’s go through the annual reports of the Chinese banks having the largest precious metals holdings, seeking for information with respect to GAPs.
Precious metals comprise gold, silver and other precious metals. The Group retains all risks and rewards of ownership related to precious metals deposited with the Group as precious metals deposits, … and it records the precious metals received as an asset.A liability to return the amount of precious metals deposited is also recognized.
From the BOC website its GAP seems to be in its infancy, so I don’t expect it to comprise much gold. ICBC on the other hand, introduced a GAP in 2010 and is thought to be largest in China.
Seizing the opportunities arising from customers’ wealth increase and capital market growth, the Bank made efforts to establish a mega asset management business system across the whole value chain and enhance its specialized operating capabilities on the strength of the Group’s asset management, custody, pension and precious metal businesses, …
The [ICBC] Group records the precious metals received as an asset. A liability to return the amount of precious metals deposited is also recognized. …
While consolidating our traditionally advantageous businesses in housing finance and cost advisory service among other things, we actively expanded our presence in … precious metals.
The Bank supported product innovation, provided and optimized new products such as … gold purchase and saving.
The Bank proactively responded to changes in the precious metals market via pursuing marketing expansion, enlarging customer base and enforcing product innovation. The Bank launched innovative products and business models, including gold accumulation plan ….
To me it’s unknown how much gold CCB’s GAP comprises.
All in all, precious metals on the listed Chinese commercial banks’ balance sheets can be gold savings held on behalf of clients instead of reflecting the banks own metals.
(Likely, gold saved in Chinese GAPs is bought and withdrawn from SGE designated vaults.)
2. Bank Gold Inventory
Chinese banks offer a wide range of retail gold products for sale. Naturally, any gold inventory is recorded on the balance sheets. More from ICBC’s 2015 annual report:
To echo the changes in market demands, the Bank developed a variety of new brands on assorted themes and introduced a slew of products, e.g. Chinese Zodiac Coins and Panda Gold and Silver Coins, under agent sales. The Bank expanded the online channels, through which the flagship store “ICBC Gold Manager” witnessed substantial growth of sales, and it also piloted the direct distribution of logistics suiting to the characteristics of e-commerce.
Additionally, I have no proof, but it can be that some of the inventory in the vaults of the SGE is appearing on the Chinese commercial bank balance sheets. Most of the banks listed in exhibit 1 have a PBOC gold import license. Once the bullion is imported into the Chinese domestic gold market, often done through consignment, it must be sold first through the SGE. By the time it has arrived in SGE designated vaults and before it’s sold, possibly it’s shown on the balance sheet of the importing bank.
3. Gold Leasing
Probably the largest share of the precious metals on the balance sheets have to do with gold leasing. At the moment, there are no official accounting rules or guidelines related to how to record bank’s gold leasing activities. (In this post, I don’t distinguish between gold leasing and gold lending because the essence is the same.) However, most banks seem to still put gold leasing activity in the precious metals category of their balance sheets.
According to the A-share annual report of the Bank of Communications [brackets added by me]:
Precious metals that are not related to the Group’s trading activities including coins and medallions sales are initially measured at acquisition cost and subsequently measured at the lower of cost and net realizable value. Precious metals that are related to the Group’s trading activities including precious metals lease and [precious metals] interbank lending are initially and subsequently recognized at fair value, with changes in fair value arising from re-measurement recognized directly in profit or loss in the period in which they arise.
Apparently, the Bank Of Communications has its gold leasing business disclosed on its balance sheet in the precious metals category.
Below is from the 2015 annual report of Shanghai Pudong Development Bank (page 17):
As the main cause for the growth in precious metals is considered to be “increased physical gold leases”, we must conclude in the case of Shanghai Pudong Development Bank nearly all precious metals on its balance sheet relate to gold leasing. But does this mean Chinese banks buy gold on the SGE and then lease it out? Not necessarily.
Chinese banks mainly do back-to-back gold leasing. Banks don’t have much money of their own. They need to borrow money or gold either from savers or in the interbank market to subsequently make loans. Would it make sense for banks to borrow money in order to buy gold to subsequently lend out gold? Or would it be more logic for banks to borrow gold to subsequently lend out gold?
ICBC operates in the lease market as an intermediary by connecting supply (lessors) and demand (lessees). ICBC can borrow gold from international banks or local gold owners with an SGE Bullion Account, and lend the gold to miners, jewelers or speculators. My assumption is that the international gold lease rate is lower than the Chinese gold lease rate, which attracts gold from the international market into the Chinese domestic gold market. (Whenever a gold loan is to be repaid from the Chinese domestic gold market to an international lender, not the physical metal is exported, but funds cross the Chinese border, as physical gold export is prohibited from the Chinese domestic gold market.)
Also note, if banks would buy gold to lend out, they are exposed to the price risk of gold. In order to cover this risk, banks need to hedge but this will involve additional costs. As a result, the logical solution is for banks to do back-to-back gold leasing.
Bank of Beijing is a good example to illustrate back-to-back gold lending. Unlike other Chinese banks, Bank of Beijing does not put gold leasing in the precious metals category. It has a separate line in its books for gold leasing.
According to the 2015 annual report of Bank of Beijing (page 123, 132):
As readers can see from the excerpts above, Bank of Beijing indeed does back-to-back gold leasing as precious metals “leased in” are equal to precious metals “leased out”. I suspect most gold leasing by Chinese banks is back-to back gold leasing.
Because Bank of Beijing has its leasing business noted in a separated line than its “precious metals”, we can see a huge discrepancy between Bank of Beijing’s precious metals holdings in exhibit 1 (RMB 55,000,000) and its back-to back leasing business in exhibit 3 (RMB 1,400,000,000).
Other banks don’t have a separate line for the gold leased out but as mentioned before, they put it in the precious metals category. A widely-accepted method to treat borrowed gold is to include a liability called “financial liability at fair value through profit and loss”. Readers who can understand Chinese are recommended to click this and this link. The ICBC annual report provides an example of how the liability is recorded.
In conclusion, back-to-back gold leasing will result as an asset (precious metals) and a liability (financial liability at fair value through profit and loss), for most banks highly inflating the precious metals category. When looking at exhibit 4 we can see the enormous growth in yearly Chinese gold leasing turnover, which must have enlarged Chinese banks’ balance sheets.
China’s commercial banks offer derivatives to retail and institutional customers. Bank of China’s Qi Jin Bao is an example. Qi Jin Bao is in fact gold option business. The retail customer pays a certain amount of money (option premium) and buys a gold call option or put option.
For example (simplified): suppose the current gold price is $ 1300/oz and a retail customer is bullish on gold and believes that the gold price will rise in 3 months time. Therefore, the retail customer buys a 3 months call option with a notional amount of 100 oz of gold at the strike price of $ 1300/oz from Bank of China and pays an option premium of $ 35/oz. If the gold price indeed goes up in 3 month’s time, the retail customer will make money. However, derivatives are a zero-sum game. If the retail customer makes money, then the Bank of China definitely loses money. If the gold price goes up to $ 2000/oz, Bank of China will lose big time. In order to mitigate this risk, Bank of China will (borrow money to) buy gold to hedge the short call position and the gold purchased will appear on the balance sheet.
Gold on the balance sheets of Chinese commercial banks doesn’t necessarily have to be gold held in China. Chinese banks like ICBC, BOC and Bank of Communications have direct access to the LBMA. As a result, gold on the balance sheets of Chinese commercial banks can be located outside China mainland.
From the descriptions above, the precious metals holdings on the balance sheets of Chinese commercial banks are far more complicated than the “everything is gold leasing” assumption. In order for us to learn more exactly what the precious metals on the balance sheets represent we need more information, more investigation is needed by gold analysts. Hopefully this blogpost can serve as a springboard to a better collective understanding.
… As a major precious metal market maker in the PRC, the Bank provided customers with precious metal trading, investment and hedging services through … trading of precious metal derivatives … and trading … the Shanghai Futures Exchange and the London precious metals market.
So, through ABC clients can trade paper gold, but these derivatives would be recorded off-balance sheet, or in a separate line next to “precious metals”. More from the ABC annual report 2014:
Our off-balance sheet items primarily include derivative financial instruments, contingent liabilities and commitments. We enter into currency rate, interest rate and precious metals related derivative financial instruments for the purposes of trading, asset and liability management and business on behalf of customer.
Implying, from my judgement, all the precious metals on-balance sheet are not (customers’) paper gold.