Western Delusions vs. Chinese Realities

I don’t want to say that mainstream analysts are stupid when it comes to China’s gold habits, but I did look up how to say that word in Chinese…

One report claims, for example, that gold demand in China is down because the yuan has fallen and made the metal more expensive in the country. Sounds reasonable, and it has a grain of truth to it. But as you’ll see below, it completely misses the bigger picture, because it overlooks a major development with how the country now imports precious metals.

I’ve seen so many misleading headlines over the last couple months that I thought it time to correct some of the misconceptions. I’ll let you decide if mainstream North American analysts are stupid or not.

The basis for the misunderstanding starts with the fact that the Chinese think differently about gold. They view gold in the context of its role throughout history and dismiss the Western economist who arrogantly declares it an outdated relic. They buy in preparation for a new monetary order—not as a trade they hope earns them a profit.

Combine gold’s historical role with current events, and we would all do well to view our holdings in a slightly more “Chinese” light, one that will give us a more accurate indication of whether we have enough, of what purpose it will actually serve in our portfolio, and maybe even when we should sell (or not).

The horizon is full of flashing indicators that signal the Chinese view of gold is more prudent for what lies ahead. Gold will be less about “making money” and more about preparing for a new international monetary system that will come with historic consequences to our way of life.

With that context in mind, let’s contrast some recent Western headlines with what’s really happening on the ground in China. Consider the big picture message behind these developments and see how well your portfolio is geared for a “Chinese” future…

Gold Demand in China Is Falling

This headline comes from mainstream claims that China is buying less gold this year than last. The International Business Times cites a 30% drop in demand during the “Golden Week” holiday period in May. Many articles point to lower net imports through Hong Kong in the second quarter of the year. “The buying frenzy, triggered by a price slump last April, has not been repeated this year,” reports Kitco.

However, these articles overlook the fact that the Chinese government now accepts gold imports directly into Beijing.

In other words, some of the gold that normally went through Hong Kong is instead shipped to the capital. Bypassing the normal trade routes means these shipments are essentially done in secret. This makes the Western headline misleading at best, and at worst could lead investors to make incorrect decisions about gold’s future.

China may have made this move specifically so its import figures can’t be tracked. It allows Beijing to continue accumulating physical gold without the rest of us knowing the amounts. This move doesn’t imply demand is falling—just the opposite.

And don’t forget that China is already the largest gold producer in the world. It is now reported to have the second largest in-ground gold resource in the world. China does not export gold in any meaningful amount. So even if it were true that recorded imports are falling, it would not necessarily mean that Chinese demand has fallen, nor that China has stopped accumulating gold.

China Didn’t Announce an Increase in Reserves as Expected

A number of analysts (and gold bugs) expected China to announce an update on their gold reserves in April. That’s because it’s widely believed China reports every five years, and the last report was in April 2009. This is not only inaccurate, it misses a crucial point.

First, Beijing publicly reported their gold reserve amounts in the following years:

• 500 tonnes at the end of 2001
• 600 tonnes at the end of 2002
• 1,054 tonnes in April 2009.

Prior to this, China didn’t report any change for over 20 years; it reported 395 tonnes from 1980 to 2001.

There is no five-year schedule. There is no schedule at all. They’ll report whenever they want, and—this is the crucial point—probably not until it is politically expedient to do so.

Depending on the amount, the news could be a major catalyst for the gold market. Why would the Chinese want to say anything that might drive gold prices upwards, if they are still buying?

Even with All Their Buying, China’s Gold Reserve Ratio Is Still Low

Almost every report you’ll read about gold reserves measures them in relation to their total reserves. The US, for example, has 73% of its reserves in gold, while China officially has just 1.3%. Even the World Gold Council reports it this way.

But this calculation is misleading. The US has minimal foreign currency reserves—and China has over $4 trillion. The denominators are vastly different.

A more practical measure is to compare gold reserves to GDP. This would tell us how much gold would be available to support the economy in the event of a global currency crisis, a major reason for having foreign reserves in the first place and something Chinese leaders are clearly preparing for.

The following table shows the top six holders of gold in GDP terms. (Eurozone countries are combined into one.) Notice what happens to China’s gold-to-GDP ratio when their holdings move from the last-reported 1,054-tonne figure to an estimated 4,500 tonnes (a reasonable figure based on import data).

At 4,500 tonnes, the ratio shows China would be on par with the top gold holders in the world. In fact, they would hold more gold than every country except the US (assuming the US and EU have all the gold they say they have). This is probably a more realistic gauge of how they determine if they’re closing in on their goals.

This line of thinking assumes China’s leaders have a set goal for how much gold they want to accumulate, which may or may not be the case. My estimate of 4,500 tonnes of current gold reserves might be high, but it may also be much less than whatever may ultimately satisfy China’s ambitions. Sooner or later, though, they’ll tell us what they have, but as above, that will be when it works to China’s benefit.

The Gold Price Is Weak Because Chinese GDP Growth Is Slowing

Most mainstream analysts point to the slowing pace of China’s economic growth as one big reason the gold price hasn’t broken out of its trading range. China is the world’s largest gold consumer, so on the surface this would seem to make sense. But is there a direct connection between China’s GDP and the gold price?

Over the last six years, there has been a very slight inverse correlation (-0.07) between Chinese GDP and the gold price, meaning they act differently slightly more often than they act the same. Thus, the Western belief characterized above is inaccurate. The data signal that, if China’s economy were to slow, gold demand won’t necessarily decline.

The fact is that demand is projected to grow for reasons largely unrelated to whether their GDP ticks up or down. The World Gold Council estimates that China’s middle class is expected to grow by 200 million people, to 500 million, within six years. (The entire population of the US is only 316 million.) They thus project that private sector demand for gold will increase 25% by 2017, due to rising incomes, bigger savings accounts, and continued rapid urbanization. (170 cities now have over one million inhabitants.) Throw in China’s deep-seated cultural affinity for gold and a supportive government, and the overall trend for gold demand in China is up.

The Gold Price Is Determined at the Comex, Not in China

One lament from gold bugs is that the price of gold—regardless of how much people pay for physical metal around the world—is largely a function of what happens at the Comex in New York.

One reason this is true is that the West trades in gold derivatives, while the Shanghai Gold Exchange (SGE) primarily trades in physical metal. The Comex can thus have an outsized impact on the price, compared to the amount of metal physically changing hands. Further, volume at the SGE is thin, compared to the Comex.

But a shift is underway…

In May, China approached foreign bullion banks and gold producers to participate in a global gold exchange in Shanghai, because as one analyst put it, “The world’s top producer and importer of the metal seeks greater influence over pricing.”

The invited bullion banks include HSBC, Standard Bank, Standard Chartered, Bank of Nova Scotia, and the Australia and New Zealand Banking Group (ANZ). They’ve also asked producing companies, foreign institutions, and private investors to participate.

The global trading platform was launched in the city’s “pilot free-trade zone,” which could eventually challenge the dominance of New York and London.

This is not a proposal; it is already underway.

Further, the enormous amount of bullion China continues to buy reduces trading volume in North America. The Chinese don’t sell, so that metal won’t come back into the market anytime soon, if ever. This concern has already been publicly voiced by some on Wall Street, which gives you an idea of how real this trend is.

There are other related events, but the point is that going forward, China will have increasing sway over the gold price (as will other countries: the Dubai Gold and Commodities Exchange is to begin a spot gold contract within three months).

And that’s a good thing, in our view.

Don’t Be Ridiculous; the US Dollar Isn’t Going to Collapse

In spite of all the warning signs, the US dollar is still the backbone of global trading. “It’s the go-to currency everywhere in the world,” say government economists. When a gold bug (or anyone else) claims the dollar is doomed, they laugh.

But who will get the last laugh?

You may have read about the historic energy deal recently made between Chinese President Xi Jinping and Russian President Vladimir Putin. Over the next 30 years, about $400 billion of natural gas from Siberia will be exported to China. Roughly 25% of China’s energy needs will be met by 2018 from this one deal. The construction project will be one of the largest in the world. The contract allows for further increases, and it opens Russian access to other Asian countries as well. This is big.

The twist is that transactions will not be in US dollars, but in yuan and rubles. This is a serious blow to the petrodollar.

While this is a major geopolitical shift, it is part of a larger trend already in motion:

• President Jinping proposed a brand-new security system at the recent Asian Cooperation Conference that is to include all of Asia, along with Russia and Iran, and exclude the US and EU.

• Gazprom has signed agreements with consumers to switch from dollars to euros for payments. The head of the company said that nine of ten consumers have agreed to switch to euros.

• Putin told foreign journalists at the St. Petersburg International Economic Forum that “China and Russia will consider further steps to shift to the use of national currencies in bilateral transactions.” In fact, a yuan-ruble swap facility that excludes the greenback has already been set up.

• Beijing and Moscow have created a joint ratings agency and are now “ready for transactions… in rubles and yuan,” said the Russian Finance Minister Anton Siluanov. Many Russian companies have already switched contracts to yuan, partly to escape Western sanctions.

• Beijing already has in place numerous agreements with major trading partners, such as Brazil and the Eurozone, that bypass the dollar.

• Brazil, Russia, India, China, and South Africa (the BRICS countries) announced last week that they are “seeking alternatives to the existing world order.” The five countries unveiled a $100 billion fund to fight financial crises, their version of the IMF. They will also launch a World Bank alternative, a new bank that will make loans for infrastructure projects across the developing world.

You don’t need a crystal ball to see the future for the US dollar; the trend is clearly moving against it. An increasing amount of global trade will be done in other currencies, including the yuan, which will steadily weaken the demand for dollars.

The shift will be chaotic at times. Transitions this big come with complications, and not one of them will be good for the dollar. And there will be consequences for every dollar-based investment. US-dollar holders can only hope this process will be gradual. If it happens suddenly, all US-dollar based assets will suffer catastrophic consequences. In his new book, The Death of Money, Jim Rickards says he believes this is exactly what will happen.

The clearest result for all US citizens will be high inflation, perhaps at runaway levels—and much higher gold prices.

Gold Is More Important than a Profit Statement

Only a deflationary bust could keep the gold price from going higher at some point. That is still entirely possible, yet even in that scenario, gold could “win” as most other assets crash. Otherwise, I’m convinced a mid-four-figure price of gold is in the cards.

But remember: It’s not about the price. It’s about the role gold will serve protecting wealth during a major currency upheaval that will severely impact everyone’s finances, investments, and standard of living.

Most advisors who look out to the horizon and see the same future China sees believe you should hold 20% of your investable assets in physical gold bullion. I agree. Anything less will probably not provide the kind of asset and lifestyle protection you’ll need.

In the meantime, don’t worry about the gold price. China’s got your back.

Jeff Clark, Senior Precious Metals Analyst