5 Sep 2011

China buying gold as a "model" to the world

- China buying gold as a "model" to the world
- US and European price suppression countered
- Jewellery demand no longer so important
- Europe may be about to shatter

Documents released by Wikileaks recently include one from the US embassy in China to officials in Washington: "China increases its gold reserves,” it noted, “in order to kill two birds with one stone". The correspondent quotes a story from China's World News Journal, published in April:

"According to China's National Foreign Exchanges Administration China 's gold reserves have recently increased. Currently, the majority of its gold reserves have been located in the US and European countries. The US and Europe have always suppressed the rising price of gold. They intend to weaken gold's function as an international reserve currency. They don't want to see other countries turning to gold reserves instead of the US dollar or euro. Therefore, suppressing the price of gold is very beneficial for the US in maintaining the US dollar's role as the international reserve currency. China's increased gold reserves will thus act as a model and lead other countries towards reserving more gold. Large gold reserves are also beneficial in promoting the internationalization of the RMB."

There is nothing particularly jaw-dropping about this stolen cable. The US has done little but try to suppress the price of gold ever since it went ballistic in 1980 following a decade of runaway inflation and the second OPEC oil shock. President Nixon dumped the gold standard in 1974 and the US paid the price. Gold is nevertheless yet to return to that 1980 level, which is calculated to equate to around US$2400/oz in today's dollars. This price is now the new near-term target for many.

Suppression of the price of gold reached its peak in 1998 when, following the collapse of hedge fund Long Term Capital Management, the Bank of England sold half its gold reserves at the lowest achievable price (around US$250/oz) under Washington's instruction. The Reserve Bank of Australia did likewise around the same time. When gold began to seriously rally once more in the mid-noughties, the US authorities were again major sellers at every new benchmark. Suggestions that the US did not actually have the gold to sell were likely behind Washington's eventual easing off on gold sales – that and a desire to allow the US dollar to devalue through quantitative easing post the GFC.

In the meantime, China has risen to be the world's leading producer of gold, surpassing the US, South Africa and Australia. The Chinese may have a love of all things gold, particularly for specific ceremonial occasions, but the bulk of China's production has found its way into the vaults of the People's Bank of China, as was revealed a couple of years ago. Those following central bank gold movements as monitored by the IMF were none the wiser.

As to whether China's increased gold reserves “will act as a model and lead other countries towards reserving more gold” is open for debate, smacking more of Chinese jingoism than pragmatism. While central bank gold purchases have indeed increased since 2009 (See The Central Bank Gold Rush), one would question whether the impetus was purely the Chinese lead. The world does not need China to point out to it that the US dollar's hegemony is being sorely tested.

And it is China that has the most to lose from dollar devaluation, being the most significant holder of US dollar-denominated debt. Yet China is still happy to peg the renminbi to the US dollar and continue to ride on the export value of a weak currency. If China really wanted to be a world leader in the place of America, it would float its currency. No doubt that's the ultimate aim – “beneficial in promoting the internationalization of the RMB” – but China is not winning friends with its glacial policy reform approach.

In the meantime, average Americans are struggling with the price of gold. US jewellers contacted by CNNMoney report that cash-strapped grooms are shying away from expensive gold and platinum and shifting towards tungsten, cobalt and even stainless steel for their wedding bands. Titanium rings are also now being rushed onto the market. As yet, however, brides are showing no intention of shifting way from the traditional gold.

Around about now is the time jewellers in India start ordering in supplies for the traditional rush of gold jewellery demand accompanying the first of the two wedding seasons (the other is early in the new year). While a growing middle class in India, China and the Middle East has assured a steady rise in price tolerance in the Asian jewellery market, the northern summer usually sees an easing off in gold prices during the months between ceremonial seasons. This allows jewellers to more confidently place their orders.

The gold price usually peaks around March and bottoms out again around now, but in 2011 gold has rallied from US$1400 toward US$1900/oz without much drawing breath. Indian jewellers have experienced the odd rare year of suppressed jewellery demand in the last decade, and this may well be one of them. But such years have usually also seen central bank selling, not central bank buying.

Before the GFC, jewellery accounted for around 75% of all gold production. Today that number is 50%, with the difference being picked up by gold coins, retail gold bars and positions held against exchange traded fund units. That's why the price of gold has not corrected this year in typical seasonal fashion. You can have your jewellery, but gold is quite simply a currency – the world's reserve currency, one might suggest.

Fresh nominal price upside may soon be tested in gold as the European situation hits a critical juncture. On Wednesday Germany's highest court will rule on whether Germany's participation in the Greek bail-out is unconstitutional, by either German or EU law. The actual Greek bail-out may become academic if Greece now moves rapidly toward default, as Friday night's developments would suggest (See The Monday Report), however, an adverse ruling might also put the entire European Financial Stability Fund in doubt.

Without an EFSF, the eurozone might just as well disband this week.


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