Will The Shanghai Fix ‘Fix’ The Gold Market?

John Maynard Keynes once remarked that “A debtor nation does not love its creditor, and it is fruitless to expect feelings of good will.” In the case of the financial arrangement between China and the West including the United States, I might add that the opposite is also true, particularly when that creditor thinks its debtor might be in over its head.  Each, though, has learned to live with the other in this complicated and intricate web of debt and money, interlocking national balance sheets and intertwined commercial interests we call the international markets.  To not do so is to act against one’s own national interest.

I expect this synergy to carry over when later this year China inaugurates its own version of a gold fix in Shanghai and three Chinese state banks join the London Bullion Market Association’s new London fix later this month.  I am not among the group that foresees a hot gold war between the Shanghai and London fixes, between China and the West. More I believe we will see a balancing of interests – a cold war of sorts between the physical metal-based Shanghai business and the paper-based London business. China would not be seeking admission to the international gold club in London if it did not intend to adhere to some common ground rules – if in fact a quid pro quo of some sort had not been agreed.

That is not to say though that the new gold market mechanisms will fall short of being transformative.  To the contrary, I would counsel to expect major changes in 2015. At the top of the list I would put the likelihood of Shanghai forcing London to honor its pricing by delivering real metal into the China market.  The three state banks China has stationed in the new London eleven-member fix regime will act as a conduit for those deliveries – a mission for the time being likely to keep the flow through the London-Zurich-Hong Kong-Shanghai pipeline moving at a steady pace.  In the process, China might force a level of honest settlement too often avoided in the previous gold fix regime.  More on that further on . . .

The price of gold in China

The question on everyone’s mind is whether or not we should expect to see China bid the gold price higher within this new mechanism?

At the moment and for good reason, China remains a buyer of gold and that is state policy. Strip away the economic jargon and the United States, in blunt terms, owes the Peoples’ Republic of China $1.3 trillion, the single largest amount of money one nation state owes another on earth. The rest of the world owes China about $2.7 trillion.  China, in a certain sense, has become the world’s sovereign banker with no one even a close second. Japan is next nearest in line with $1.26 trillion in foreign exchange reserves.  In no uncertain terms, China has put itself on the front line of the now raging global currency war and, if it is not careful, could become its principal victim.

China, over these last several years, has come to its own way of dealing with this issue through what can only be described as an enterprising and aggressive gold acquisition program. Some estimate its gold hoard to have risen from 1054 metric tonnes (the official number) to 5000 tonnes (the generally accepted figure among experts) with one estimate, released last week, at an incredible 30,000 tonnes (a number I find difficult to justify).  Koos Jansen, one of the top experts on China’s gold mobilizations, puts the overall import figure from 2007 through 2014 at 8800 tonnes.  That number, based on actual movement of physical metal through the Shanghai Gold Exchange, might be closest to the truth.  No one, though, is quite certain how those imports are divided among China’s central bank, its state bank counterparts and the Chinese people themselves. Whatever the real number, China arguably has conducted the most ambitious gold mobilization since the United States built its prodigious 20,000 tonnes Treasury hoard following World War II.

A hilltop assessment of current supply-demand fundamentals tells us that China may have already reached the point of diminishing returns with respect to tapping existing sources for the metal. Over the past two years, the exchange-traded funds were drained of everything except what still belongs to strong-handed investors. Global gold mine production has flat-lined at roughly 2800 metric tonnes and may be poised for a decline. On the demand side, central banks as a group are net buyers of the metal.  National repatriation efforts may be a hidden source of demand not often discussed among analysts.  China already competes with India, the rest of Asia, the Middle East and western investors for the existing supply. If it is indeed successful in establishing settlement in exclusively physical metal on the Shanghai Exchange, the narrowing supply-demand dynamics are likely to act as a catalyst for higher prices – perhaps the primary catalyst for higher prices, something that has not been the case for decades.

Will the physical gold market dog finally wag the paper market tail?

There is one more important aspect to the analysis worth highlighting. If the gold market has reached some sort of watershed wherein the amount of available gold begins to dwindle and possibly dry up entirely, then China’s strategic economic interest would best be served by higher global bullion prices – the so-called second leg to its long-term gold market strategy.

A yuan-based price coupled with physical settlement and increased domestic demand could end up becoming the hammer that breaks paper trading’s grip on the international gold price. China’s policy makers, under such circumstances, need do nothing more than sit back and watch as physical demand from China drives prices higher through the new market mechanisms.  It would become an ultimate irony should statist, communist China become the driving force that restored free market economics in the gold market. In the end, the ability to monitor, defend and advance the value of its gold reserves might be the real driving force behind China’s application for admission to the international price-setting club.

So it is that I see China’s latest forays in the international gold market as an attempt to fuse with and influence the current market structure rather than circumvent or supersede it.  China, in my view, seeks synthesis not antithesis, and though some might be disappointed in the strategy, I see it as bracing for gold’s future and even more bullish for gold in the long run than a policy of confrontation.  By taking its seat at the gold pricing table, China inadvertently will act as a proxy for gold coin and bullion owners all over the world.

Given the flow of economic power from West to East, it seems fitting that gold should ride the crest of that wave.  After all, the East’s interest in gold is based in its ancient culture and that abiding attachment is unlikely to disappear anytime soon. Time is on China’s side and on the side of the gold accumulator who owns his or her metal outright and can afford to sit back and watch the show.  On the Chinese calendar, 2018 will be the year of the Earth Dog.  By then, the physical market dog might finally wag the paper gold market’s tail, instead of the other way around.  In the end, the old aphorism still holds true:  He (or she) who owns the gold makes the rules.

___________

If you appreciate the kind of bedrock analysis you just read, you would probably enjoy and gain from our e-mail newsletter service, which alerts you whenever a new issue is published. It comes free of charge and you can opt out of the service at any time. Last, we will not deluge you with emails.

********
–– To register for USAGOLD’s Review & Outlook, go here. ––

A little USAGOLD history. . . . Pictured are News & Views hard copies from 1999 just before gold began its secular bull market. News & Views was Review & Outlook’s popular predecessor at a time when gold-based publications were few and far between. The “Big Breakout” headlined in the November, 1999 issue refers to a price jump from $260 to $330 per ounce.  Your editor sees a good many similarities between that period and now.