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Sep 2014 - Struggle for Control

The Struggle between East and West for Control of the Gold Price

After Diggers, the gold price fell in ~6 weeks by over US$100/oz from ~$1320/oz to ~$1210/oz by 22 September 2014, and fortunately the A$ fell too, currently at ~US$0.89, which has cushioned some of the blow for the Australian gold producers.

Goldmans were successful with their crystal ball yet again,  re-iterating their forecast (in early Sept 2014) of $1050/oz by y/e December 2014, and stating "short" gold, based on a stronger US economy and strengthening US$.

I attended the first (Govt participated) China Gold Congress in Beijing from 10 to 12 September and saw why China is so bullish on their long-term outlook for gold. The size of the conference was about the same as Diggers, ie ~1500 to 1700 delegates, which is fairly good for a maiden conference in a low / weak gold price environment.

As for the Goldmans' comment, a western delegate at the Congress commented,  "Everyone knows that Goldmans talk their own book. If they have or can harness the financial power to cause that to happen and make money for their clients (and gold collapses along the way), what's wrong with that ?"

At the Congress, China was clearly frustrated with the gold price. More than one presenter stated "per year : we (China) produce the most physical gold (~428t in 2013), consume the most gold (~1100t in 2013), and trade the most physical gold (~31,000t in 2013), but yet we have little control over the gold price, especially outside of our normal trading hours (Comex)". (In fact it has been estimated that 1331t have been withdrawn from the SGE [Shanghai Gold Exchange] vaults so far this year and could reach ~1870t in 2014).

China believes one of the main issues affecting the gold price is the strength of the US$, showing a classic inverse correlation to gold. The US$ index has continued to strengthen because there is no alternative reserve currency, with the  € (Euro), £ (GBP) and ¥ (JPY) all in trouble.

Gold was observed to have strengthened as the Euro rose and has weakened along with the falling Euro. The Euro (€) is still in a mess with Germany not wanting to keep propping up the weak southern countries (mostly west and south of Switzerland/Austria), especially the still unaddressed debt of Greece, Italy, France etc. However, Germany cannot afford to break away and reform a new mega strong DMK because that would make its goods too expensive for its major European trading partners, and there are the linked inter-country unrepayable $bn Euro debts owed to Germany.

The GBP (£) has been mired for some time in the Scottish referendum, which though voted on and decided is apparently semi-undecided and reputedly Scotland can declare independence without another referendum. As for the YEN (¥) having created so much public debt following Japan's earlier economic collapse, the regarded only choice open to them is rising interest rates which it cannot afford - hence another mess.

The strength in the US$ was hence regarded as largely due to it being the only reserve currency that did not have significant underlying issues, and no matter what happened, the US Fed and world central banks would never allow it to fail, as their highest forex holdings are in US$ (so they have a vested interest) and a fall or collapse in the US$ could destroy the western world's financial system.

The US media has been trumpeting the return of the King US$, inferring a strong US economy (Ronald Reagan apparently stated a strong US$ means a strong America), stating that the best measure of a strong US$ is a weak gold price. The US$ has risen now for 9 straight weeks with QE stated as guaranteed to end next month (October 2014) and expected rising interest rates in 2015 together with falling inflation (showing that money can be printed without affecting inflation) resulting in higher real interest rates, which are usually negative for holding gold.

However, CPM refuted the real interest rate argument in their presentation, stating that real interest rates can be shown to have only impacted on the gold  price when they are ~5% to 6%, or when US interest rates are ~7% to 10%, which looks unlikely to suddenly occur.

An ICBC presentation stated that it had to be recognised that the US$ could now have a 5-year "turn in the sun", based on the US$ index possibly having 12 to 15 year down periods followed by 5-year up periods. However, another interpretation (and possibly a better fit to the 1971 to 2012 chart), could be 10 years down and 5 years up (as in 1971 [120] to 1981 [85] down, 1981 to 1986 [164] up, 1986 to 1996 [83] down, 1996 to 2001 [120] up, 2001 to 2011 [74] down, and now 2011 to 2016 up [currently 85 in 2014] {which could "tie-in" to the possible timing of the RMB becoming a reserve currency in 2 to 3 years' time}).

Of course that does depend on gold being simply a currency, whereas throughout history gold has vascillated between being a currency and a commodity.

 Against this background, on 29 September 2014 (being the one-year anniversary of the official launch of Shanghai's FTZ [free trade zone]) the International Board was to be formed by China in Shanghai's pilot FTZ (other FTZ's are planned, Shanghai is just the first one). The two initial aims of the International Board are the establishment of a recognised daily world gold benchmark in RMB/g (with physical trading backed by a 1000t gold vault - note this vault is separate or additional to China's reserve holding) and the internationalisation of the RMB as a reserve currency.

However, on 18 September, China's Premier Li Keqiang launched its international gold bourse for both domestic and international traders, 11 days earlier than planned (due to the weak gold price ?). All gold transacted within the FTZ has to be physically backed and held in the currently 1000t FTZ vault. Known as "Shanghai Gold" contracts they are denominated in RMB. There are 8 contracts mostly between 100g and 1kg with a 99.99% purity, a 12.5kg bar and a 25kg bar -  the main contract is expected to be the 25kg bars.

The 1000t gold vault is to be gradually established with $16bn used on buying gold for it so far this year, although it can have withdrawals and it appears that so far 1331t have been withdrawn from it this year.

China has planned for this internationalisation, and the rest of the western world is scrambling to catch up. Singapore announced it was having trading difficulties with its 25kg US$/oz launch now delayed from September to "sometime in October". At the Congress, the CME (Comex) stated in a presentation that they would be launching a new 1kg US$/oz physical contract in Hong Kong later this year (date not specified) - which all infers that the western world were not prepared for the Shanghai Gold contracts.

Dubai also intends to have its own tradeable physical gold contract, either this year or next year, but Dubai does not form part of the western world bloc.

The CME (Thomson Reuters) stated that they had taken over the silver fix at the LBMA's request, and expected to take over the gold price fix too, as part of the gradual demise of London and expected significant retrenchments over the next 2 years. CME's expected collapse of London within 2 years was due to manipulation, corruption and the Libor scandal, unlike the clean, transparent, regulated, efficient CME (although some [possibly "sour grapes"] have stated that it resembles the "pot calling the kettle black").

What happened in the replaced silver fix, was that the LBMA canvassed 444 (clearly the LBMA has no problem with the number 4, despite Chinese hotels avoiding it in the room number and floor level) of its participants, of which ~25% wanted to take part provided it was more transparent. In that second survey the majority wanted the silver fix to be set by CME/Thomson Reuters.

Anyone can sign up for it provided they are LBMA approved (apparently a lengthy process that can take months, but gold bars are issued that comply with the tested and regulated LBMA approved size of 400oz (yet another 4 and specified in oz, not g or kg - have they never been to China ?, or 1000oz if silver) and comply with CME's and Thomson Reuters requirements. So the world silver fix has been replaced and is now currently set by 3 western world participants on a digital CME trading screen / platform.

The LBMA stated that they are now starting on the surveys to replace the London gold fix and expected to have a similar result (as in fixed by the CME in US$/oz). Chinese companies were going to be invited to become participants provided that they followed the approved LBMA programme (it seemed doubful that they can participate in the survey, for which the outcome seems to be already known/expected, ie CME) and complied with CME requirements, and presumably produce 400oz gold bars fixed in US$/oz.

There have been western media remarks stating that Shanghai's FTZ has a long way to go in terms of relaxing regulations and is taking far too long (time-wise) to do so, but have missed the point of China's long-term vision for itself. China is not in a rush to get things done, everything seems to follow a clearly defined path that only China fully knows what it is.

ICBC (and China) appeared to firmly believe that in the long term, the gold price has to rise, simply from its direct correlation with the combined world central bank's balance sheets as shown in an ICBC presentation, with the current movements in the gold price since mid-2013 described as "short-term fluctuation in a long-term rising chart".

Jeffrey Christian's CPM organisation (who have been reasonably accurate with their gold forecasts since 1980), gave a detailed presentation on gold markets, and showed why they expected gold to end 2014 at close to ~US$1260/oz (in complete contrast to Goldmans), and for gold to steadily rise to ~$1550/oz or so by the end of 2018.

One of CPMs key points was that the derivatives market is supposed to be deriving (because by definition, it is a derivative) its trading values from the supply and demand price trading in the physical gold market, not dictating the price to the physical gold market. It seems that currently, "the tail is wagging the dog, not the dog wagging its tail".

It has to be recognised that China does not think of gold from a < 1 year  (or for a number of people less than a 2 week) viewpoint, it takes more of a 5, 10 or 20-year outlook and beyond.

Comex's futures turn over every 2 months, its traders don't want delivery and its almost all settled in paper gold (as the physical capability doesn't in fact exist), whereas Shanghai's futures currently turn over every 6 months, and have to be settled in physical gold.

Other competing currencies aside, China's rationale for the continued strength in the US$, despite adding a further $3trn in QE/debt was the USs gold holding - as in despite everything, the US does not appear to have sold any gold, such that in China's view, the Fed still holds its 8,134t of gold, and that was why the world's central banks hold most of their forex in US$ (as well as the US debt).

So clearly when the RMB/yuan becomes a reserve currency, China is going to have to hold more than the US in gold reserves, after all China has to be No.1 and have the dominant world currency, so it probably has to have ~9,000t or more when it declares its hand. China may still take 2 to 3 years (or longer) to become a reserve currency, however, it believed that it was on the correct path to do so, it simply needed more recognition and tradeable derivative forms.

It probably has not been noticed, but in our/ERA at least annual visits, we have observed that in ~the past 10years, the RMB has strengthened from ~8RMB/US$ to ~6RMB/US$, or ~8RMB/A$ to ~5RMB/A$.

As to how big China's gold reserves currently are given the last number was 1054t reported in 2009 (up from the previous number of 600t in 2003), China could be easily be adding 1000t per year, or have >6,000t now, and in 2 more years possibly >8,000t.

Has the gold price fallen and is currently low because China is Goldmans "client" ? - maybe. If you are building up gold reserves, you want to buy at as low a price as you can, a strategy that has proven very well by China's regular "sabre rattling" reducing commodity prices, and "buying up big" at low prices.

Receiving a $100/oz lower price on 1000t of gold = a saving of $3.2bn (1mKg x 32.2 x 100).

A number of presentations focused on the falling gold imports through Hong Kong in 2014. Two chief reasons were given, namely that gold no longer has to be imported through Hong Kong, instead it can pass unreported through Shanghai's FTZ. As shown in a presentation by the ANZ in Mandarin, Australia now exports most of its gold to China. From 2000 to 2010, Australia shipped ~4%pa of its gold to China, but in the first half of 2012, 47% of Australia's gold (or 132t) was exported to China.

The second reason given is the growth of financial products and derivatives, as in Chinese investors no longer need to hold gold to "play" the Shanghai futures market, although direct shorting is still banned or has to be capable of being backed using physical transactions.

One surprise I had was the size of China's domestic jewellery market which had retail spending of US$76.6bn in 2013, having doubled from $37bn in 2011. After the last Congress presentation there were about 135 awards in 15 different categories such as the top 10 provinces that produced the most gold, the top 5 counties, or the highest profits, or those that had exploration success, or top refineries, or the top 5 proprietary gold bar brands, or the top 10 jewellers based on their sales - all received massive plaques from the China Gold Association to a background "jingle of jaunty music".

At the Congress dinner there were about another 15 or 20 awards including 5 to the top 5 people that had made the Congress such a success.  Also at the dinner they had the lucky door prizes. Each of the top 5 jewellers presented 10 of their items on fashion models, and after the 5th jeweller presented their jewellery, that jeweller gave away 20 or 30 items of their jewellery as door prizes. After the 4th there were 10 gifts, 3rd: 5 gifts, 2nd: 3 gifts in special gift-boxes in a photo ceremony (bear in mind, these are just randomly drawn prizes), and lastly the top jeweller with his unique designs gave one jewellery gift as a lucky number door prize.

The jewellery was completely different (being more regular items) compared to the specialist items shown by Anglogold that have been seen at other conferences. However, aside from the jewellery, China is manufacturing and selling gold and silver in more everyday forms such as cups, goblets, teapots, plates etc as shown in the figure, along with up to ~1m high solid gold buddhas etc.. These items are being produced by the individual major gold companies, and by some of the banks, such as ICBC.

ICBC sells its items in catalogues and its 36 city branches in China, 170,000 agencies and 400 overseas branches. Chow Tai Fook opened its 2000th store, mostly in China in January 2014, compared to India which has 30,000 gold selling retail outlets.

The reason why Shanghai is becoming China's gold trading centre and not Beijing is because it historically used to be the world's gold trading centre, trading ~60% of the gold in the world.

Shanghai became the gold centre of the world in the Qing dynasty (1644 to 1912). There was apparently a lot of shorting, but settlements still had to be done using physical gold. In 1921 Shanghai established gold mines and gold bars throughout the world, with a standard gold quote of 97.8% or 0.978 and lending houses, spot and futures trading. In 1937 the war occurred and Shanghai's gold trading gradually temporarily became obsolete.

In 1958/59 China globalised its gold reserves to stabilise the markets and provided gold to stabilize nations. In 1960, Shanghai was the leading financial centre, especially in silver while gold had ~16,000 trades per year, and a highly regulated central bank.

The SGE (Shanghai Gold Exchange) is currently the third largest gold exchange in the world after the US & UK, and the SFE (Shanghai Futures Exchange) is the 3rd largest futures exchange in the world, after the US & UK.  So China's ambition appears to be for Shanghai to gradually reclaim its historical status, as the gold trading hub of the world.

China currently doesn't trade options. Option trading is still coming. Simulated option trading has been in trading trials since November 2013, and is expected to start in 2014 or 2015. When option trading starts, it's not like Singapore where it can open and then close because the systems are not in place, for China it has to work with 100% efficiency from launch day 1.

Some would say  - can't be done, can't be taken away from Comex. But the iron ore demand has not waned and the iron ore price is no longer set by BHP & RIO, it is set by Chinese exchanges at its current low prices that enable China to buy it at bargain levels in China. China as the major consumer, now controls the iron ore price (and quite a few of the other commodity prices too).

China operates according to the "articles of war", the tiger (CME/Comex) has already been lured down the mountain to operate in Hong Kong (or as the CME stated in its presentation, the next obvious market expansion for Comex is Hong Kong). So where are the negotiations being done, and documents signed - in China, not in the US, as illustrated by the new JV between the Gold Associations signed between the CGA and WGC in front of everybody in the Congress.

China has a firm belief in gold's future, driven by a further 200m people expected to join the middle class to form 500m by 2020, and the fact that Chinese only have 5g/capita in gold, compared to the world's average of 23g/capita. There is still the untapped $800bn pension, insurance and annuity market that could diverse and invest some of their portfolio in gold assets too. And that's just China, there are many developing follower countries that also prefer to hold gold or silver more than paper US$.

Gold's industrial uses are also increasing as evidenced by the successful trials alloying it with palladium as a partial replacement for platinum in autocatalysts. Possibly as shown by the WGC, gm-for-gm ~20% of platinum's use in autocatalysts can be replaced by relatively cheaper priced gold.

The precious metals program for Shanghai's International Board was contracts in gold, then silver, then platinum and then spot control.

The US$ may still have two years left "in the sun" before another 10 years of weakness, however, at some stage the developing eastern countries of China, Russia, India, Malaysia & Indonesia, the Middle East, South America and at some stage Africa, etc, who treat gold as a commodity are going to wrest control of the gold price from the developed western countries that treat gold (and other precious metals) as just other paper currencies.

Disclosure and Disclaimer : This article has been written by Keith Goode, the Managing Director of Eagle Research Advisory Pty Ltd, (an independent research company) who is a Financial Services Representative with Taylor Collison Ltd.

Figure 1. Some Gold and Jewellery Items on display at the CongressGDNsep14

  • Written by: Keith Goode
  • Monday, 01 September 2014

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