Tuesday, March 27, 2012

15 February 2011 – China’s gold gulp


The NYSE Composite Index is roughly where it was 10 years ago.  Stocks are recovering from the pounding they took a few years back when the market shed about half its value in the wake of the sub-prime mortgage collapse, but the NYSE is still nowhere near the highs it achieved in 2007.

Meanwhile, over the past ten years the price of gold has quadrupled:
Anyone who bought gold in the wake of the Dot-Com collapse could sell it now for more than four times the purchase price.  That’s a pretty decent return on investment when compared to what’s been going on elsewhere in the market.
In times of economic uncertainty, people, as they have done for tens of thousands of years, tend to put their money into precious metals.  To the detached observer and student of contemporary economic theory, this may seem counter-intuitive; after all, gold is merely another commodity, and commodity prices (as the past ten years have demonstrated) can be very volatile.  At the same time, though, absent the development of the sort of transmutation technology that Edison predicted would be in routine use by the year 2011, which - he stated - would result in the proliferation of the gold taxicabs I referred to a few weeks back, it seems that gold will always be a preferred instrument for procuring security in the face of unstable markets.  If you think prices are high now, for example, here’s what adjusted-dollar prices looked like in the early 1980s, the last time the US was in the throes of a major recession and folks were struggling to protect their assets against inflation:
There’s no mystery to it; for millennia, gold was the highest standard against which the value of currency could be measured - literally measured, as the value of coinage was dependent upon the purity and mass of the metal used.  The problems of protecting physical currency against devaluation led to terms only vaguely remembered today, such as ”debasement” of the valuta of the realm, or the practice of ”clipping” coins.  The latter bit of pecuniary malfeasance was sufficiently common in the Middle Ages that it is thought to be the origin of the popular nickname of King Eric V of Denmark (r. 1259-1286), who for his general untrustworthiness is known to posterity as “Eric Klipping.”
The mutability and fungibility of gold made the physical metal a highly useful means of transporting value in a compact form, either in coins, in bullion bars, or in finished objects that could, if necessary, be melted to produce more coinage.  Gold, of course, is no longer in use as a currency standard. While gold coins have been used for thousands of years, the use of gold as a specie standard has always been problematic due to its scarcity (silver specie being much more common).  Britain went informally to a gold standard early in the 18th Century and formally adopted the gold specie standard a century later.  By the end of the 1800s the countries that mattered were all on a gold standard; Britain used the sovereign, Germany the gold mark, America the eagle.  Canada, as usual, had a biaxial system based on both the eagle and the sovereign. The practice of “pegging” lesser currencies to more influential ones got under way at this time, leading to a gold exchange standard under which silver-based currencies were convertible to metallic gold. 
The massive expenditures of the First World War broke the gold exchange standard, and countries that had hoped to return to convertibility were unable to do so due to wartime inflation and, in the case of Germany, as a result of having lost its gold supply via reparation payments.  In order to stem the flow of gold overseas, Britain in 1925 replaced the gold specie standard with a gold bullion standard (under which currencies were required to be backed by reserves of physical gold held by the government).  The US adopted a similar standard, to which move some economic historians attribute the prolongation of the Great Depression, as federal legislation required that the Federal Reserve hold a certain amount of gold to back up its currency issue (Milton Friedman disagreed, arguing that “The Fed” could have loosened the money supply without disturbing the bullion standard.  Incidentally, there’s a similar feel to the ongoing debate about whether to raise the debt ceiling in the US.  Given that the near-term alternative is default, this would seem to be a no-brainer.  But then, I’m not an economist).  After the Second World War, Bretton Woods saw the implementation of dual system based on the US decision to set the price of gold at $35 per ounce, and an implicit decision by other (free) economies to use the US dollar as the reference point for their own currencies.  This lasted until 1971 when Nixon - prompted in part by the expense of the Vietnam War, and in part by moves by foreign nations to buy US gold with US dollars, simultaneously reducing the US gold reserve and US influence abroad - put a stop to convertibility.  Since then, the US dollar has been a fiat currency.  Amongst other features of mixed benefit, this has made it easier for governments to engage in deficit spending.  As a means of dealing with acute financial crises, the flexibility offers some benefits; however, it has also enabled governments to indulge in chronic deficit spending, which may be subsequently “inflated away” by increasing the money supply - although not without long-term costs, and not indefinitely.
Why bring this up?  Well, because we’re in the midst of a “gold boom” in Asia the likes of which we’ve never seen.  Much has been made of the gradual economic liberalization of China, but from a Western perspective the “liberalization” has been slow, irregular, rife with favouritism, prone to corruption, and so weighted down by permitting and regulations that progress has been, to put it mildly, “uneven”.  For decades - ever since the relative decline in importance of the last “Asian Tiger”, Japan - speculators have been speculating about what might happen when the “power of the Chinese consumer” is finally released.  We’re seeing some of that now.  A colleague sent me a piece by Eric Sprott and David Franklin, a pair of analysts at Sprott Asset Management, which I’ve attached for your delectation.  Entitled “Gold Tsunami”, the brief paper - it’s only three pages long - provides some startling details on what’s been going on in the world gold market since Beijing started allowing its citizens to own bullion, including gold.  This can’t have been an easy decision for the Communist Party bureaucracy; as Alan Greenspan once put it so beautifully, “An almost hysterical antagonism toward the gold standard is one issue which unites statists of all persuasions. They seem to sense... that gold and economic freedom are inseparable.”
Well, the Chinese people are exercising their newly-granted freedom with a vengeance.   China is already the world’s largest gold producer, but in 2009, it imported 45 tonnes of gold.  In 2010, it imported more than 209 tonnes.  That’s more than a four-fold increase in imports in only one year.  China’s demand is expected to hit 600 tonnes this year, which puts it right behind India (at 800 tonnes, the world’s largest gold consumer).  Between the two, they will consume more than half of the world’s annual production of about 2,650 tonnes.  And it’s not just gold.  China’s appetite for silver also increased fourfold between 2009 and 2010.  As Sprott and Franklin note, in 2005 China exported just over 100 million ounces of silver (that’s 28,409 metric tonnes) - and in 2010, they imported just over 120 million ounces: ”This represents a swing of 200 million+ oz. in a market that supplied a total of 889 million oz. in 2009 - a truly tectonic shift in demand!” 
And it’s being felt.  Bullion producers worldwide are reporting shortages of bars and coins.  Sprott and Franklin argue that simple consumer spending isn’t driving the surge; according to their figures, the retail demand for gold jewellery in china has only gone up by 8%.  That said, they acknowledge that China traditionally drives gold prices up in January as Chinese citizens prepare for New Year celebrations, which include, among other things, hong bao, or “lucky money”.  It should also be noted that gifts of gold to newlyweds are traditional in China, and now, due to the relaxation of regulations and growing individual wealth, may be becoming more common.  By and large, however, Chinese citizens seem to be buying gold for a very traditional reason: to guard against the inflation that is resulting from heavy government overspending, especially on infrastructure projects widely seen as unnecessary (to put it in bleak demographic terms, Beijing is building cities for citizens who have not been, and are not being, born).  China’s unprecedented gold gulp is being facilitated by its banks on a scale that dwarfs anything conceivable in the West.  The Industrial and Commercial Bank of China (ICBC), already the biggest consumer bank in the world, recently began a “Gold Accumulation Plan” that allows investors to accumulate gold through a daily dollar averaging programme, with a floor of 1 gram of gold (roughly $42 USD) per day.  The GAP is not yet a year old (it began on 1 April 2010), but it already has 1,000,000 subscribers and has already purchased 10 tonnes of gold.  And the ICBC has 212,000,000 separate accounts.  According to Sprott and Franklin, if the GAP became popular with ICBC customers and if it were to spread to China’s other banks, consumer “gold hoarding” could swiftly account for 10% of the world’s annual gold production. 
And that’s only China.  If the appetite for physical gold spreads, then the bulk of world production could swiftly be eaten up by consumer demand.  This is not a good thing; gold is one of those elements whose unique physical properties make it an indispensable feedstock for all manner of industries.  If you want to talk “strategic minerals”, it’s hard to get more strategic than gold.  Gold shortages could be a real possibility in a world plagued by economic uncertainty, especially about what America’s economic future looks like in view of the current economic situation and the policies, extant and proposed, of the present Administration.  On that topic, the Obama Administration’s budget, released Monday, forecasts that the Federal debt will jump by $2T to reach $15,476,000,000,000 by 30 September 2011.  That’s 102.6% of GDP = the first time the US has hit that debt level since the Second World War.(Note C)
Maybe the Chinese are on to something.
(H/T to Dave M., BEng, MSc, FMA, CIMC, CD, former bird-gunner, and the only rocket scientist I know)