While gold prices plummeted last year countless headlines flashed in the U.S. that gold's bull market is over, American investors responded to the price decline by selling their investments in gold shares and in the SPDR Gold Trust (NYSEARCA:GLD).
But on the other side of the world we saw a completely different reaction to lower gold prices: the Chinese were buying like crazy. Given the roughly 1,100 tonnes of net imports along with at least 400 tonnes of domestic production that didn't leave the country gold demand in China was at least 1,500 tonnes in 2013. This is more than half of annual mine supply (2,800 tonnes), and more than a third of total annual supply including recycled gold (about 4,200 tonnes).
This should surprise no one. The PBoC has presumably been accumulating a lot of gold, and Chinese citizens, who have a proclivity for saving, have shown an interest in gold. In fact they have been encouraged to buy gold by their government! This interest turned into a frenzy in June as prices hit multi-year lows, and it prompted Zero Hedge to post a short piece entitled Stunning Images From China: Ten Thousand People Waiting In Line To Buy Gold. Here is one of these images.
What is so unusual here is that this frenzy to buy gold was almost certainly prompted by low prices. The bubble mentality and the tendency of people to literally line up to participate in an investment opportunity is typically endemic of sharply rising prices, when J. D. Rockefeller's proverbial "shoeshine boy" is telling you to buy.
The fact is that the market for gold in China is growing both at the state and individual levels. And what I see in this picture is not a bunch of house-flippers and tech-stock day traders, but a group of individuals that comprise a burgeoning middle class that values its hard-earned and meager savings to the point that they are willing to stand in line for hours, possibly days, in order to buy the one asset that has preserved wealth for thousands of years of human civilization.
Chinese demand for gold is insatiable. There is little doubt about that. However there are several specific attributes of this demand that remain shrouded in secrecy. In particular we do not know how much gold the PBoC has accumulated versus how much gold private citizens have accumulated. Furthermore, while we can guess that the Chinese citizens are buying gold as a form of savings or "investment," many have attributed the PBoC's accumulation to a broader political agenda and the desire to back the Yuan with gold. The former is almost a certainty--there is little doubt that the Chinese want to play a larger role--perhaps the dominant role--in forming global monetary and trade policies.
The latter aim may follow from the former, although its inevitability has been exaggerated. That isn't to say there is no logic behind the assertion. By backing the Yuan with gold the Chinese can force the political issue, especially as this will give the Chinese the world's most desirable currency as determined by Gresham's Law.
How Much Gold Does China Have, and Who In China Owns It?
The first part of this question is fairly easy to answer, especially since import and production data is readily available from the time that the Chinese gold market reached a level of significance in about 1980. We simply have to look at China's cumulative gold production and its cumulative net imports. This data is readily available to us courtesy of Charts 'R' Us.
Thus as of a few months ago this figure stood at about 7,500 tonnes. But with net imports at nearly 100 tonnes per month recently, and with annual production at 400 tonnes year (all of which stays in China), this figure is probably closer to 8,000 - 8,500 tonnes.
The latter question is open to interpretation with the available information. We know, for instance, that as of 2009 the PBoC has about 1,050 tonnes of gold.
But the PBoC does not report all of its purchases. As the chart shows it accumulates for several years and then reports after an extended accumulation period.
For two reasons we can assume, without direct knowledge, that the PBoC holds far more than 1,050 tonnes.
- This assumption follows from the aforementioned pattern of withholding gold reserve data for several years.
- According to Bloomberg, the PBoC recently bought a gold vault that has a 2,000 tonne capacity. This isn't the PBoC's only vault. Therefore assuming that the PBoC holds a minimum of 2,000 tonnes is completely justified, and we can speculatively say that the figure is probably significantly higher than this.
But other than our knowledge that PBoC gold reserves must lie between 2,000 tonnes and about 8,000 tonnes we have little knowledge.
However estimates have been made. For instance, according to the China Gold Association PBoC gold holdings exceed 2,500 tonnes, with more than 600 tonnes added in 2013 (see the blue bars on the following chart).
However this is just an estimate. James Rickards, in his book Currency Wars, suggests that this year the PBoC will come out and claim that it has 5,000 tonnes of gold.
Ultimately we simply don't know, and we will have to wait for the next PBoC announcement. But we do know a couple of things. First, the figure is certainly much higher than the 1,054 tonne figure reported in April, 2009. Second, all of this accumulation inevitably leads to the question: Will the PBoc back the Yuan with gold?
A Gold-Backed Yuan?
Despite a plethora of headlines indicating that China plans to back its currency with gold I have not been able to find any convincing documentation to this effect. In fact some of the most reliable sources that I follow for information on gold have posted headlines that go too far in assuming this. For instance Keith Barron, talking to Eric King of King World News mentioned a World Gold Council document that supposedly confirms China's plans to back the Yuan with gold. Presumably the document in question is one published a couple weeks earlier: Gold, the Renminbi and the Multicurrency Reserve System. But the piece makes no such claim. It merely argues for a global currency system in which gold and the Renminbi play larger roles than they do now. In fact the document specifically dismisses the notion that the world will revert in some way back to a gold standard or a gold exchange standard.
People also like to stretch statements from Yao Yudong of the PBoC's monetary policy committee, in which he calls for a new Bretton Woods, to mean that he wants the Yuan to be backed by gold. Tyler Durden of Zero Hedge published an article with the following headline in response: Did China Just Fire The First Salvo Towards A New Gold Standard? He protects himself by embedding the claim in a question, yet there is certainly sensationalism here that is arguably unwarranted.
Yet a gold-backed Yuan is a distinct possibility. As I demonstrate in a moment it is logistically possible. Furthermore, as I hinted at above, the PBoC may have political and economic motivation to made such a drastic move. However this would be a phenomenal step to take, considering that it would hinder the flexibility in controlling the money supply that central bankers and politicians love. Perhaps a compromise would be a partial backing, as doing so would make the Yuan extremely desirable on the global economic stage.
The political justification for backing the Yuan with gold is compelling. Ultimately we live in a world where the "golden rule" is very real: he who has the gold makes the rules. This is an issue I address extensively in my discussion of the gold market in the 1970's when the United States wanted to undermine the golden rule and failed. With the Bretton Woods agreement broken along with the $35/ounce peg, U.S. officials--both monetary and political--expressed deep concern for the implications this would have on America's role on the political and economic stages.
The PBoC's aggressive accumulation of gold in recent years is a sign that top Chinese monetary officials are acutely aware of this reality. To back the Yuan with gold would be equivalent to stating that paper money is no good in China, and it would be symbolically equivalent to China holding up a giant middle finger to the United States and the nations of western Europe who have so strongly advocated the demonetization of gold over the past 40 years.
While there is no documentation that this is going to happen, let us take a moment to see how it can.
The Logistics of a Gold-Backed Yuan
The following is one of my favorite charts:
It shows that while there is no official gold standard in the U.S. that at certain times in history gold's value will rise to reflect the U.S.'s gold holdings. This means that, to a certain extent, we have a de facto gold standard from time to time.
This chart also suggests to me that if China wants to implement some sort of "market friendly" gold standard or gold exchange standard, that it only has to back its monetary base with gold by 50%. As the following chart shows when the value of U.S. gold exceeds 50% of the monetary base this ratio tends to go parabolic and then crash. 50% also gives the PBoC some money-supply flexibility.
A 50% gold backing is certainly possible in the next decade.
China's monetary base currently sits at about 5.64 trillion Yuan.
This comes to about $931.43 billion at the current exchange rate (1 USD = 6.0552 CNY). At the current price 1 tonne of gold costs about $39.45 million, which makes China's 1,054 tonnes worth $41.6 billion. This is miniscule compared to China's monetary base. However we have said that China certainly has at least twice this amount of gold and perhaps 5 times this amount. China's gold is worth $98.6 billion if it holds 2,500 tonnes, and $197 billion at Rickard's estimate.
Thus we can estimate that China's monetary base has a gold backing of about 11% - 21%
Furthermore we have estimates that suggest that with gold prices where they are the PBoC should accumulate at least 600 tonnes annually. Of course at higher prices it may accumulate less but the value of its holdings will rise along with the price. In fact higher prices are inevitable given that China controls more than a third of the gold market with prices this low.
Thus, 10 years from now it is conceivable that should Chinese and PBoC gold purchases continue on the current path, that we could have $2,500/ounce gold (which, according the above chart of the value of America's gold in terms of the money supply, is still inexpensive) and a PBoC with 10,000 ounces of gold. Assuming reasonable monetary base growth in China its reserves will be valued at more than half of its monetary base.
This scenario is definitely possible. Furthermore, it may underestimate the extent to which the PBoC backs the Yuan with gold. For instance, Chinese gold production has been soaring and it can continue to do so. Thus this will give the PBoC the opportunity to purchase even more gold than I suggest above. Furthermore, I suspect that in a world where China is accumulating so much gold that $2,500/ounce is a low-ball estimate. Keep in mind that right now the value of America's gold is just 9.2% of the monetary base, as I calculate here. This means that if the value of America's gold were to reach the current money supply (i.e. we are not taking ongoing QE into consideration) the appropriate price is over $13,000/ounce, or $6,500 if it reaches 50%.
These figures are a result of conjecture, but they are within the realm of possibility, and they are arrived at using conservative assumptions. Thus they suggest to me that China can back its currency with gold. As I have said above it may not come to this, although there are arguments supporting both sides of the debate.
There is no doubt that the Chinese are accumulating gold at a pace that is perhaps only rivaled by the United States during the 1930's and 40's. The following chart illustrates that accumulation.
The similar gain in China, and the expected continuation of this trend are highly suggestive of the idea that the PBoC will back the Yuan with gold. While there is no documentation to this effect it is within the realm of non-remote possibility. Furthermore such a strategy would give China several economic and political advantages.
From an investment standpoint we can expect that this will give long-term support to the gold price, as is evidenced by China's aggressive buying on weakness. In addition to buying gold, investors may also want to consider taking a long position in the Yuan. This is difficult for American investors, but not impossible, as I discuss here.
Ultimately Chinese citizens want wealth, and Chinese politicians and central bankers want power, and they are all turning to gold to satisfy these wants.
Additional disclosure: I own gold coins and select gold miners.