The Mechanism of China's Silver Accumulation

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Includes: PSLV, SIVR, SLV
by: Golden Economizer

I was gratified to see how well my recent article (Is China Behind The Big Silver Short Dec 25th, 2010) was received, when over 50 websites worldwide picked it up in the first 24 hours. But I am afraid that a fair bit of confusion was created by that article, which I want to clarify here.

First, I am not presenting this as fact. I am presenting this as a theory that explains the observable facts.

With no transparency in the banking industry, we will never get a chance to see the swap books of JP Morgan (NYSE:JPM) or HSBC (HBC) to find out which of their clients are shorting silver, or how much of the money behind silver shorts comes from JPM’s own proprietary trading desk; and this is how it SHOULD be.

But the presumption IS that the CFTC is monitoring these books, and would perform their duty to investigate any clearly manipulative and excessively large short positions not being held by legitimate hedgers of mine production. Sadly, we cannot depend on the CFTC to put fair, realistic position limits in place, or even to enforce the unrealistic position limits already in place. These position limits are far too high compared to annual silver production, or to above ground silver inventories, to actually succeed in limiting anything.

The CFTC is just another captured “regulatory agency” like the SEC and there will never be any transparency in the shady operations of the mega banks. So, let’s look at the circumstantial evidence available to us and build a case against them, just as any criminal investigator would: By using method, means, motive, and opportunity.

METHOD:

Last week’s article never intended to state that China had a net short position in silver. The title of the article was in question form, and the body of the article explained my theory that the Chinese have both long and offsetting short positions in silver, which may result in combined net position of zero. I stated that the Chinese were using these opposing positions, in which China may hold the same exact number of long COMEX future contracts and short COMEX future contracts. That would result in no net long or short position, as a mechanism whose purpose is to accumulate silver metal and dispose of excess U.S. dollar reserves. These reserves are constantly accumulating in the Chinese Central Bank month after month as a result of the persistent trade deficit.

The brilliance of this mechanism is that it could allow the Chinese to secretly drain physical silver metal inventory away from the COMEX without spiking the market price of silver. Such actions would hurt their producers and exporters. They merely need to hold their long contracts to maturity and take delivery of the physical silver, while selling their short contracts before maturity for cash. They'd then use the proceeds to buy more short contracts with maturities further into the future (roll their shorts forward for longer dated shorts). The money the Chinese lose on the shorts (paper) as the silver price gradually climbs can just be considered additional acquisition cost on the longs (silver bars).

MEANS:

We Americans have been accumulating Chinese produced goods for many years now, about four times the amount of American goods being consumed by the Chinese. We settle the difference in U.S. dollars, a good deal for the U.S.: We trade freshly printed paper for scarce resources and labor. The Chinese already pay for all the American goods they require by exchanging a greater quantity of their own goods. This way they are constantly accumulating U.S. dollar reserves in the Chinese Central Bank, and they'll want to find a way to use or invest these dollars so they don’t sit idle.

As these dollars continue to build up in China, the Chinese have accumulated nearly a trillion dollars worth of U.S. Treasury bonds, and another trillion dollars worth of U.S. Agency bonds (bonds of Fannie Mae (OTCQB:FNMA), Freddie Mac (OTCQB:FMCC) and Ginnie Mae). All these bonds pay a below market rate of interest because they are implicitly or explicitly guaranteed by the U.S. government. However, it still amounts to more than allowing the reserve dollars to remain idle in the Chinese Central bank.

MOTIVE:

But now the Chinese realize that:

1. The principal returned on their maturing bonds is worth less and less every time because of the incessant quantitative easing (money printing) by the federal reserve, which is a form of gradual default

2. Fannie Mae, Freddie Mac, and even the U.S. Treasury may default outright on their bonds at some point in time

3. Hard assets and commodities represent a safer store of value than fiat currency

One measure that the Chinese have taken is to reduce their purchases of U.S. Treasury Bonds, even though the trade deficit with the U.S. continues at high levels. In January 2008, China was the single largest buyer of U.S. Treasury Bonds, with purchases totaling $153 billion. In September 2008, the Chinese became the largest holder of U.S. Treasury bonds, surpassing the Japanese for the first time.

By June 2009, China became a net seller of U.S. Treasury bonds, and their purchases have continually moved to the shorter maturities. According the U.S. Treasury Website, Chinese holdings of U.S. Treasury bonds have declined by about 4% year over year from October 2009 to October 2010, even though they have been steadily accumulating treasuries since July 2010.

According to a recent Bloomberg article, China imported 209 metric tons of gold during the first ten months of 2010, compared to 49 tons imported in all of 2009. Even though they are the world’s biggest gold producer, they exported zero tons in 2009. Only India consumes more. Although India’s gold consumption is mainly in the form of jewelry, this is deceptive. The Indians may wear it around their necks and wrists, but they use it as more of a savings account, especially in rural India. The savings of Chinese citizens amount to about 40% of their personal income, so what more perfect vehicle than gold bullion to protect their savings from inflation and government instability?

In April 2009, China’s Central Bank announced that they had covertly accumulated 454 tons of gold since 2003, raising the official figure on Chinese gold reserves from 600 tons to 1054 tons in one day, after remaining unchanged for six years.

Since the Chinese are wisely accumulating gold, why not silver? We have no public announcement by the Chinese Central Bank to go by, or any official figures of their silver holdings (if any), so we need to see if we can form a theory based on the available facts.

The Chinese have a long established cultural affinity for silver. Silver began to be used as a currency in Guangdong, China in 1423 when it became legal tender for payment of taxes. Provincial taxes had to be remitted to the capital in silver after 1465. In 1914, the National Currency Ordinance established the Silver Dollar as the national currency of the Republic of China. In 1949 the incoming Communist regime took China off the silver standard, but there are still many Chinese alive today who can remember a time when silver was used as money in China. In 2004, China legalized private ownership of gold and silver bullion for its private citizens, and in 2008 they began actively encouraging their people to invest their retirement savings in gold and silver. The Chinese word for “bank” uses the same symbol as silver.

So the primary motive of the Chinese Central Bank in accumulating silver is to wisely transfer dollar reserves to tangible assets (as they have already admitted they are doing with gold) to protect themselves against the out of control money printing by the Fed.

Another motive is to start an asset backed currency at some time in the future. As the U.S. dollar is continually overprinted by the Fed, its days as the world’s reserve currency are numbered. The Chinese are just biding their time, trying to cash in as much of their U.S. debt holdings (while they still maintain SOME purchasing power), before the day when the Yuan ultimately becomes the world’s reserve currency by default. The first steps have already been put into place, for example through the currency swaps and bilateral trade agreements with Brazil, Australia, Indonesia, Turkey and Russia. These countries all have natural resources that China needs, and are markets for exports of Chinese finished products.

When the dollar, pound and euro implode from overprinting, the world will need a new reserve currency, and will not trust another one consisting of nothing but unbacked fiat paper. By accumulating a huge cache of gold and silver, the traditional, historical monetary metals, the Chinese will be ready to back the Yuan when the world’s oil exporters will be demanding payment in hard assets. The level of gold/silver redeemability chosen for the Yuan will determine the value of all other world currencies from that day forward, by their free market exchange rate with the Yuan.

A third motive for the Chinese to be accumulating silver now is the increasing necessity of silver as a raw material for high tech goods produced in China. There is no substitute for silver in many applications, and the demand is the most inelastic of any commodity. China would like to dominate future production of solar panels, switches, flat panel TV’s, computers, cell phones, GPS units, batteries of all kinds, especially hybrid car batteries, silver bearings, silver solder, and the list goes on. A ready stockpile of silver will protect the productive capacity Chinese industry in the face of expected future silver shortages.

OPPORTUNITY:

I now consider it much more likely that the Chinese Central Bank has it’s short COMEX silver position with HSBC bank, the largest international bank in China. The bank is known to have a huge silver short position, (which is unlikely to be a legitimate producer hedge) and probably has its corresponding long COMEX silver position with JP Morgan, although this might also be with HSBC. I am just speculating that keeping the positions at two different banks, under two different names, would help to camouflage China's strategy of accumulating precious metals and dumping U.S. dollars. With all the global banking secrecy, there is never any shortage of opportunity to unload a bunch of U.S. dollars. But their window of opportunity is closing because of the historically low inventory levels of silver at the COMEX.

This opportunity appears to be coming to an end with looming delivery defaults at the COMEX. In September 2010, there were 3002 silver contracts standing for delivery at the COMEX on first notice day, August 30, 2010. Of those, 84% of the holders (2519 contracts totaling 12.595 million oz) actually took physical delivery,

In the next delivery month, December 2010, there were were 17,208 contracts standing for delivery on first notice day, November 26, 2010. Presumably 16%, or probably more, were talked into settling in cash, likely at a hefty premium to the contract’s value based on spot. Using the same 84% ratio of contracts that actually took delivery in September then, that leaves 72.3 million ounces of silver actually delivered to long contract holders by the COMEX in December 2010. A figure representing more than six times as many silver bars as delivered three months earlier in September. As of January 6, 2011 the COMEX released inventory figures of only 48.9 million remaining ounces of silver registered for delivery.

There is an internet rumor going around that billionaire hedge funds (on the advice of former JP Morgan traders and in competition with the Chinese) settled their December long contracts at expiration for large cash premiums by posting the necessary cash and demanding (threatening) to take physical delivery on their long contracts. This would help explain the 9% gain in the price of silver during November, on top of a 14% gain in September and a 9% gain in October. In that time, silver never once fell below the 20 day, 50 day, or 200 day Moving Average during those three months.

Click to enlarge:
Click to enlarge

Here is a link to a financial message board. On it, an apparent market insider posted Wednesday that the participants were so happy with their easy COMEX silver profits in December that they plan to make much larger purchases of COMEX silver long contracts in the last few weeks of February, 2011, and stand for delivery in March, the next delivery month for COMEX silver.

I will be looking at the March COMEX silver delivery figures with great interest, and will not be at all surprised to see major gains in the February and March price of silver. The post also warns of a planned takedown of gold (and indirectly, silver) during the month of January in order to cover some of their silver shorts (scare investors into selling their silver) in time to minimize the banksters’ pain in March. This is portrayed as a desperate, last resort tactic since there are enough existing gold inventories available for the banksters to work with, but no silver and buying silver on the open market would only spike the price.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: Long PM's