Investors have done well in the past with a simple strategy of buying what China was buying. So earlier this year, things were looking up for gold when it was revealed that China had swept past India to become the world’s biggest buyer in 2013.
For the first time, Chinese demand topped 1,000 tonnes, reaching 1,176 tonnes after a 41% year-on-year gain, not including central-bank buying.
Apparently Chinese consumers had rediscovered their affection for the yellow metal and gone bargain hunting after prices shed 28% last year. The China buying dynamic was credited with restoring gold prices to their upward trajectory. But now, a succession of holes in the bullish China gold-demand story have appeared.
Last week, the World Gold Council (WGC) forecast China demand would likely be flat this year, suggesting last year’s surge was a one-off event. There was also a worrying explanation as to why Chinese gold demand slowed so precipitously: The WGC revealed that China may have more than 1,000 tonnes of gold tied up in financing deals.
This suggests a big chunk of China’s gold demand is a part of another growth story, namely the spectacular growth in China’s shadow banking, for which that the government is now trying to apply the brakes.
Put another way, gold demand in China has become a function of the enormous yuan carry trade, where U.S.-dollar borrowing has been used to fund exposure to all sorts of yuan investments.
Reports suggest using gold as collateral was just another way to secure U.S.-dollar loans which could then be funneled back into China.
So resources which the world thought it sold to China for consumption have turned out to be for something else. More likely, those purchases were just another way for shadow-banking liquidity to find its way into speculative areas such as property investment.
China does not release data on its gold purchases, but one proxy for the size of gold financing deals is the growth in mainland China’s gold imports from Hong Kong — these have leapt from less than $5 billion in 1990 to roughly $70 billion in 2013.
The collateral connection clearly takes some shine off the China gold narrative. For one, it looks unlikely previously spectacular China gold demand will be repeated. Instead of the 41% growth we saw in the past year, the WGC now foresees Chinese physical gold demand rising at a more pedestrian 25% by 2017.
One conclusion is that marginal demand growth for gold in China is less about physical buying and more about volatile shadow banking, which the authorities have been trying to rein in.
This also raises the possibility of a gold crunch, depending on how the People’s Bank of China flushes out the yuan carry trade by orchestrating a weakening in the Chinese currency.
The 3% drop in the yuan this year against the greenback has already put pressure on such trades. One example has been distressed selling hitting iron ore last month, as it too was used as collateral and caught in a yuan-carry-trade squeeze. But aside from worries over margin calls hitting gold, there are other question marks next to the China gold story.
The notion that China is in a position to sweep up gold prices seems out of sync with the nation’s wider economic cycle. China’s economy is now clearly going through a slowdown, and it has sent a succession of commodities lower — where it has been a price-setter — from steel to copper to iron ore. And given that gold prices are often taken as a proxy for inflationary expectations in times of monetary expansion, it’s also worth looking at China’s potential impact.
China, after all is widely credited with creating the lion’s share of new credit in the global economy in recent years, so it should not be unreasonable to expect it was a factor pushing up gold, as it likely did for a range of metals. But now as China tightens credit, what else will go into reverse?
One sign that China has gone from being a source of inflation to a source of deflation is arguably seen in prices at the factory gate: Producer prices have been declining for over 24 months in China.
Meanwhile, demand for gold in China has typically strengthened when local investors seek protection against a weakening yuan, just in the same way that gold traditionally benefits from a weakening dollar. But this was not the case recently, as the yuan had been strengthening against dollar.
Overall, there appear to be few fundamentals in China that seem ready to rescue gold. Instead, Chinese buying related to collateral financing threatens a new vulnerability that could make gold the latest metal to fall victim to China’s slowdown.