Editorial: Mainstream media misses the boat on gold prices

Gold investors have become far too familiar with the same old reasons offered by the financial press for short-term gold price movements.

The story goes something like this: gold prices move with speculators’ opinions on inflation. When the U.S. economy looks good, the chance of another round of quantitative easing diminishes, inflationary fears fall off and the gold price drops. If gold prices rise the financial scribes simply reverse the equation, write their stories and leave for the day chuffed by their explanatory powers.

But this musty train of thought neglects a fundamental shift that is quietly going on behind the scenes — a shift that could emerge as the prime determinant of gold prices going forward.

Central banks hold roughly one-sixth of all the gold ever mined in their reserves, but they are often overlooked by investors. Perhaps this is because the banks shy away from the media spotlight, or maybe their status as gold sellers in the 1990s led to investors forgetting their potential as a key source of demand.

They are, however, back in a big way after last year’s largest gold purchases in more than four decades — a total of 440 tonnes.

As pointed out by the Thomson Reuters GFMS survey, such buying from the “official sector” overpowered speculators last year (who sold gold futures contracts on a grand scale) and propelled gold prices to new highs.

The scenario flies in the face of the common picture painted by the global press, which depicts speculators as the evil force driving commodity prices, such as oil, wherever they like.

And while GFMS analyst Neil Meader told a crowd in Toronto early this month that central bank buying was led by mid-tier countries like Mexico, Russia and South Korea, he was surprisingly quiet on the activities of the one central bank that most gold investors are focused on: the People’s Bank of China.

The omittance may have had something to do with the fact that GFMS deals with official data, and it is no secret that the world’s emerging economic giant has no fondness for reporting on its economic manoeuvres.

Indeed, China last released its official gold holdings in 2008. And while the numbers showed gold reserves doubled over five years, there are signs that buying is quietly accelerating.

Accelerated buying matters to gold prices because of China’s buying power. Years of the West sending dollars to China in exchange for its products has led to US$2.9 trillion in reserves — the largest of any country.

Given that the total value of the gold supply is estimated to be worth US$5 trillion, and that only 1.9% of China’s reserves are made up of gold, the potential for it to establish itself as the principal player in the gold market is a real one.

This is why it is surprising Meader had little to say on the subject. When pressed by an audience member for his opinion on whether China has been stealthily accumulating the metal, he offered only that it was hard to get data on such matters, and that there could be other reasons for evidence supporting the theory.

So what is the evidence?

One point is the divergence between China’s domestic demand for the metal and its official buying. The argument is a simple one: physical demand for last year’s fourth quarter was estimated at 191 tonnes, but the country bought 227 tonnes and produced another 100 tonnes domestically.

And those purchase numbers only represent buying done through Hong Kong. While Hong Kong purchases are the only official numbers China releases, they by no means represent the totality of its buying. Ditto for domestic production. Chinese policy is to report on gold production from official status mines, and doesn’t count the host of smaller gold mines in the country.

Another piece of evidence is a cable leaked last year by WikiLeaks from the U.S. Embassy in Beijing. The cable said China was increasing its gold holdings to fight back against attempts by the U.S. and Europe to suppress the gold price and spur on other countries to replace dollars with gold as the key reserve currency.

What the cable doesn’t touch on is the predicament China finds itself in when it comes to holding gold versus U.S. dollars. The country is, after all, one of the largest holders of U.S. currency. If it signals a preference for gold others could lose faith in the greenback, which would further devalue China’s remaining dollar reserves.

But the greenback’s value could also plummet regardless of Chinese actions, leaving the country dangerously exposed to an ill-favoured currency. With recent events in Europe making Euros look vulnerable as well, the appetite for any fiat currency is at an all-time low.

But there are imaginable scenarios where China could bolster its gold reserve and still support the greenback’s value.

One such scenario would see China start by amassing gold while announcing it would be the buyer of last resort for the metal at a given price — for argument’s sake, let’s say US$1,500 per oz.

The key to the process is that China would be buying gold in U.S. dollars while continuing to affix the value of its own currency, the renminbi, to the dollar. So if the dollar devalues, China simply ups the amount it pays for gold. This would achieve two things: it would bolster China’s gold reserves further, and it would support the dollar. Investors would know they could exchange a fixed amount of dollars for renminbi, which would become a currency backed by significant gold holdings.

It would also serve to set a floor on gold prices for gold investors, and there aren’t many investment vehicles out there that offer such value protection.

At this point things would get very interesting, because a path would clear for capital even larger than Chinese dollar reserves to enter the market: pension funds.

Global pension assets ring in at US$30 trillion, but because pension fund managers are mandated to invest conservatively, gold — with its lack of income and high price volatility — has largely been ignored by the sector, until now.

In his book Hard Money: Taking Gold to a Higher Investment Level author Shayne McGuire estimates that from a huge bundle of pension capital, only 0.15% is kept in gold and gold stocks.

If China came in and set a floor pension fund managers would have all the assurances they would need to start moving into the sector, and the capital they control would flood a comparatively small gold market, sending the metal to unforeseen highs.

While such a scenario might seem far-flung at this stage, a few points in its favour should be considered: speculators have been selling, Ben Bernanke has been saying ‘no more quantitative easing’ and Mark Carney has been bracing Canadians for higher interest rates — all of which should point to the end of the gold rally. And yet the price of gold, while correcting slightly, has remained robust.

Could it be that the largest gold holders in the world — the central banks, led by China — are already accumulating the metal on selling?

If so, it could be merry days ahead for investors who eschew the short-sighted tales spun by news wires, and instead focus on the seismic shifts that have begun in the official sector.