Chinese gold demand on the rise

Early signs of market instability and economic overheating have triggered another speculative runup in China’s gold demand, revealed by renewed hoarding of gold jewelry in major Chinese cities.

Many retail stores in the coastal areas are reported to have depleted their gold jewelry stocks, and the central bank has started to sell gold bullion to domestic fabricators in an effort to return the market to stability. Historically, China’s gold consumption and imports have been extremely sensitive to inflation. The rapid escalation of inflation in 1992 and the first half of 1993 caused widespread hoarding of gold jewelry in major Chinese cities. This not only drove up retail prices for gold products, but also upset the country’s gold market.

China produces about 130 tonnes of gold a year. Before August, 1993, Chinese gold miners were forced to sell at the regulated price of US$240 per oz., which barely covered extraction costs. As a result, up to 20% of domestic gold bullion leaked to neighboring countries (and the colony of Hong Kong especially) in search of higher prices.

Burgeoning domestic demand and shrinking domestic supply also fostered a surge in the smuggling of gold from other countries into China. Of the 360 tonnes of gold imported into China in 1992, about 160 tonnes were brought in illegally.

It is important to note that China’s gold import figure had the effect of exaggerating the level of actual domestic gold consumption in that some of the offtake was used to cover the cross-border leakage of domestically produced gold bullion.

To quell the chaos in the gold sector and discourage smuggling, the central bank recently adopted a policy under which the price paid to domestic gold producers is linked to the international gold price and allowed to float. As a result, domestic gold prices shot up in July. The bank buys gold from miners at a discount of 10% less than the world bullion price, converted at the market rate of the local currency.

In addition, jewelry manufacturers are allowed to buy gold from the central bank at the world price using yuan dollars (Chinese currency). At the retail level, prices for gold jewelry are set by domestic demand and are virtually free-floating.

With these changes, China’s gold imports and domestic consumption will effectively be determined by domestic demand, the world market price and the local currency market rate of exchange.

With its domestic gold prices tied to the currency market, China’s central bank will have a tougher time returning its gold market to stability. In the event of a quick resumption of domestic gold consumption and rising domestic gold prices, for example, only a depreciation of the yuan will restore balance to the domestic gold market.

If the central bank intervenes in the market and props up the yuan, the disparity between low domestic and higher world gold prices will widen, spurring the importation of gold bullion into China. The only viable solution, then, is to eliminate the price disparity, which means allowing the local currency to depreciate.

We expect the central bank will opt to intervene in the market rather than allow the yuan to fall, as the currency market has important implications for the country’s foreign capital inflows and trade. The price spread between domestic and international gold prices, therefore, will likely widen, increasing pressures to import bullion.

— From a recent issue of “The China Analyst,” published by the Montreal-based Bank Credit Analyst Research Group.