China’s Problem with Gold

The most recent figures for Chinese gold consumption have just been released, and my goodness they’re large. The figures are up 480% on last year to 209.7 metric tons in the past 10 months, accounting for 10% of global production

As large as this is though, its just a drop in the ocean put next to China’s foreign exchange reserves.  Previously gold made up a minuscule 1.2% of China’s overall reserves, doing quick back of the envelope math the new purchases are worth roughly $9.4 billion, while in the first three quarters of 2010 China’s foreign reserves increased $419.9 billion, or in other words gold purchases were 2.2% the size of the rise in foreign reserves. 

Great for gold investors right? Well not really.

Chinese demand for gold is quite clearly the effect of a closed capital account. On the consumer side this simply has to do with a lack of investment options. China’s stock market hasn’t gained value since 2007, bank deposits are consistently below inflation. Property is the main investment, but government regulations makes it difficult to buy more than a few flats. So when China loosens its laws on other types of investments Chinese citizens tend to pile in. On the government side this comes in the form of the need to maintain the value of their constantly expanding foreign reserves, which means diversifying among a fairly limited asset pool – primarily dollars, euros and yen – all of which have been showing a fair amount of risk recently. Attempts to look at other assets, such as stocks, and now gold, have the tendency to move the market in ways that result in state investors not doing nearly as well as they hoped.

The problem is that acknowledgement that China is buying gold at a speed that would keep up with the monthly jump in the country’s foreign reserves would increase prices so much that it would no longer be worth it for China to invest. Particularly because demand is only likely to shrink in time as the offshore RMB market becomes more pronounced and Chinese foreign-investment options grow (as they already are).  China has more or less acknowledged that it faces this problem, which is why it has so far mainly been buying in secret, and so far has not been buying out of proportion with the national reserves.

And, of course, the other problem is that it’s never safe to bet on the consistency of the Chinese government.