Lower Gold Prices Spur Demand for Physical Gold

As gold prices continue to hover around the $1240 an ounce level, demand for the physical metal remains extremely robust especially demand from China. Yet, despite reports of strong demand, prices still seem to be taking the lead from traders reacting to announcements from central banks, particularly the US Federal Reserve and certain non-related economic news.

After gaining for most of the month, the price of gold notched up its first weekly drop in six due to further signs of U.S. economic growth, concerns over the U.S. Federal Reserve’s withdrawal of monetary stimulus and a slump in Chinese demand.

Last Wednesday, the US Federal Reserve announced its’ FOMC’s decision to taper its asset-purchase program.  The FOMC decided to trim its bond purchases by another $10 billion in its first meeting of 2014. In December when the Fed announced that it was going to taper its purchases, gold prices fell sharply. But, this time the Fed’s decision to cut down on its asset-purchase program had little adverse effect on gold prices. Therefore, even if the Fed continues to taper its asset-purchase program, it is unlikely to have any long-term effect on gold.

The recently appointed chairman of the Federal Reserve, Janet Yellen, is considered dovish, much like former Fed chairman Ben Bernanke. Thus, Yellen may opt for additional monetary expansion should the recovery in U.S economy falter. And, if the Fed comes up with new monetary measures such as pegging long-term interest rates or raising the inflation target, these measures could increase the demand for the yellow metal as a safe-haven investment.

When Ben Bernanke took office in 2006, the Fed had $834.6 billion in assets, the vast majority of which were US Treasuries.  The Fed now holds around $4.1 trillion in assets. And, the balance sheet consists of toxic debt such as mortgage debt ‘guaranteed’ by insolvent government agencies.

In 2006 the Fed’s capital ratio was 3.22%. But, currently as Bernanke leaves office, the Fed’s capital ratio is just 1.34%. And it’s deteriorating rapidly.

This capital ratio in banking represents a sort of ‘margin of safety’. In a severe crisis situation, banks with a higher capital ratio are able to withstand major financial shocks.

Three years ago, the Fed’s capital ratio was 2.17%. A year ago it was 1.82%. Six months ago it was 1.54%. Now, it is only 1.34%. This means that the Fed would effectively be rendered insolvent if its assets lost more than 1.34% of their value. So, the Fed now has a razor thin margin of safety to guarantee an exploding balance sheet, filled with what could become worthless paper.

While the policies of the Fed may have benefited a small percentage of people owning stocks, it has also caused prices of many basic foodstuffs to increase, and the labour force participation rate in the US has declined to its lowest level in decades. So apart from artificially propping up prices of equities, I believe that Bernanke’s policies have left the Fed as well as the global financial system in a far more precarious condition than when he started. And, unless the US economy suddenly grows at an incredible rate, which I very much doubt, the dollar will come under more pressure during this year. This will in turn put pressure on dollar denominated assets. The Chinese have obviously figured this out and hence have chosen to buy as much gold as possible.

Last year, Chinese demand for physical gold was unprecedented and may have reached, People’s Bank of China purchases included, over 2,500 tons, which actually totals the entire global mine supply for all of 2013 outside of China, exposing a disparity between the gold price quoted on the futures exchange of Comex and supply and demand for the underlying metal.  China has $3.5 trillion in foreign exchange (of which at least $1.7 trillion are denominated in U.S. dollars) and is aware that the United States is forced to devalue its currency, evaporating Chinas reserves. For this reason China has a strong incentive to diversify away from the U.S. dollar into gold. Hence the enormous physical gold purchases in 2013.

Since November demand for physical gold in China has surged. Not only did we observe strong demand at the Shanghai Gold Exchange (SGE), it was also seen in a massive increase in consumer demand as lines of buyers flocked to local jewellery shops.

A lot of the gold sold on the SGE was sourced via Hong Kong and Switzerland from the UK. The trade numbers from these countries from the last months haven’t been published yet, though in the first ten months of 2013 the UK has net exported 1199 tons to Switzerland, Switzerland has net exported 779 tons to Hong Kong, and Hong Kong has net exported 957 tons to the mainland. Hong Kong itself net imported 510 tons of gold over this period. The UK’s primary seller was the world’s largest ETF holding GLD, whose inventory dropped by 551.7 tons.

This year, demand for physical gold in China has been very strong due to the celebration of the Chinese lunar year, the year of the horse, starting January 31. In the trading week from January 20 – 24 physical gold withdrawn from the Shanghai Gold Exchange (SGE) vaults amounted to 57 tons. This is the third week in a row that SGE withdrawals have been more than weekly global mine production. In the first 24 days of 2014 withdrawals from the SGE totalled 216 tons. It seems that January 2014 will break the all-time record of monthly withdrawals, surpassing the 236 tons from April 2013.

Owning gold is ingrained in the Chinese culture. It has been regarded as a core asset for centuries by the Chinese and thus it is likely the strong demand from China will continue especially at the current low prices.

Buyers in the east are snapping up jewellery, coins and gold bars as investors in the West dump their gold especially the gold being held in gold ETPs. The SPDR Gold Trust, the largest gold ETP and which is listed in New York, accounted for 64% of global sales last year.

Consumer purchases of gold in China surged 30% in the 12 months through September to 996.3 tons, overtaking demand in India, where usage gained 24% to 977.6 tons, the World Gold Council estimates. In the first nine months of 2013, China was at 797.8 tons, already eclipsing its full-year record of 778.6 tons, set in 2011, and full-year usage may exceed India’s all-time high 1,006.5 tons in 2010.

While China overtook South Africa as the world’s largest gold producer in 2007, domestic output failed to keep up with the nation’s consumption. Mines produced 403 tons in 2012, while demand was 776 tons, according to the China Gold Association. Output last year through November was at 392.14 tons, up 7 percent from a year earlier, data show.

The government lifted a ban on bullion trading and opened the Shanghai Gold Exchange in 2002, making buying easier for investors in the most-populous nation. Huaan Asset Management Co. and Guotai Asset Management Co. won state approval in June to list the country’s first gold-backed ETPs, and the Shanghai Futures Exchange extended trading hours in July.

The significant increase in physical demand for gold in Asia, especially China is set to continue, and it looks as if Asia is going to play a much bigger role for setting the international prices for gold.

Although the Chinese government claim that their gold holdings remain unchanged at  1050 tons, I estimate them to be around 5000 tons. Even if the correct figure is around 4000 tons, this would put China in the number two place after the USA. However, even though the latest world official gold holdings show that the US has 8,133.5 tons, I very much doubt it. In fact I would not be surprised if the US is holding any gold whatsoever. Not only has the US government refused to do an official audit on their gold for last 50 years, in a Congressional hearing, when Ben Bernanke was asked by Ron Paul if he considered gold as money, the Fed chief responded with an unequivocal no. What puzzles me is that if policy makers in the US see no value in holding gold, then how come they don’t liquidate their holdings? I think it is because they can’t as they don’t hold what they claim to have.

I think China is making very intelligent strategic financial move which is preparing to back their currency or part thereof with a monetary metal such as gold. If they do this, they will be in a strong position to challenge the relative importance of all the major fiat currencies in the world. And, this will be a major game changer in the world of international finance.

While the price of gold remains suppressed, take advantage of the situation and accumulate more gold and silver.

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