China And Gold: What We Might See From Both In The Next 12 Months

Your gold portfolio will be directly impacted by the moves China makes over the next 12 months.

Readers of the Daily Pfennig® newsletter already know that China is a significant player in the gold market. It’s the world’s largest producer and the largest consumer of the shiny metal. And, despite its clandestine ways, we know that the country has a lot more gold than what its recent Reserve update suggests.

But, we’re only in chapter three of the book China is writing about gold. And its moves over the next year, whether public or private, will impact the gold market in big ways.

Here are three developments we’ll likely see from China over the next 12 months – developments that may have a direct bearing on the gold sector.

Currency Moves Are Not Over
That’s right: China may not be done devaluing its currency.

In a recent edition of the Daily Pfennig® newsletter (http://www.dailypfennig.com/2015/08/12/china-intervenes/), we wrote about the 2% “adjustment” made to the yuan vs. the U.S. dollar. There are various reasons for the move, but how it pertains to us gold investors is very interesting. What many investors may not be aware of is that the International Monetary Fund (IMF) had been encouraging Beijing to act on its exchange rate. In an IMF meeting that took place before China’s devaluation, their economists wrote that it was “urgent” the central bank make an adjustment: “More flexibility is becoming increasingly critical to move to an effectively floating exchange rate.”1

And, after the peg was broken, they wrote this: “China needs to move to something akin to a floating exchange rate within two to three years. But steps over the next few months could include a further widening of the band and changes to how the central parity is set.”2

In other words, the IMF was not only behind the move, but is encouraging Beijing to make further adjustments to its currency.

The reason the IMF is pushing this strategy is because China wants the renminbi to be included in the Special Drawing Rights (SDR) currency basket – and based on IMF statements and actions to date, it seems clear the organization wants to accept it. One box they need checked, however, is for China’s currency to have a more “market-determined exchange rate mechanism.”

The decision on whether or not to include the renminbi in the IMF basket was to be announced this fall. However, for a variety of reasons, it was pushed back to 2016.3 With this new timeframe, China has plenty of opportunity to devalue its currency again. Based on the cooperation it has displayed thus far to the IMF, we should expect Beijing to comply.

And there’s plenty of room for it to do so. Not only was this China’s first devaluation in 20 years, the renminbi’s depreciation is not as dramatic as it may initially seem when compared to other countries. In just the past 60 days, the currencies in Japan, Chile, Brazil, and South Korea all fell more than China’s 2% move.4 Both the Russian ruble5 and Kazakhstan tenge6 have since crashed. Vietnam devalued the dong by 1% the week after China.7 Now, China may be forced to depreciate its currency even more just to keep up.

How Could This Affect Gold Investors?
In the short term, the knee-jerk reaction by markets to these moves is gold positive. In the week after China’s announcement, gold had its best week in more than two months. And this occurred while other commodities were flat and stock markets fell. In other words, gold did what it was supposed to do.

In the long term, we have to consider the growing possibility that this currency “war” will end badly. Central bankers may have won the battle surrounding the 2008 financial crisis, but the war isn’t over. If it were and global economies were truly healthy, central bankers wouldn’t continue to suppress interest rates, print money, add recklessly to debt levels, and devalue their currencies. The longer these and other financial “solutions” are implemented, the greater the erosion in the confidence of central bankers and their currencies. The whole system becomes increasingly vulnerable to systemic fallout.

Historically, currency wars have ended in collapse more often than not. This is not only gold positive, but shows just how critical gold is to one’s portfolio in the current environment.

This is not the only impact China will have on the gold market over the next 12 months.

Gold Reserve Updates Are Not Over
China’s announcement last month regarding its updated gold reserves was a disappointment. The People’s Bank of China (PBOC), China’s Central Bank, reported it now held 1,658 tonnes in gold reserves. This was a 57% increase, but it was widely expected to be greater.

But this, too, is only a beginning chapter in the book on China and gold. It’s clear that Beijing wants to be included in the IMF basket. That was the motivation behind the gold reserve announcement.

Most analysts don’t believe China’s central bank was entirely forthcoming in the amount it reported. If that assessment is correct, the motivation behind the smaller-than-expected increase means China doesn’t want to run up the price at this point because it’s not done buying.

And that game plan has already been implemented. It wasn’t widely reported, but, on August 14, 2015, the PBOC announced it had added another 1.1% to its gold holdings, bringing its total to 1,677 tonnes (53.9 million ounces).8

This is curious because Beijing has never provided updates this close together. Here’s the history of its publicly reported gold reserve amounts since 19809:

This stepped-up schedule strongly suggests Beijing has more gold than previously reported. It also tells us that Beijing may continue to reveal its holdings gradually, so as to not affect the market. So, it’s possible that we’ll see modest, incremental increases in China’s gold holdings over the next 12 months.

Again, regardless of the strategy, China’s goal is acceptance into the IMF currency basket. And higher gold reserves – especially in the face of global doubt regarding the amount China has reported to date – will help to garner further acceptance. That’s because higher gold reserves strengthen the currency and increase transparency.

Even if the PBOC doesn’t have monthly updates, we should expect another major announcement before next November’s G-20 Summit. The summit has a rotating president, and guess who hosts it next year? Xi Jinping, President of the People’s Republic of China.

Thus, we fully expect the IMF to accept the renminbi into the currency basket before that summit. And, to increase its chances, China will continue to add gold to its reserves and publicly reveal those amounts. This is all gold positive – and could kick-start a new gold bull market if it surprises the mainstream.

Gold Buying Is Not Over
Regardless of any currency move China may make, or how and when it announces updated gold reserves, the country continues to devour physical gold in record amounts.

First, deliveries from the Shanghai Gold Exchange (SGE) are a good proxy to measure demand. And that demand continues to grow unabated. For the week ending August 7, 2015, deliveries from the vault were the third largest weekly total ever.10

What’s interesting is that this occurred after the July announcement of its gold reserves. These withdrawals also come at what is normally a very weak time of year for Chinese demand. (The strongest time of year is yet to come: autumn.)

Year-to-date, SGE withdrawals total 1,585 tonnes (as of the second week of August 2015).11 This is more that what was withdrawn by the same date in 2014 – itself a record year. To put that in perspective, the current pace of SGE deliveries equates to roughly 80% of global mine production.12

Second, as confirmation of demand within the country, China has more than doubled its pace of purchases over prior years.13 Increases of this magnitude are a direct result of spiking demand.

We don’t know exactly how much gold China has accumulated, but we do know it doesn’t export any meaningful amount of its own production. We also know China imports gold not just through Hong Kong but all member banks of the Shanghai Gold Exchange, qualified miners, and even jewelry dealers and manufacturers.

By all accounts, demand for physical gold in the country is in a runaway mode. And no change to this trend is in sight. This is obviously supportive of the gold market.

The Next 12 Months Could See A Bullish Trigger
Put it all together and here’s what you’d find China has done over the past couple months:

• Devalued its currency for the first time in 20 years

• Announced an increase in its gold reserves after more than five years of silence, and then a second announcement a month later

• Bought physical gold at a record-breaking pace

Importantly, these trends show no sign of stopping.

Indeed, the culmination of these combined efforts is yet to play out, and probably will in spectacular fashion. By this time next year, we expect the gold market will look and feel a whole lot different – and we expect the price to be a lot higher, simply from China continuing to use it to advance its own purposes.

We don’t know when these expected developments will come to a head, but we can count on China to make any final big moves when doing so is in its best interests. That day appears to be one year away or less.

For that reason, it might be a good time to consider your gold allocation. You might be glad you did.

Until the next Daily Pfennig® edition…

Sincerely,
Tim Smith
Vice President, World Markets Sales and Servicing Trader
EverBank World Markets, a division of EverBank
1.855.813.8484
www.everbank.com