Stephen’s Posterous

China reveals big rise in gold reserves
By Jamil Anderlini in Beijing and Javier Blas in London, FT.com

China has quietly almost doubled its gold reserves to become the world’s fifth-biggest holder of the precious metal, it emerged on April 24, 2009, in a move that signals the revival of bullion after years of fading importance.

Gold rose to a three-week high of more than $910 an ounce after Hu Xiaolian, head of the secretive State Administration of Foreign Exchange, which manages the country’s $1,954bn in foreign exchange reserves, revealed China had 1,054 tonnes of gold, up from 600 tonnes in 2003.

The news could spark interest in gold among other central banks. “When the largest holder of foreign exchange reserves discloses an increase in gold holdings, other countries may decide to think more carefully about underweight gold positions,” said John Reade, a precious metals strategist at UBS.

The increase in China’s gold reserves has come primarily from domestic production and refining. However, the news raises questions about the future of Beijing’s foreign reserves policy. Ahead of the G20 summit in London this month, China suggested global reliance on the US dollar as a reserve currency should be reduced.

China has been diversifying away from the dollar since 2005, when it broke the renminbi’s peg to the US currency and officially marked it to a basket of currencies, but it still holds more than two-thirds in US dollar-denominated assets by most estimates.

As its trade surplus and forex reserves ballooned in recent years, Beijing continued to buy huge amounts of US Treasury bonds while raising the proportion of purchases it allotted to other currencies and to gold.

China’s accumulation of gold has taken place as European central banks have gradually cut back back gold sales following a 1999 agreement to prevent the market from being flooded after prices were dragged sharply lower after the UK decided to sell part of its reserves.

“China’s announcement signals a broader shift in central banks’ attitude towards gold,” said Philip Klapwijk, chairman of GFMS, the precious metal consultancy.  Suki Cooper, a gold analyst at Barclays Capital, said China’s move was “reigniting gold’s relevance as a monetary asset”.

European central banks agreed to limit gold sales to 500 tons a year in 1999, under the Central Bank Gold Agreement after a UK decision to sell part of its gold reserves dragged prices sharply lower. 

Since 1999, central banks in Europe have sold large amounts of gold, investing the proceeds into bonds. But in the past two years they have curtailed their sales significantly while central banks outside Europe became net buyers of bullion.

China’s forex reserves grew from $623bn at the start of 2005 to $1,906bn at the end of September last year but in the last six months the spectacular growth has slowed to a virtual stop, with reserves rising by just $7.7bn (€5.8bn, £5.2bn) in the first quarter.

That means smaller new purchases of everything from US Treasuries to gold. Paul Atherley, Beijing-based managing director of Leyshon Resources, said that even after the latest purchases China had a very small percentage of its reserves in gold, far below the US or other developed countries.

“Those [gold] holdings are still too low in terms of the size of its economy and the growing significance of its currency,” he said. The announcement boosted gold prices to a three week high above $910 an ounce as investors bet other countries could follow.

Russia has being an active buyer, following Beijing’s similar pattern of purchases from local miners. China became last year the world’s largest producer of gold, outranking South Africa.

Since the financial crisis started, investors have piled record amounts of money into gold, boosting prices to above $1,000 an ounce. Gold hit a low of $250 an ounce a decade ago, when central banks started selling the metal.

Additional reporting by Chris Flood

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There have been many pseudo reserve currencies through the ages. Now, the governor of the People’s Bank of China has called for a new global currency “disconnected from individual nations”.

Russia, too, wants to move away from a world dominated by the dollar. Kazakh president Nursultan Nazarbayev suggests such a currency could be called the acmetal, an amalgam of “acme” and “capital”.

But is there a case for one? In theory, yes. Although no one was banging the table for change when emerging growth rates were still being powered by deliberately undervalued domestic currencies. The reserve currency status of the dollar helped to create nasty global imbalances, one of the main culprits of the current downturn.

As China, for example, recycled export earnings back into dollar-denominated assets, the US could happily run profligate trade deficits with impunity. That helped push up the price of US assets, particularly house prices.

Now surplus countries are stuck. They cannot diversify fast enough and a rapid sell down of US assets would destroy their portfolios. Not only that, global central banks holding about two thirds of their reserves in dollars are hostage to the Obama administration.

Unsurprisingly, huge budget deficits and the Federal Reserve’s leap into quantitative easing have foreigners fretting over the longer term health of the dollar.

Theory is one thing, however. In reality, currencies live and breathe more than just short-term economic air. The two other life forces for a reserve currency are sovereign credibility and power.

China, Russia and India simply do not have long enough economic track records to justify backing a reserve currency. Find a single investor in this crisis that has panicked out of dollars into roubles. Of course, if China one day emerges as the dominant economic and military power, the status quo will change. Until then, investors cannot be rushed.

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The currency markets have been in a strange place recently. For the last few months the dollar maintained its strength even in the anticipation of more government debt and Federal Reserve policies that would seem to encourage dollar weakness.

With the most recent announcement of the newest plan to nuke the festering assets on the balance sheets of U.S. banks, the dollar is stronger, rallying even when the equity market is rising.

There are numerous expectations about what could transpire for the dollar in coming months. Some believe the greenback will, or should, weaken due to anticipation of a bloated federal budget and current-account deficit that concerns foreign investors about the U.S. system’s stability. Others suggest that if markets do recover, it would undermine the case for the dollar, as investors would be more persuaded to buy riskier assets denominated in other currencies.

“It’s really a struggle today, and a tug of war between improvement in risk appetite, which should be driving the dollar lower and foreign demand for dollars, and the assurance for foreign investors that there is basically a floor the U.S. government wants to create for these toxic assets,” says Kathy Lien, director of currency research at GFT. “The risk for the banks are diminishing by the day and that’s why banking stocks are rallying.”

Others arrive at a divergent view of the plan’s impact on the dollar. Chris Gaffney, vice president at EverBank World Markets Group, believes the dollar rally on Monday, March 23, 2009, is the result of traders reversing earlier gains after the dollar sold off sharply late last week.

While he believes the plan increases the risk to the U.S. currency, he noted that traditional safe-haven assets such as U.S. Treasurys and gold have not rallied along with the dollar. The lack of a positive move in those assets could also be a profit-covering move, but this interpretation has its own complications, because it undermines the case for safe-haven positioning by investors.

It may be that investors are reacting positively to a plan that increases investor appetite for risk, but are also heartened by the swiftness of the U.S. government’s moves, when compared with others.

“It’s fair to say there is an element of this that [the market] was oversold,” says Chris Furness, head of currency strategy at 4Cast Ltd. “Everyone and his brother were short at the time. There’s also a slight feeling in the background that maybe the U.S. administration is getting to grips with things, or rather more quickly than most of the rest of the world.”

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The US Federal Reserve is printing money. The US government is spending wildly today so there won’t be a depression tomorrow. It sounds like a recipe for currency collapse. Yet the dollar keeps picking up. And the trend seems unlikely to change soon. What’s going on? Well, consider the competition.

Start with the dollar’s predecessor as reserve currency, the pound. At $1.38, it is close to setting what would be twenty-year lows against the dollar, less than a year after it set quarter-century highs.

Let us count the woes. The banks have big foreign liabilities, the deficit-ridden UK government has taken on most of the risk in the banking sector and the Bank of England is going to add £75bn in freshly mouse-clicked notes to the pool of sterling assets. Who wants them? Not foreign investors.

The euro, Icarus-like last summer, also looks to be heading fast for the soil. Eurozone growth is bad. Its banks are in trouble. How to avoid an unfortunate roast of Portugal, Ireland, Greece and Spain is the question. But now throw in Belgium, Italy and Austria, whose banks are among the worst affected by eastern Europe’s implosion.

In Frankfurt, Jean-Claude Trichet, head of the European Central Bank is not in favour of easing. In Berlin, Chancellor Angela Merkel is not keen on bailing. The zone is sinking.

Just like Japanese exports: down by an annual 46% in January. The yen’s rise last year was in part technical. Short Japan had been the hedge funds’ mantra. Then it became time to drop those risky yen shorts and run for cover. But Japan’s fundamentals are now exposed and none too pretty. Exports are plunging. Recession is intense.

The US’s fundamentals are dreadful, too. But policy-making could hardly be more activist. It is in essence a huge gamble on recovery. For now, the world would rather take that gamble and buy the multitude of treasuries the US government is issuing than contemplate anything else. The reserve currency will forge ahead. Unless the world starts to think the big US wager is going to fail.

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Suki Cooper is on the Commodities Research team at Barclays Capital, which focuses on the precious metals markets covering gold, silver, platinum and palladium.

Gold broke briefly back over the $1,000 per troy ounce last month driven by an explosion of interest from embattled investors. As the credit crunch continues to evolve from a global financial crisis into a worldwide economic recession, will this momentum increase, or might gold become vulnerable to profit taking?

Suzi Cooper answers the above questions and many more.

With the dollar so strong can we really see gold holding more than $1000 an ounce?

Suki Cooper: Gold’s legacy as a monetary asset and with key consumption being outside of the US means there is a positive relationship between the dollar and gold prices. A weakening dollar would certainly appear to be broadly supportive of an uptrend in gold prices, but the converse does not necessarily hold true. In the past, a strong dollar has not necessarily prevented gold prices appreciating.

Although the gold/dollar relationship is strong it is not one that will unquestionably cause an equal and opposite reaction. History shows this relationship tends to weaken during periods of dollar strength, and the relationship becomes stronger during periods of dollar weakness. Back in March 2008, when gold prices breached the $1000 level for the first time, the dollar had hit record lows against most major currencies as well as inflationary concerns being ripe.

This time, gold prices have rallied despite the traditional drivers not being supportive. Instead this rally is being driven by safe haven buying in light of concerns over the broader economy. Investor demand has been tremendously strong. In our view, prices are more likely to make a sustained move above $1000 in the second half of the year in line with our expectations for the dollar to weaken against the euro.

At what point will gold become less attractive than other asset classes?

Suki Cooper: Given its dual role as a commodity and a monetary asset, gold prices tend to flourish in an environment that is supported by its fundamentals and the external environment. Thus if its underlying physical market balance is in excess surplus and there is not sufficient investment demand to soak up that excess, prices would come under pressure.

Investors buy gold for many different reasons, as a dollar hedge, equity hedge, hedge against market uncertainty, inflation hedge, and as a safe haven asset to name but a few.

To what extent do you believe the current gold price is reflecting investor sentiment or do you believe that fundamental demand is the primary driving force?

Suki Cooper: So far this year, we have seen signs of mine supply stabilising, but jewellery demand weakening. In contrast we have seen a surge in investment demand, whether we are looking at paper exposure, ie futures or physical exposure ie bars, coins and physically backed ETPs, exchange traded products.

To date the growth in investment demand has been more than sufficient to offset the decline in jewellery demand. In our view, this rally lies firmly in the hands of investors. Sentiment remains positive towards the metal. Speculative futures positions continue to hover around 5 month highs and inflows into the physically backed ETPs in the first two months of this year exceeded inflows for the entire year, last year. Inflows in February doubled the previous record which was only set in January.

If one accepts the notion that world economies and currencies are in a slow but long-term decline, should we expect silver to continue to rise as a safe haven or will its reduced demand in industrial applications pull the rug out from under it?

Suki Cooper: Much of silver’s uptrend has been fuelled by gold’s positive performance rather than its own fundamentals. The gold-silver ratio shot up from the mid-50s at the start of 2008 to over 80 towards the end of the year. Compared to a long-run average of around 60, current levels would imply silver is undervalued whereas gold is overvalued.

However, the fundamental outlook for silver has deteriorated. Photography and jewellery demand for silver has been on a downtrend in recent years, but taking into consideration downward revisions to global GDP growth, the outlook for industrial demand is also set to remain weak over the forthcoming months. In turn, the underlying supply and demand outlook for silver looks set to remain unfavourable in 2009.

The real driver of silver prices despite its poor fundamentals has been the tremendous growth in investment demand as investors have built exposure to silver as a cheap proxy for gold.

How much refined silver is there above ground versus above ground refined gold in the world and with the Gold:Silver Ratio at nearly 70:1 ($910/$12.77) do you think that silver is a better option than gold?

Suki Cooper: In terms of above ground stocks the gold:silver ratio would be around 4:1. In our view, the fundamental outlook for gold looks more favourable in comparison to the fundamental outlook for silver.

Although gold jewellery demand has suffered in light of higher prices, investment demand has been able to offset this. Despite higher prices, the gold supply response has been rather muted. We expect total supply from mine output, official sector sales and gold recycling to fall year-on-year.

In contrast, we expect modest growth in overall silver supply, this combined with the deterioration in demand for key end uses of silver, means excess surplus is set to grow y/y. In turn, should we start to see net redemptions in the build of investor interest, silver could be exposed to further downside risk, in light of its weaker fundamentals for prices to fall back on.

Can investment demand for gold keep growing over the medium/long term at a rate high enough to outweigh the falling jewellery demand?

Suki Cooper: At least for now, the growth in investment demand has been more than sufficient to offset the decline in jewellery demand and the slowdown in producer hedge-book buybacks. But traditionally jewellery demand (which normally makes up around 70 per cent of demand) has tended to provide the floor to prices, physical buyers return to the market as prices ease and provide a cushion.

Low and stable prices are the most favourable for key jewellery consumers but even in an environment of higher prices, demand tends to return to the market as price volatility eases. However, as this end use has dried up in light of higher prices, that floor is yet to be tested. The rally is dependent on investment demand, in our view, the drivers to support investment demand are set to remain positive throughout this year. Longer term, should the investment demand turn less positive, prices will once again be dependent on jewellery demand to provide a floor.

Will gold resume its traditional inverse relationship to the dollar or will gold fall in conjunction with the dollar as it has recently benefited from the flight to safety as well. 

Suki Cooper: As mentioned previously the gold/dollar relationship tends to weaken during periods of dollar strength, and the relationship becomes stronger during periods of dollar weakness. In our view, those investors who choose to hold gold as a currency hedge are likely to return to the market as the dollar weakens. In turn prices are likely to receive a boost as a specific purpose hedge as well as continuing to attract safe haven buying.

Some very smart people are saying that the gold ETF’s are really paper gold holders and that there is little or no physical gold in their own warehouses. What does this mean?

Suki Cooper: Not all gold ETFs are physically backed, the underlying for some of the products is allocated gold, unallocated gold or even futures. Those that are physically backed, do say on their websites that they hold allocated gold.

I understand that gold acts as a safe haven, even though it has few industrial uses, because it is relatively scarce. I gather platinum has more industrial uses and is even scarcer, yet it is not seen as such a safe store of value as gold. Why is that?

Suki Cooper: There are a number of reasons, although platinum is also a precious metal, it does not have a legacy as a monetary asset. Industrial demand makes approximately 80 per cent of total platinum demand yet only accounts for around 10 per cent of total gold demand.

Gold plays a dual role as a commodity asset and a monetary asset, and safe haven buying has supported gold prices, but the two metals have very different dynamics at play. Platinum has on occasions benefited from positive sentiment across the precious metals, but platinum prices move more in tandem with its supply and demand dynamics.

We’ve seen gold rise during this financial crisis reinforcing its safe haven status despite a sharp drop in demand in markets such as in India. However, do you think that the price will continue to be at elevated levels as the recession deepens and investors shun every asset class except cash?

Suki Cooper: There is potential for a correction in the near term, as the investment horizon of new investor demand is tested. Thereafter we would expect renewed investment demand to buoy prices as investors return to the market turning to gold as a dollar hedge or an inflation hedge; in line with our expectations for the dollar to weaken against the euro on a 12-month basis, and deflationary concerns to give way to inflationary concerns as well as broader safe haven buying.

The factors which boosted prices to $1000 the first time round and the factors that boosted prices to $1000 this year are likely to combine to create a gold favourable environment.

Some economists say that we are heading for a period of high inflation, a point of view I agree with. If that is the case, Gold is clearly a good investment. However, there are many ways to invest in Gold, such as coins, ETFs, mining stocks etc. Which one is the best?

Suki Cooper: Gold is sometimes bought as a hedge against inflation, but it is far from a perfect or dynamic hedge and may need to be held for longer periods to be effective. Many studies show that gold can be a leading indicator of inflation but this strategy should be implemented with caution as gold provides a leveraged return.

In terms of gaining exposure, this depends on whether one is seeking exposure to the physical asset, in which case storage costs, insurance and security are some of the factors that need to be taken into consideration. Whereas investing in stocks does not give you access to just the underlying gold prices, but also other factors that will impact the share price.

Depending on which ETF is chosen, this can be a way of gaining exposure to gold without having to store and insure the metal.

Could you please compare the gold with other precious metals such the platinum and palladium in terms of investment attractiveness in 2009? What would be the best investment strategy in precious metals in 2009?

Suki Cooper: Although the precious metals complex can move together, the fundamental outlook for the metals is set to vary significantly. The outlook for platinum and palladium looks weak in the near term as the bulk of demand, over 50 per cent, is centred around the auto industry.

We expect the platinum market to be in a modest surplus this year, as falling demand has been matched with curtailed supply. The surplus is likely to be concentrated in the first half of the year with vehicle sales falling in key platinum markets.

Platinum is primarily used as a catalyst in diesel markets, and although diesel vehicles make up a growing share of the market in Europe, total sales have fallen. In terms of supply, we have seen cutbacks in response to lower prices, but platinum stocks remain close to historical lows, providing a deflated cushion should further production cuts start to emerge.

Even though the supply side remains supportive, a recovery in demand will determine whether prices start to recover slowly or encounter a sharper pick-up.

We expect palladium’s fundamentals to remain weak given the bleak outlook for demand. Palladium is primarily used in gasoline vehicles with the US being a key market, however, above-ground inventories remain high. Strong investment demand has been a key supportive factor for palladium prices, and in the near term remains key for prices.

The outlook for silver looks set to deteriorate further in 2009. Mine supply is set to grow, despite some lost production due to cut backs in base metals production; most of the new supplies stem from the start-up of primary silver mines. The market surplus is exacerbated by the industrial demand that is set to tumble due to the weakening macro-economic environment.

Gold on the other hand, has seen a surge in investment demand that has offset the weakness from the jewellery sector. If this investment demand continues to grow, the market could be in a physical deficit this year. Both gold and silver prices are dependent on continued growth in investor interest boosted on the back of safe haven buying while the platinum group metals are more dependent on a turn in industrial demand.

What do you believe will be the greatest pressures that will force commoditiy prices to rise, and what indicators should we observe to help us make this determination?

Suki Cooper: There are key factors on both the demand and supply side from where the greatest pressures that will force commodity prices to rise can come from in our view. One key factor has been the supply side which has been hit by a combination of declining prices and still sizeable input costs. There have been numerous projects across the metals, mining and energy sector which have been delayed or cancelled owing to tight financing conditions.

From the demand front, a more positive global economy will lead to increased commodity demand and pressure prices higher especially with the constraints faced on the supply side. China in particular has been key in commodity demand growth. However an uptick in economic growth will not mean the outlook for all commodities will be positive, as always it will be important to distinguish between individual commodities as it is specific underlying demand and supply dynamics that drive prices.

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If size is the measure of achievement, then President Barack Obama has outdone every one of his predecessors since Harry Truman. Setting out spending plans for the next decade on Thursday, the administration announced that the US government would run a $1,750bn fiscal deficit this year. Equivalent to 12.3 per cent of gross domestic product, the gap between tax receipts and spending is at its greatest since the second world war.

The ambition inherent in the plans is similarly large – to stimulate the economy out of recession and transform the healthcare system while (and here’s the tricky bit) returning the public finances to a reasonable footing. It is hard to square the last of those, shrinking the fiscal deficit to $533bn by 2013 (then expected to be a mere 3 per cent of GDP), with the rest.

To do so requires the assumption that the economy will return swiftly to 5 per cent nominal growth a year by 2011 and 6 per cent thereafter. Questions about the effectiveness of the current stimulus package aside, the assumption is that such spending will be temporary, with private demand emerging on cue to fill the hole as the economy recovers. The lesson though from Japan’s lost decade is that the economy falters as soon as government support is withdrawn.

Structural changes in the US economy may make this feat even harder. At the peak in 2007, finance contributed fully one-third of domestic corporate profits. Chastened, and soon to be heavily regulated, assumptions for tax revenues based on the recent past are likely to prove optimistic.

It would be remarkable if the gap can be paid for by greater government efficiency and higher taxes purely for the rich. If the president can resurrect the economy and rapidly bring the deficit down at the same time, he may want to try walking on water next.

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Hillary Clinton says the US and China are in the same boat, and rowing in the same direction. She is wrong - or at least, it would be better for both if she were. Both nations share a common interest in fending off a global recession. Even so, their leaders should focus on unpicking their co-dependent relationship, not deepening it out of fear.

China and the US do share one thing in particular: a $1.4 trillion loan agreement. That's how much US government paper the Middle Kingdom has bought up in order to park its foreign currency amassed through years of trade with the West. With the US about to launch an almost-$800bn stimulus to prop up its economy, China is under pressure to buy more.

Continued support of the US government might help revive Chinese exports, which have been hit by the share decline in US demand. It would also help keep up the value of the dollar, and thus of the huge Chinese portfolio of dollar-denominated assets.

But a common interest isn't the same as a common destiny. If US defaulted on its borrowings, or tried to inflate its way out of them, China would suffer as any other forsaken creditor. Unemployment would rise, and state investment might shrivel.

But the wealth being created inside China by its rapid industrialisation, and the infrastructure already in place, mean that over the long term, the country would still rise. A bust US, no longer the world's risk-free borrower of choice, would fall - and fall hard.

Both countries need to make some painful adjustments. The US needs to start substituting exports for borrowing, while China needs to swap American consumers for the home-grown kind. Neither task is easy. The US needs to re-learn how to produce low-value goods, while China must reorganise its economy and find new jobs for millions of export workers.

Big imbalances create a common interest - and a common problem. Contrary to Clinton's suggestion, the unravelling of the co-dependency between the US and China should be a global policy priority. Then each country can find its own direction.

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It is small consolation, but the most prominent disaster scenario for the US economy has lately become less of a concern due to an entirely unforeseen and different disaster. Economists had worried for years that the unsustainably high current account deficit would one day result in a dollar crisis. The US recently needed over $2bn of excess global savings each day to manage its excess consumption and some warned this deficit could top $1,000bn a year.

The past five months have seen a rapid improvement even as the dollar has rallied. December had the smallest trade deficit in nearly six years. And with consumer spending set to drop by the most since the Great Depression, the benign trade trend will continue.

Oil prices are another factor. Last July saw US oil imports reach a monthly record of $43bn but this shrank to just $16bn in December. By this summer, the average oil import price may be $80 a barrel lower than a year earlier. The volume of imports should also be lower too.

The current account deficit peaked at an annualised $844bn in the third quarter of 2006, about 6.5 per cent of gross domestic product. Economists at BMO Capital Markets believe it will fall to about $400bn, or 2.8 per cent of GDP, by the fourth quarter of this year, even assuming a rebound in crude oil to $50 a barrel. By late 2010, they expect the deficit to trough at about 2.6 per cent of GDP.

So far so good, even if a dollar crisis might have been preferable to the emerging scenario. Asian exporters and petro-states now have fewer dollars to recycle even as US debt issuance balloons to a record. The result may be sharply higher US yields that drag on growth, exacerbating the slowdown. The saying used to be: “It’s our currency but your problem.” Now Americans stand to bear the brunt of the adjustment.

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