Screen-traded fiat gold could get very violent wake-up call

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by Michael J. Kosares

“This could turn into a very violent wake-up call for [screen-traded gold]. People talk about ‘fiat currencies’, but we also have ‘fiat gold.’ Volatility is too cheap right now.” — Gold refiner quoted by John Dizard in his Financial Times column this weekend

Note: This post is a follow-up to last weekend’s China’s London-Zurich-Hong Kong gold conduit — a major financial coup d’etat

In the initial Reuters report on the London-Zurich-Hong Kong-Shanghai gold pipeline, Macquarie gold analyst Matthew Turner suggested that the 1016 metric tonne United Kingdom export (up from 85 tonnes the previous year) might have been shipped to Switzerland for refining into “smaller bars more attractive to Asian consumers or to be vaulted there instead.” Though vaulting cannot be ruled out, the recasting explanation makes considerably more sense given the times and the extraordinary amount of gold being imported by China – over 1500 tonnes so far this year according to research published by the Koos Jansen website. It is difficult to imagine a scenario in which China would be interested in vaulting gold in the West – particularly at a time when the West is experiencing difficult financial and economic circumstances.

On the other hand, we know that four of the world’s top gold refineries are located in Switzerland — Valcambi, Pamp, Argor-Heraeus and Metalor. Roughly 70% of the world’s annual gold production is refined in Switzerland and it is considered the center of the world’s gold refinery business. Its bars are trusted on the world’s gold exchanges by the top banks, bullion dealers, jewelry manufacturers, and nation states alike. If Turner is right about recasting the bars into Asia-friendly units, and I think he is, Switzerland would be the place to do it, particularly in light of the volume reportedly being re-refined. In my view, China intends for this gold to be transported to and remain in the East otherwise it would not have gone to the trouble to have it recast into Asia friendly bars.

To gain a deeper understanding of what China might be up to, some background is essential. Let’s start with the trading units at the two major Chinese exchanges involved in the gold trade – the Hong Kong Gold and Silver Exchange and the Shanghai Gold Exchange (SGE) – because that goes a long toward explaining why the 1016 tonne export made an initial stop in Switzerland before moving on to China.

The tael is the standard unit of weight on the Hong Kong exchange. It equals 1.20337 troy ounces, or 37.4290 grams, fineness in the past has been 99% but this standard has been upgraded to 99.99% to conform to international trading standards. According to gold expert Timothy Green’s The Gold Companion (1991), the standard trading sizes on the Hong Kong exchange is five and ten taels. The basic contract is 100 taels, or 120.377 troy ounces, as opposed to the standard 100 troy ounce contract on U.S. futures’ exchanges.

The Hong Kong Gold Exchange is an outlet for much of Asia and the tael trading units, once again according to The Gold Companion are used in China, Taiwan, South Korea, Thailand and Viet Nam. The SGE is the only gold exchange in China and its contract-trading unit is the kilo bar (32.15 troy ounces), once again a significant deviation from the western exchange standard.

Dragon’s hoard includes Chinese people, Peoples Bank of China

Should this scenario prove to be accurate, most of the metal moving from London to Asia through Switzerland will more than likely end up in the hands of consumers in the form of jewelry and small bars. What few people realize is that all of this activity is fully sanctioned by the Chinese government and the Peoples Bank of China (PBOC). In fact, once again according to the Koos Jansen website, the Shanghai Gold Exchange is owned by the PBOC and as a result any gold imported and stored at the exchange for future delivery is, indirectly at least, gold inventory at China’s central bank. SGE widely publicizes itself as a “delivery market” thus the smaller and familiar kilo bar size as its chief trading unit makes a great deal of sense.

If, as the smaller bar sizes suggest, the UK-Swiss aspect of the pipeline functions as a bar resizing operation, then we may have a long way to go before China’s official sector (central bank) needs are satisfied simply because so much of it is going directly to Chinese consumers. It also implies that the demand we have already seen, as large as it is, could be just the tip of the iceberg. It is no secret that the Chinese people have a traditional, transcending attachment to gold. That same attitude, it should be kept in mind, permeates almost the whole of Asia, and as more and more people partake in the fruits of Asia’s rise economically the demand for gold is likely to grow with it. China is likely to take advantage of any drop in the price to load up as it did in the April-August, 2013 time period. In one of my early articles on China’s burgeoning interest in gold (June, 2009), I indicated that Chinese demand would likely put a floor under the market for many years to come. The statistics below bear that out.

Drawing again from the Koos Jansen analysis, the China Gold Market Report – authored by the key players in China’s gold market, including analysts for the SGE – lists the following distribution of physical metal through the Shanghai exchange in 2011:

456.66 tonnes – Jewelry manufacturing
53.22 tonnes – Industrial raw materials
21.55 tonnes – Gold coins
213.85 tonnes – Investment gold bars
13.52 tonnes – Other, unnamed industrial purposes
284.88 tonnes – Net investment (??) “…[D]emand arising from the transfer process of gold as an investment tool (This might be the portion that goes to central bank reserves.)

Total = 1043.68 tonnes

To offer a measuring stick that might give that number additional meaning – the total equals roughly 40% of annual mine production, one-eighth the U.S. gold reserve, and nearly one-third Germany’s reserve. (Keep in mind, too, we are talking 2011 numbers not 2013 numbers after the latest massive imports.)

Fiat currency, fiat gold

John Dizard’s column in this weekend’s Financial Times explores the unsettling developments in the physical gold market and what problems they might impose on the paper gold market. Though the column itself is a very positive one for gold’s prospects, it runs under a negative headline that has little to do with the content: Cry of negative gofo heralds trouble for gold. The words “paper traders” should have been added to end of the headline, because that is clearly the point Dizard is making.

He points to the very situation we have just covered in depth on the China connection, and talks about the shortage of kilo bars globally, the recasting of 400 troy ounce LBMA/ETF (exchange traded fund) bars, and the upside down forward rate on physical gold. Dizard poses the question, “Could the gold flow back from those kilo bars to recasting as good delivery 400oz bars?” In other words, does the London-Zurich-Hong Kong-Shanghai pipeline run in both directions? An unidentified gold refiner answers: “Much of that has been converted to jewelry. It would be a lengthy process. Those are pretty sticky hands…This could turn into a very violent wake-up call for [screen-traded gold]. People talk about ‘fiat currencies’, but we also have ‘fiat gold.’ Volatility is too cheap right now.”

Final note

One more point of interest before I put this piece of the China analysis to rest: HSBC, the multinational bank headquartered in London, is the chief storage facility for the largest gold ETFs. As mentioned in my previous article, much of the gold transferred to Switzerland by HSBC came out of the ETFs. In addition, HSBC is an important trading member in the daily London Gold Market Fixings. Founded by Sir Thomas Sutherland in the British colony of Hong Kong in 1865, HSBC stands for the Hong Kong Shanghai Banking Corporation.

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