It seems that every day there is a new article telling us about China’s “insatiable” demand for gold. But, has the China gold hype caused us to lose focus on the fundamental drivers of gold price and why we should buy and hold physical gold?
Bullion.Directory precious metals analysis 2 October, 2014
By Terry Kinder
Investor, Technical Analyst
insatiable: not satiable; incapable of being satisfied or appeased
One of the key elements of China gold hype is the idea that gold is moving from east to west. It’s the giant sucking sound that Ross Perot used to talk about, but this time it is gold moving out of western vaults heading east instead of jobs heading south.
Gold watchers today make two important comparisons: China is known to be buying gold, while the U.S. is strongly suspected of selling its gold. And the U.S. is widely thought to have much less than it claims, while China is fully believed to have much more than it admits.
The above observation is interesting. It may even have important geopolitical implications one day. But, what is the above really saying? Simply put, the location of the gold is changing.
In terms of trade and commercial life, this type of thing happens all the time outside the realm of China gold hype. The United States imports oil from Saudi Arabia. Europe imports natural gas from Russia. We could just as easily say that oil is flowing from east to west as saying that gold is flowing from west to east.
The difference between oil and gold is that oil is consumed while very little of the gold ever is. Therefore, the above ground supply of gold is enormous.
Gold is one of the most liquid of all assets. Some analysts consider that up to 86% of global above-ground inventory could theoretically be mobilized in a relatively short time. However, the extent to which all of this gold can be considered “free float” is debatable. In financial markets, liquidity means the size of trade that can be executed without affecting the price.
So, considering the very large above ground stock of gold, and the fact that gold is a very liquid asset, the China gold hype can become a little confusing:
If you worry who might ever buy your gold and silver, talk to the folks with thousands of years more experience with failed governments and failed currencies than we Americans have. Be assured half the world’s population, over three billion customers, happily stand in line to buy your gold and silver with their unwanted dollars. But don’t necessarily expect to get those precious metals back!
If we are to believe this bit of China gold hype, some 3 billion people are waiting with baited breath to buy your gold should you decide to sell it.
It’s unclear exactly how one of these 3 billion people would connect with you to purchase your gold. It is also left unsaid why they wouldn’t simply purchase gold locally.
But, assuming that somehow one of these 3 billion people manages to connect with you, rather than going to their local bullion dealer, you shouldn’t expect to get your gold back, presumably because the only way to do so would be to pry it out of their cold, dead hands.
None of this makes even one tiny bit of sense. We are supposed to believe that gold, having a massive above ground supply as well as being one of the most liquid assets on the planet, will be gobbled up by the 3 billion insatiable people in the East, never to be seen again.
That, in a nutshell, is the China gold hype story – the gold is gone and never, ever coming back.
But, why should that be? When has wealth ever stood still? Are we to believe that once the gold is in Chinese hands that their wants and desires are fixed as is their future economic status? Apparently nothing changes in the land of the China gold hype.
All this ignores the fundamental drivers of the gold price, which have nothing to do with the gold’s location, annual mine production, sales of rounds, etc.
So, what are the fundamental drivers of the gold price?
One factor driving the gold price, as noted by Craig Stanley, is the real interest rate:
Real interest rates are the only metric that is correlated with the gold price. If you can hold U.S. dollars via Treasury bills, notes or bonds and they are paying a positive real interest rate that is not being inflated away, then why hold gold that doesn’t pay anything?
While the real interest rate is an important factor influencing the price of gold, it isn’t the only one.
Perhaps the most insightful work regarding gold price formation has been done by Robert Blumen.
But, before diving in to Blumen’s work on how the gold price is formed, let’s see how he nicely dissects another central tenet of the China gold hype – China’s “economic miracle”.
(Note: Some errors in spelling and / or grammar have been corrected in the quote below)
The China bull story as far as I can tell is based on the growth rate of GDP. Their economy is allegedly growing at 9%, if you believe the number. But the GDP number is more of a measure of spending. You can go along spending money for quite a while, but that doesn’t mean that it’s a useful allocation of resources in the face of scarcity. In the end if you have nothing that people want to show for it, it was wasted. And GDP does not capture that distinction.
The idea of export driven growth, it’s a contradictory concept. Economic growth means the ability of an economic system to produce more goods and services that people want and are willing to pay for, at a higher price than it costs to produce them. What they call export-driven growth is really a policy of holding their own currency exchange rate below the market rate in order to reduce the domestic monetary costs of their export industries. This creates a misallocation of labor and capital and a relative over-production of export goods at the cost of fewer imports and fewer goods for domestic consumption.
If the cost of China’s policy were properly accounted for, it would be evident that the marginal export goods that are apparently produced at a profit (under the phony accounting of depreciating money) is in reality produced at a loss. But this loss is hidden because it is distributed over the entire population by reducing the purchasing power of their currency. And that impacts their ability to buy imported goods, or, as many domestically produced goods that have an import component.
They have a huge infrastructure bubble. They are building far more roads, bridges, power plants in relation to the rest of their capital structure. Bridges and roads to nowhere show up as GDP because spending is required to create them. But not all spending is created equal. Spending on things you don’t need or things that cost too much to produce is waste and it moves resources away from where they are needed to create real growth.
It is likely that some amount of Chinese gold buying, at least by its citizens, is due not to China being an economic superpower, but instead because China is a super-destroyer of capital, something almost entirely ignored in the China gold hype.
Since China, through its economic policy, has chosen exports over imports, the Chinese have fewer choices of goods to purchase than they would have otherwise, had their central economic planners not interfered in the economy and instead allowed it to develop according to the wants and needs of their citizens.
Many Chinese made the rational decision to buy gold in light of the artificially depressed Yuan, believing that their wealth was better protected than by storing it in a manipulated currency. But things only get worse in centrally planned China:
Economist Brad Setser wrote a paper around 2006 about the Chinese banking system. In his paper, he went back a number of years into the history of their banking system. Setser found that during this time, interest rates had been set at below-market levels by the central planners. This of course meant more demand for loans than banks could supply. Rather than rationing by price, resource allocation had been largely driven by political favoritism. Not surprisingly, most of the loans from this period went bad. The entire banking system eventually became nothing but a sea of bad loans. Then there was a bail-out, putting all of the bad loans in a bad bank. And then, they started over from zero and rebooted the whole system. But by the end of the time that Setser covered in his research, they had gotten right back where they started, full of bad loans again. More recently Edward Chancellor and Mike Monelly of the respected value investing firm GMO have produced a research piece saying more or less the same thing.
Overall they have a completely dysfunctional capital allocation process. That’s why I’m a bit of a skeptic on China.
China has wildly misallocated their capital and gutted their banking system at least twice. Contrary to the China gold hype, China appears more of an economic basket case than a superpower. Which brings us back to those billion plus Chinese who, supposedly once they buy your gold, won’t ever be letting go of it.
However, given the precarious economic situation in China it is reasonable to believe that at least some people, under stress, will let go of their gold and it will flow to where it will, whether within China or to other points west, north or south.
In the world of Chinese gold hype, the same defective banking system, led by China’s central bank, has its sights set on controlling the physical gold market:
China developed the largest physical gold market in the world, the Shanghai Gold Exchange (SGE). In fact, the SGE opened for international trading last week with a ceremony led by China’s central bank chief who raved about the importance of gold ownership. China has made it clear it wants control of the world’s physical gold market.
The first question that comes to mind after reading this piece of China gold hype is why, exactly, does China want to control the physical gold market?
What altruistic motives might our dear friends at China’s central bank have for controlling the physical gold market? The same central planners who have pushed down the price of the Yuan, robbing the Chinese of purchasing power, are supposedly going to allow the physical gold price to float freely.
The same central bank planners who pushed interest rates to artificially low levels, creating massive malinvestment, want the price of gold to be freed, increasing the value of its citizens’ wealth stored as gold.
Perhaps this all makes sense within the context of a geopolitical struggle with the United States, where the Chinese Government wants to wrest control of the physical gold market from the west. Possibly, as some have speculated, they intend to create a gold backed trade note or want to back the Yuan with gold. However, given the recent efforts of China’s central bank are we to believe the China gold hype?
Are we to believe a one-party state, with a planned economy, will allow the free market to determine the price of gold long-term?
The idea that the physical gold market can be controlled reflects a fundamental misunderstanding of how the price is formed.
In the long run this misunderstanding is similar to the idea that prices – whether the price of money as represented by interest rates, or the price of gold – can be manipulated.
Perhaps prices can be pushed in one direction over shorter time periods, but gaming gold price formation in the long run will prove much more difficult. Exchanges, whether physical or papers futures markets, are inadequate to the task of restraining the gold price. This is because gold is an asset rather than a consumable commodity and its price is set on a different basis, as Blumen explains:
The key to understanding the gold price is that gold is in demand as an asset, not as a commodity. A commodity is a good that is purchased in order to be permanently removed from the market (usually destroyed), while an asset is a good that is purchased because the buyer values it more as a holding than for its direct use. The most important consequence being held rather than destroyed is that the accumulated stockpiles of exceed annual production by a large margin. In the case of gold the ratio is between 50:1 and 100:1 while for most (consumed) commodities it is less than 1:1, (i.e. less than one year’s total production is held in above-ground stockpiles).
The large above ground stock of gold makes it an ideal asset as opposed to being a commodity.
A market like the Chicago Mercantile Exchange (CME) was geared towards trading consumables (or derivatives of those consumables) that can be analyzed through the lens of supply and demand. So what is the difference between the way price is formed in a consumption market versus an asset market like the gold market?
…the price of a good in a consumption market goes where it needs to go in order to bring consumption in line with production. In an asset market, consumption and production do not constrain the price. The bidding process is about who has the greatest economic motivation to hold each unit of the good. The pricing process is primarily an auction over the existing stocks of the asset. Whoever values the asset the most will end up owning it, and those who value it less will own something else instead. And that, in in my view, is the way to understand gold price formation.
This explanation is much more nuanced than the insatiable Chinese demand pointed to in so many China gold hype articles. Another factor that drives the gold price, according to Blumen, is the marginal price:
Gold is an asset. People buy it in order to hold it. The price of gold is set as people balance, at the margin, the amount of additional units of gold they want to hold against additional units of other assets or cash they want to hold, or consumption.
If you think of the possible gold buyer as the guy who is saying, “Do I want to hold one more ounce of gold or this $1,800 that I have?” The answer to his question is going to be different for each person and for each additional ounce.
You might say “yes, I want one more ounce of gold instead of $1,800”. Now, you have an ounce of gold and if I ask you the question again you might say, “No, now that I have bought that additional ounce, I’ve got enough gold”.
On the supply side, are the people who own gold. From their point of view they have to answer the question, “Do I want to keep holding this ounce of gold or do I want to sell it on the market and have $1,800?” That $1,800 might stay in cash or maybe they have another use in mind for it. The supply side is everyone who has any gold and the buy-side of the market is anyone who has any money that they might want to put into gold.
Unlike the 3 billion plus in the China gold hype article who are willing to stand in line to buy your gold but won’t turn loose of it again, things doesn’t necessarily work that way in the real world.
In the market, people rebalance between gold and dollars until they’re happy with what they own. At that point there will be no more trading if no one ever changed their mind. But now and again people do change their mind; they realize they want more of one thing and less of another thing. Then you have more trading to bring the market back into balance.
In finance there is a similar concept called, optimal portfolio theory in which they see portfolio management in terms where people are trying to hold the ideal amount of each different form of savings. The portfolio manager rebalances based on the expected properties of each asset until they have the right mix.
The cliche of having to pry the gold out of the dead gold bug’s hand is greatly exaggerated.
But I think that the concept of the gold bug who plans to take it all to the grave is over-stated. I asked a person the gold business whether gold retail trade is all selling and no buying. He told me, “No of course not, there are always buyers and sellers”. After all, what is the point of having a store of value if you never use the value? That is John Maynard Keynes and his parable of the cake that is never eaten. But Keynes was really painting a caricature of the capitalist system which encourages saving for the future. The future does arrives at some point, whether it is old age or emergency, and at that time, the value of additional saving is diminished relative to spending.
And it is important to understand the cost of owning gold is not necessarily the amount of money you could get by selling it. Prices are only a way of quantifying true costs. The cost of owning an ounce of gold is whatever other sort of economic opportunity that you are sacrificing by owning the gold instead. People who own gold are every day looking at “what other economic opportunities am I giving up by holding this ounce of gold?” and then “Do I want to shift the next ounce of gold somewhere else that will give me a better return or a better consumption experience?”. If you could swap an ounce of gold for one unit of the American Dow Stock Average that was at the time yielding 12% then the cost of owning an ounce of gold is not owning a unit of the DJIA. The cost of owning gold is the opportunity cost, of which holding cash instead is only one possible choice.
Let me give you another example; if the price of a new car that you like is twenty ounces of gold, you might prefer the gold. The cost of owning the gold is 1/20th of a car. But if the price of that car in gold ounces dropped to one ounce, you might say, “Nineteen ounces of gold is enough and I’d like to have that new car”. And at that point it makes sense to swap a single ounce of gold for a car. You still have nineteen ounces of gold, so you haven’t sold all of your gold, but at the margin, you have sold the least valued ounce for something that became more attractive.
Another fundamental driver of the gold price according to Blumen but largely ignored by the China gold hype, is reservation demand.
There are two different expressions of demand for a good. If I trade with you, I supply one apple and I demand one banana and you do the opposite. We each demand something by offering something in supply. When there’s a buyer and a seller, the buyer demands and the seller supplies. That is exchange demand.
The concept of reservation demand is where you demand something by holding onto it rather than selling it. This concept might sound unfamiliar but it is very relevant to everyone’s life. We all have reservation demand for many goods. I have reservation demand at the moment for an auto, a dining room table, a couch, a mobile phone, and so forth. My reservation demand for cash in my pocket is $20. Any good that you’re any holding onto rather than selling, you are exercising reservation demand.
Most of the market research about gold deals with exchange demand, which has the advantage that you can measure it. But reservation demand is far more relevant to the price. The profile of reservation demand among people who own gold is the main determinant of the gold price from the supply side.
Hand in hand with reservation demand is reservation price which represents the price that someone who holds gold would be willing to sell it.
A very closely-related concept is reservation price. This is the price where you would be willing to sell a good that you currently hold. In the gold market, you can think of every ounce with a price tag on it. Or maybe today, it would be a QR code instead of a tag. That price depends on who owns that ounce of gold and their reason for holding it. Short-term traders might take a position for five minutes looking for a small move. If they got their $10 move they would sell and lock in a profit. You have other people who have a much longer time horizon, years or even decades, and a much higher expectation of where they’re going to sell. And even the same person will have a different price tag on each ounce. The first ounce you might be more willing to sell than your last ounce. It is important to understand that reservation prices are not necessarily money prices; they may be construed more broadly in terms of economic opportunities as I described just a moment ago.
You also might object that a lot of people may not know exactly what their reservation price is in money terms because it is impossible to know accurately what the purchasing price of money will be at a time when you might want to sell. And this is true. Many gold buyers are envisioning that we are going to experience hyper-inflation in some countries and their plan might be to look for distressed assets that go on sale during a hyperinflation. That would be the time to sell their gold, or more accurately, to swap their gold for assets. This type of person may conceive of the reservation price as, “When I can buy a small business, like a cleaners, for five ounces of gold” or “when I can buy a rental apartment for 10 ounces of gold”. People conceive of the reservation price more broadly in terms of what is going on in the world around them.
So, contrary to the China gold hype, the location of gold doesn’t drive the gold price. Nor does annual mine production, sales of rounds by the various mints, or even the normal supply and demand dynamics of commodities markets. Gold price formation is influenced by the following:
An undue focus on the China gold hype has caused some to lose focus on the fundamental driver of the gold price. These fundamental drivers are not what many have been led to believe.
By focusing less on the China gold hype and more on the fundamentals of gold price formation you will have a clearer understanding of the real reasons to buy and hold gold as well a better idea of what actually drives the price of gold.
Cover image Four nines fine standard 400 oz gold bars by Andrzej Barabasz (Chepry)
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