The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Kevin: David, as we promised the listener, you talked to the head of the World Gold Council in China, Albert Cheng, about the dynamic growth, three decades of growing gold demand in China, but at this point you had mentioned that it is reaching a warp speed, it’s just going into hyper-drive.
And just a reminder, that we do have transcriptions of each of the programs, if you check the McAlvany Weekly Commentary site.
David: Development of the gold market has been robust over the last three decades, and you are right, it is moving into an even quicker pace. As we mentioned a few weeks ago, looking at the Shanghai Futures Exchange and the Shanghai Gold Exchange, and the fundamentals, the nuts and bolts, the transition from the Chinese being merely price-takers, as consumers, to price-makers, as traders of the commodity, in excess of what we see in London and New York.
That is still a future aspiration, but they are very intent on target-setting and goal-completion, and I think this is where talking with Albert is absolutely critical. Albert worked with the Royal Bank of Canada decades ago, introducing the Maple Leaf into the Asian context, and knows, from the ground up, what consumption habits and behaviors have been throughout Asia. Now headquartered in Singapore and responsible for the entire Asia region, he is very keenly aware of how that development has taken place.
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Albert, thank you for joining the conversation. There are so many things that are developing in the gold market and we have, as a company, benefitted from the work that the World Gold Council has done for years. We look at your research as very important to understanding the supply and demand dynamics in the marketplace, as you are managing director in the Far East for the World Gold Council. I think that is particularly important today, as we have seen a trend which, perhaps, started 30 years ago, the importance of demand in Asia compared to demand for the product in the U.S. and Europe. It has been on the increase, and now, even more so. Maybe we could just start there. What do you see as this trend carrying forward, or is this a short-term anomaly? Thirty years might suggest that it has been in place and will remain in place, but maybe you can speak to that.
Albert Cheng: Thank you, David. Thank you for having me. You are asking me about a subject that I have been closely involved in over the last almost 30 years. I remember in 1985 when I joined the Canadian Mint, selling Maple Leafs in the region. At that time, my boss from the Canadian Mint was actually looking to set up a distribution network in Hong Kong to sell Maple Leafs. At that time, what had driven him to come to Asia was that he had started a business in North America, selling very well in Canada and the U.S., and eventually in Europe, selling very well in Germany and Austria.
Potentially, our market is not just limited to North America and Europe, we had to go east. So he started to visit, first, Japan. Japan is the first Asian market that opened up to gold, in the late 1970s, right after the U.S. opening. We have seen that Japan jewelry, as well as investment demand, was at peak in the 1970s and 1980s, until the so-called 20-years “lost decades” when the Japanese economy went into trouble, so the gold market gradually subsided.
But at the same time you see the emerging of Soviet Asia first in the 1980s, and eventually, we have seen in the last ten years, China. The global gold market is actually in the last 30 years, gradually moving from the center in the West, in the U.S. and in Europe, into the Asian part. It started off in Japan, as I said, and for that matter, India has always been an anchor in the Asian market. Historically, India has never come across any colonial rule or any restriction on Indian owning or purchasing or enjoying gold jewelry. None of this has happened in the past. So there is a consistent history of Indians buying gold jewelry and owning gold for many, many years.
In Southeast Asia, it started off as a very restricted market, and I remember 30 years ago only Singapore is a free port for gold to come in and go out. All the rest of the markets, Thailand, Indonesia, Malaysia, they are all restricted markets, some form of restriction on gold imports and gold trading. And like these markets in East Asia, China is totally closed in the ’70s. It only started to relax a little bit on gold jewelry in the late ’70s, and then again in the ’80s. Taiwan was a closed market for a long time until the late ’80s when they opened up. So, the phenomenon of global markets moving from the West to East, was 30 years, and it escalated in the last ten years. And actually, one of the reasons is the participation of the China market. The China market was very much controlled by the People’s Bank. Under the so-called communist regime, all gold has to be purchased by the state, and if the user wants to buy gold, they have to buy from the central bank. So this central purchase allocation system lasted until 2002 when they set up the Shanghai Gold Exchange and allowed a market mechanism for people to sell gold and to buy gold through an exchange. Ever since they set up an exchange, we see the jewelry business become more vibrant because at that time then, people who want to produce gold jewelry, people who want to retail jewelry or wholesale jewelry, don’t need to get a special license from the People’s Bank anymore. It used to be they had to get a special license.
Now, right after that, no need to get license, it is just based on pure market demand, and the ability of the manufacturer to produce, and it’s really a free market economy for the jewelry market and the market picked up very fast. In 2002, the whole China Gold consumption is about 200 tons. Fast track to now, about 13 years, last year it was over 800 tons, and 2013, this year, we are talking about more than 1,000 tons. So in a space of 10-12 years, the market has increased by 5-6 fold, all in the gold jewelry area, as well as the investment areas.
David: The Third Plenum Congress reinforces the five-year plan transition in the economy away from government investment and toward enfranchising households, and increasing the consumption component of GDP. It seems that income, and income for the average person or family in China, is a very critical variable over the next several years. If, or when, we see an increase in income, we will continue to see, or maybe even see a further escalation in the gold price, or rather, gold demand, and we might assume, gold price. What are your thoughts on income trends in China?
Albert: That’s correct. We have a lot of independent studies talking about the emergence of the middle class in China and BCT has released, I reported not too long ago that by 2020 there will be 218 million middle class people in China. 218 million is actually double the current population of Japan. We know, before China took over as the second-biggest economy, Japan had the biggest economy in the world, and by 2020 we are going to have 280 million middle class, double the size of Japan. And these people are not just young people or old people, these are people who are economically active, creating wealth every day, and the wealth that they create they have to consume, and that is exactly in line with what you just talked about.
The government is encouraging domestic consumption, changing the economic model in China. Instead of relying very heavily on exports, China has to look inward, to encourage domestic consumption. And domestic consumption is either edible things, food and beverages, or then you have to talk about apparel, and talk about accessorizing to make yourself look pretty, and gold jewelry is one item that you naturally look for when you have accumulated enough wealth and you want to spend it.
And gold has a dual nature. It is both a commodity, and also an asset class in the financial market. The Chinese understand gold, and gold is a very simple asset that has only one price, and it is very accessible in China via the many gold shops in China and many banks who are providing all kinds of gold products to invest in, so the investment component of the gold market in China is also getting bigger and bigger.
In the beginning of 2002 when the Shanghai Gold Exchange was established the investment market was talking about 2 or 3 tons, and we are estimating that in 2013 this year the investment market is about 350 tons.
David: 350 tons for the investment market, up from 2 to 3 tons.
Albert: In ten years.
David: Ten years ago.
Albert: Ten years ago.
David: That’s absolutely fascinating. China surpassed Japan as the second largest economy, now China is surpassing India as the largest consumer of gold. They are also the largest producer of gold. There are several things. We are talking about general consumption of gold by individuals. Back in 2009, we had an update from the central bank and it had been many years where we had not heard about an increase in gold reserves. We can only speculate if they are adding to gold reserves today. What are your thoughts? Is the PBOC continuing to add to their gold reserves? Are they waiting for a propitious moment in time when they might announce it’s no longer 1,000, or just above that, tons, but it is somewhere competitive with, perhaps, the eurozone, in terms of gold reserves?
Albert: There you ask million-dollar questions. I think we have to understand that emerging markets, in particular, those emerging markets in Asia, are always looking at trying to diversify their foreign reserves, because of the wealth that was created in the last ten years. Be it Korea, or Thailand, or China, or Indonesia, the last ten years has given them the opportunity to accumulate a lot of wealth through the export business, and we have seen Thailand, we have seen Korea, we have seen India, all adding gold into their reserves, and they have made it very publicly announced at the time that they purchase. I think different countries have different policies of treating their reserve and reporting their reserve to IMF, and so we have to respect that.
But the fact that central banks invest like individuals, why individuals have chosen to invest more in gold, particularly after the 2008 subprime crisis, followed by all these crises, whether the euro or the global financial crisis, is that people are looking at the role of gold in their portfolio, and they keep putting in more percentage in gold, and hence we see there is an escalated increase in consumption in the investment sectors. And the case in point in China was in the last ten years, the investment component has increased from 2 tons to 350. It is a sign of not only the availability. Of course, availability counts. You can count the actual number of doors open for gold investment through banks – I would say more than 100,000 branches of banks have opened up for people to invest in gold.
David: In China?
Albert: In China.
David: 100,000 branches for banks.
Albert: You walk in, you want to buy either physical gold, or you can buy a gold savings account.
David: Tell me about the gold savings accounts, because this is something so foreign to a U.S. person dealing with a U.S. bank. Fortunately, they know enough to spell gold, g-o-l-d, but they could not tell you what number it is on the periodic table, and frankly, most people in the financial arena in the United States have never actually held, or are familiar with, the actual products. You can actually have gold backing your savings? How does that work?
Albert: These gold savings accounts are as simple as opening a savings account. The bank will buy on your behalf, the amount of gold that you are willing to purchase at the time that you purchase from them. And the mechanics of it is, they will put up the price of gold in gram form. So let’s say, today it is 200 renminbi per gram, you just tell the bank to credit into your account 1 gram of gold into your savings book and then at the same time debit 200 renminbi from your savings account, from your cash account to a gold account, you are debiting 200 renminbi, and then you are credited 1 gram of gold. And the bank will actually purchase that 1 gram of gold on your behalf.
Now you may say, purchasing 1 gram of gold is so tiny, how can a bank do that? But a bank can do that if they have millions of customers. If a million customers, each one at a different point in time purchases something, then they group it together, and at the back office they can purchase on behalf of the customer. This is how the bank has made gold saving so easy. And people are saving in gold in a unit of gold, not in a unit of currency.
David: That’s very unique. It’s interesting, Albert, you mentioned in your discussions earlier today that there is a proliferation of products, and will continue to be a proliferation of products. What you just described is that many of these products have one critical characteristic: Accessibility.
Albert: That’s correct.
David: Accessibility to everyone. One gram of gold is very accessible, if I work a day, a week, a month, in any of those time spans I should be able to save and buy 1 gram.
Albert: One of the banks, ICBC, has a program where they will actually take the order for a month. It is called a gold accumulation program. It is gold averaging. Let’s say this month has 20 working days, and I want to save $10 per day, so I say, “Bank, I want to buy $10 worth of gold every day in the next 20 days.” So in the beginning of the month I take $20 from your account and on the day, every day, I buy $10 worth of gold from you. If today, the price of gold is high, your $10 buys less gold. If the price of gold comes down, your $10 buys more gold.
And then over a year you will know how much gold you have accumulated, but it is no different from a spot purchase. The difference of this is that you are buying on the daily average, and also on the fixed amount. You ask why a bank can do that, $10 is a tiny amount, but you group a million customers, 2 million customers, each buying $10 is a lot of money.
David: It is.
Albert: And this is the economics for banks to do it. And unfortunately, in America, I know, if people want to buy gold they have to go to bullion houses, or coin dealers.
Albert: Financial institutions don’t get involved. Perhaps this is historical, that this business is a non-bank business. So, let the bullion houses run it. But in China, as I mentioned earlier on, during the early communist regime, nobody had private wealth, so everything was the state, and then when China gradually opened up, allowed personal wealth, the gold business was only gradually opened up in late 1970 in jewelry only, fully opened up since 2002 to everybody, there is no backage. There are no bullion houses, or bullion merchants, or coin dealers, with 100 years of history that say, “Hey, government, we are in this business, don’t let the bank take over our business.”
But in the case of China, it is a piece of paper, start from fresh. In those early days the World Gold Council, including myself, has been actually working with a regulator, that this market has to open up, and it has to have a healthy development, financial institutions should be involved in the gold business, because for one thing, they provide convenience, they provide credibility, and also, it is where People’s Bank put their money. So having these financial institutions deal with gold, to market gold, I think is the best distribution system, which China has adopted.
David: There is an issue that I think many of our listeners, many of our clients, have wondered about, have been confused by. Gold has been going down for two years, and yet, the demand dynamics have been fairly positive, particularly when you look at the role that China and India play. Over 50% of physical metals are consumed by these two countries. The U.S. market is 6%, according to the World Gold Council. How is it that the price is set largely by the U.S., when our footprint in the marketplace is a fraction of that you find in India and now, even more importantly, China?
Albert: I think the gold market, as I just alluded to, has just opened up about 42-43 years ago, since 1971, and the market started in London and New York. This is where the market started and trading is there, and all these logistics are there, and that was 40 years ago. As the market moved east, this is only the consumer that we’ve found, but the trading mechanism is still in North America and Europe.
And don’t forget, the other component of the gold market is the so-called derivatives market. The derivatives market and the futures market and the options market, all these financial products create our gold, actually they create, or engineer, our investment banking, which are, by and large, in the Western World.
So, in determining this flow of demand and supply, this also matters, these price-determining factors, which is the thing I talk about. Because the Eastern market just started about ten years ago, primarily focused on the consumer market, consumers are price-takers, consumers are not price-makers. Only dealers, the traders, are price-makers. The consumers are price-takers. And the market, let’s say, in China, started off with a consumer-driven market, and it has created this impact.
I think the future development of the Eastern market is to create the death of this other derivative product, the options, the futures, and the involvement of the China participant into the global trading market. And this, then, will be reflected fully, and that will be something that will be in the making in the next 10-15 years, that the global market will merge together. Right now it is a little bit lop-sided. It is market-making, trading here, price-taker, consumption market there. But the China market is evolving. There will be more people acting, people will be getting involved in the global market.
David: So the futures exchange that was started just a few years ago here in China will go a long way toward developing the derivative market for gold, and so then perhaps the other metals, as well. There is a positive element to that. The negative element, if there is one, is that it invites speculation, and perhaps more volatility, and I wonder if more people are trading gold and silver via the derivatives markets, with added volatility. Does that begins to change the general person’s perception about the stability of gold. Does it undermine, in some sense, those gold accounts and those private holdings of gold, seeing the price erratically moving up and down, not on the basis of supply-and-demand fundamentals, but perhaps games that can be played in the futures and options markets? What comes to mind is, in the U.S. market, you can sell an asset short without having the asset in your possession. I don’t have to own gold to sell it short. Perhaps that can be addressed by the futures exchange here.
Albert: I think in the gold market, like any commodity market, there will be a layer of users, a layer of speculators, and a layer of so-called liquidity providers, which then makes it a market where somebody will take risk for you because they are more risk-taking, but people who are real users don’t want to take the risk and want someone to share the risk. I think a healthy market will have all components with many users. At the moment, the China market, as I said earlier, is very heavily driven by the consumption market. We need a layer of this to make the market more complete, and also product associated with that in order to make the market more complete. And it currently is lacking, in terms of product.
The other good thing is, in terms of knowledge, the Western World, the American and European world, as people have been in this business for long enough, there is a lot of knowledge base being accumulated, which is beneficial when they are participating in the market. Here in the East, we are lacking this kind of talent. This requires years to build up into an understanding of how it works globally. So I don’t see that this is something contradictory. A healthy market needs to have all components and all participants, all working toward a goal of making the market liquid for people who want to hedge, or for people who want to buy, or people who want to use it and don’t want to take the risk, there are all different mechanisms for them to use, and at the moment is lacking sufficient development in the Asian market, which we need to look at very seriously.
David: Albert, one last question as we wrap up. Most of our questions have dealt with demand components. Looking at the supply of precious metals, you have an inelastic supply. You can’t just go out and double production of gold from mines, and there is a set amount of gold that has ever been created. If, in fact, there is continued increase in demand, given the demographic changes, and the economic reforms and political reforms here in China, what do you imagine occurring with supply constraints, and second to supply constraints, how does that impact the price?
Albert: Supply constraints are not a new component. It has always been there because there is a 6-7 year lag behind exploration, or behind a price curve, how supply can respond to it. The market has been buffered by the adjustment of the scrap gold. The scrap gold, I would say, is a buffer which is price determinant. When the price was high you saw more people willing to part with their old jewelry, or somehow some of the investment that they forgot about a long time ago, suddenly they remember it and they take it out and market it. So I would say that I’m not too worried about the supply constraints because there was always a buffer or store of this recycled gold, and this recycled gold, of course, is subject to price, and all the gold that has been mined is 174,000 tons, and it is there forever. And this amount will gradually add up at the speed of 2,500 tons per year, and this is always there when people want to meet the metal price.
David: It is a matter of price. Well, Albert, thank you so much for your time, your insight, the continued efforts through the World Gold Council, to bring clarity and insight into the gold market. We appreciate you, and we appreciate your work. Thank you.
Albert: Thank you, David.