Debunking the Thomson
Reuters GFMS Gold Survey 2016 report. New information provides a more
detailed perspective on the Chinese domestic gold market.
In the Gold
Survey 2016 report by GFMS that covers the global gold
market for calendar year 2015 Chinese gold consumption was assessed at 867
tonnes. As Chinese wholesale
demand, measured by withdrawals from Shanghai Gold Exchange designated vaults,
accounted for 2,596 tonnes in 2015 the difference reached an extraordinary
peak for the year. In an attempt to explain the 1,729 tonne gap GFMS presents
three brand new (misleading) arguments in the Gold Survey 2016 and reused one
old argument, while it abandoned five arguments previously put forward in
Gold Survey reports and by GFMS employees at forums. Very few of all these
arguments have ever proven to be valid, illustrated by the fact that GFMS
perpetually keeps making up new ones, and thus gold investors around the
world continue to be fooled about Chinese gold demand. For some reason GFMS
is restrained in disclosing that any
individual or institution in China can directly buy and withdraw gold at the
Shanghai Gold Exchange, which is the most significant
reason for the discrepancy in question.
According to my estimates true Chinese gold demand in 2015 must
have been north of 2,250 tonnes.
The reason I keep writing about this subject (the discrepancy in
question) is that it eventually will enable me to show
that global physical gold supply and demand as presented by GFMS is just the
tip of the iceberg. And, as stated in my
previous post true physical supply and demand is far more
relevant to the gold price than the numbers by GFMS.
New Information has enabled me to shine a fresh light on the Chinese
domestic gold market, so we’ll zoom in once again to get the best assessment
of the mechanics of this market. This post is part two of an overview of the
Chinese gold market for 2015. In the
first part we focused on the (paper) volumes traded on the Shanghai Gold
Exchange (SGE) and Shanghai International Gold Exchange (SGEI). In this post
we’ll focus on the size and mechanics of the Chinese physical gold market,
while at the same time addressing the fallacious information in the Gold
Survey 2016 (GS2016).
The Gold Surplus In China According to GFMS
First, let’s have a look at an overview of the key supply and demand data
points for 2013, 2014 and 2015, as disclosed in Gold Survey reports by GFMS.
Without GFMS mentioning the volume of SGE withdrawals for 2015
(2,596 tonnes) in the GS2016 they disclose apparent supply in the Chinese
domestic gold market at 2,293 tonnes. Mine output accounted for 458
tonnes (page 22), scrap supply for 225 tonnes (page 36) and net import was
1,610 tonnes (page 54). The latter is incorrect because GFMS has double
counted 63 tonnes Australia exported to China, as demonstrated in my post Australia
Customs Department Confirms BullionStar’s Analysis On Gold Export To China,
but the let’s not nitpick.
On other pages in the GS2016 we read total (consumer) demand for
2015 was 867 tonnes (page 52), consisting of retail bar demand at 199 tonnes
(page 52) and gold fabrication at 668 tonnes (page 41). According
to their own data there was a surplus of 1,426 tonnes (2,293 – 867) in the
Chinese gold market. Whilst, in 2013 the surplus accounted for 826 tonnes and
in 2014 for 917 tonnes, according to data disclosed in previous Gold Survey
reports. Meaning, in the past three years GFMS has observed 3,169 tonnes (826
+ 917 + 1,426) that were supplied to China not to meet demand, but for
reasons that are constantly changing - wait till we get to
the plea.
Remarkably, in the GS2016 report GFMS writes:
Hong Kong remained the primary conduit of Chinese gold imports, though
its share has been contracting since 2013 … Gold import from
this conduit was traditionally regarded as a simple proxy to estimate Chinese
consumption … The declining dominance of Hong Kong and the increasing proportion
directly routed into Beijing and Shanghai therefore points to the necessity
of changes on methodology to calculate Chinese gold demand.
Exhibit 2.
GFMS states that when all Chinese imports came in through Hong Kong this
inflow was “regarded as a simple proxy to estimate Chinese consumption”,
but now gold is also being imported directly from countries like Australia,
the UK and Switzerland, such inflow “points to the necessity of changes
on methodology to calculate Chinese gold demand”. How can it be that a
couple of years ago Chinese gold import from Hong Kong reflected demand, but
a few years later direct massive additional import from the UK and Australia
does not reflect demand?
As you probably know (otherwise you can read it here)
most of the gold supply in China flows through the SGE. Consequently
wholesale demand can be measured by the amount of gold withdrawn from SGE
designated vaults. Comparable to the difference between apparent supply and
consumer demand shown in exhibit 1, is the difference between SGE withdrawals
and consumer demand – the latter being even wider.
In the GS2016 GFMS has written a chapter fully dedicated to the humongous
difference between SGE withdrawals and their assessment of demand. The
chapter is titled “A Review And Explanation Of How China’s SGE’s Withdraw
Numbers Are Impacted By Other Trading Activities”. In this post we’ll
only briefly discuss whether the arguments are valid, as one of them has to
do with China’s highly complex VAT system and I like to expand on this
subject in detail in a separated post. However, we’ll expose more of
the mechanics of the Chinese domestic gold market in this post, which
conveniently demonstrates why nearly all the arguments by GFMS that will be
discussed later on are bogus.
This might surprise you, but I actually had fruitful correspondence in the
past months with a Senior Precious Metals Analyst at GFMS and a Senior
Analyst at Metals Focus (MF). Both
gentlemen have been very helpful in sharing their methodology for computing
(Chinese) physical supply and demand data. I have to say
both of them have answered all my questions. This service is seldom
provided by the the World Gold Council, the Bank Of England or the
London Bullion Market Association. Based on the information shared
by GFMS and MF I’ve refined my view on our on-going disagreement with respect
to the Chinese gold demand.
The Mechanics Of The Chinese Domestic Gold Market And Estimating
True Chinese gold demand.
Let us refresh our memory regarding the structure of this market. In the
Chinese domestic gold market nearly all physical gold supply and demand
flows through the SGE because all bullion import1 into the
domestic market is required to be sold first through the SGE and there are
rules and tax incentives that funnel nearly all domestic mine output and
scrap supply through the central bourse. As gold in the Chinese
domestic market is not allowed to be exported1, the
amount of gold withdrawn from SGE designated vaults therefore serves as a
decent indicator for wholesale demand.
However, there are a few possibilities through which SGE
withdrawals can be distorted for measuring demand.
- If metal is in some manner recycled2
through the central bourse. When gold is bought and withdrawn from the
SGE vaults and promptly sold and deposited into SGE vaults (for
example though process scrap), these flows would
inflate SGE withdrawals while not having a net effect on the price of
gold, hence the related supply and demand volumes would be deceiving. Although
article
23 from the Detailed
Rules for Physical Delivery Of the Shanghai Gold Exchange states
that bars withdrawn from SGE designated vaults are not allowed to
re-enter these vaults, this rule does not fully prevent gold from being
recycled through the exchange. If bars withdrawn are re-melted and
assayed by an SGE approved refinery they are allowed back into the
vaults. And thus, some recycled gold can inflate SGE withdrawals as a
measure for true demand.
- Another example that could distort SGE withdrawals is when
international members would withdraw gold from vaults of the SGEI in the
Shanghai Free Trade Zone2 (SFTZ), these withdrawals are
included in the total SGE withdrawal figure, to store elsewhere in the
SFTZ or export abroad1.
For ease of reference we’ll label the amount of gold recycled
through the SGE that has no net effect on the price, and gold withdrawn from
SGEI vaults that is not imported into the Chinese domestic market as distortion2.
Therefor, in order for us to make the best estimate of true Chinese gold
demand we should subtract the amount of distortion from SGE withdrawals. The
crux of true Chinese gold demand is establishing the amount of distortion,
that’s it.
Previously I assumed the scrap numbers by GFMS mainly reflected gold that
was making it’s way back to the SGE and these flows included disinvestment.
Both assumptions appeared to be false.
- Scrap numbers from GFMS and MF, although they’re
certainly not equal, are collected from refiners that are not all SGE
members. Implying not all refineries scrap is making its way to the SGE,
but is sold through other channels.
- Scrap numbers from GFMS and MF include jewelry
and industrial products sold back from consumers, they do not include
disinvestment that flows directly through refineries to the SGE. GFMS
does measure disinvestment at retail level, for example, when people
sell bars back to banks these will get netted out to compute net retail
bar demand. But if an affluent investor or institution wants to sell
(disinvest) 500 Kg they’re likely to approach a refinery directly.
In my nomenclature “distortion2” is the part that
inflates SGE withdrawals as a measure for demand, “scrap” is supply from sold
fabricated products like old jewelry, and “disinvestment” is supply coming
from investment bars sold directly to refineries making its way to the SGE.
As a consequence, these new insights regarding scrap and disinvestment
supply have changed my perspective on the Chinese supply and demand balance.
To reach a more clear understanding of what was just described, I’ve
conceived an exemplar graph to visually interpret the Chinese physical gold
supply and demand balance. Have a look.
As you can see in the graph above total supply and total demand
are exactly equal, this is because one cannot sell gold without a buyer or
buy gold without a seller. Consequently we can gauge demand by measuring
supply. Please note, in the supply and demand balance shown above,
and in our further investigation, two elements are left out. On the supply
side I left out stock carry over in SGE vaults from previous years, as this
information is not publicly available. On the demand side I left out gold
bought at the SGE that was not withdrawn from the vaults, as this information
is also unknown.
In all its simplicity the example chart shows that the difference
between consumer demand and true Chinese gold demand is caused by direct
purchases from individual and institutional clients at the SGE. While GFMS
merely counts demand at retail level, by jewelry and bar sales at shops and
banks, the real action is at wholesale level, at the SGE.
GFMS fully neglects direct purchases at the SGE (demand) and any
corresponding disinvestment to the SGE (supply). Hence our disagreement.
At the moment the SGE has almost
10,000 institutional and over 8.3 million individual clients that are
able to buy gold directly at the SGE. There is even an SGE
smartphone application called “Yijintong”
that allows anyone with an internet connection to open an SGE account and
trade directly on the SGE wholesale platform enjoying the lowest spreads in
China. Furthermore, the
SGE counts 183 domestic members and 63 international members.
From
the SGE (December 2015):
Yijintong is the first professional mobile terminal of state-level gold
market jointly researched and developed by the Gold Exchange and all its
members …
Yijintong has comprehensive functions and advanced systems, which
are compatible with various Android and iOS operating systems. Right now, it
possesses market, transaction, search and information functions, so investors
can conduct transactions via mobile phones … In early 2016, Yijintong will
support mobile phone online account opening. After that, new users will be
able to establish Shanghai Gold Exchange’s “Gold Account” business on their
mobile phones directly, and avoid the step of visiting stores. It has brought
convenience for personal investors to participate in gold and silver
transactions.
Investors can log into Yijintong through mobile phones to conduct daily
and nightly market transactions and search, utilizing all-day mobile phone
services for gold and silver transactions, allowing Yijintong to become a
mobile phone gold and silver investment edge tool that integrates functions
and practicability, which also helps investors to do well in both work and
financial management.
Exhibit 7.
Exhibit 8. Download methods: iOS and Android mobile phone users
can scan the QR code and open it in the browser to download and install
directly.
The China Gold Association (CGA) makes yearly estimates of direct
purchases at the SGE. In their Gold Yearbook 2013 direct purchases (net investment)
were assessed at 1,022 tonnes, computed as SGE withdrawals minus consumer
demand. The CGA neglects any distortion flowing through the SGE hence I
stopped using their methodology. Have a look at the screenshot below.
Unfortunately me personally can’t exactly compute true Chinese gold
demand, as I don’t have business relationships with all Chinese refineries to
gauge disinvestment supply flowing to the SGE. In any case, these are the
formulas:
True Chinese demand = net import into the Chinese domestic market1
+ scrap + disinvestment + domestic mine output
Although a tad complex, the exact formula including SGE
withdrawals is:
SGE withdrawals = net import into the Chinese domestic market1
+ (domestic mine output – domestic mine output that not flows to the
SGE) + (scrap – scrap that not flows to the SGE) + disinvestment + distortion
+ (an amount equal to “domestic mine output that not flows to the SGE + scrap
that not flows to the SGE” being disinvestment or distortion)
Although not all scrap as disclosed by GFMS ends up at the SGE, it’s
definitely all genuine supply and therefore useful in the first formula
above. Same goes for domestic mine output.
The part of scrap and domestic mine output that doesn’t travel to the SGE
(although being genuine supply) must be replaced by either disinvestment or
distortion at the SGE (exhibit 4). Note, in the knowledge direct purchases
from the SGE are immense in China (exhibit 9) we can safely assume that
disinvestment flows to the SGE are sizable as well.
My new insights unfortunately do not imply that we can make a more
precise estimate of true Chinese gold demand. However, I think the best
approach is to set the lower bound of true Chinese gold demand at net import1
+ mine output + scrap. While I think true demand is likely higher because
disinvestment to the SGE can be significant.
Sadly because disinvestment is unknown, distortion is also unknown
(exhibit 4)
Let’s return to our discussion with GFMS. The big question is of
course, how can total Chinese gold demand by GFMS be 867 tonnes, in a market
where mining output accounted for 450 tonnes (source),
net imports by my calculations accounted for 1,575 tonnes1, and
there is also scrap and disinvestment supply, but
export is prohibited and the premium on gold in China
was positive throughout the whole year?! This cannot be.
I would like to show a real life example to illustrate what’s going on the
Chinese gold market: In 2015 the Chinese stock market (the Shanghai
Composite Index) declined by 40 % from June till August. Seeking for a safe
haven the Chinese bought physical gold en masse
directly at the SGE; some weekly withdrawals in July, August and September
transcended 70 tonnes. The gold was of course sourced by imports (look at the
premium in exhibit 10), yet GFMS doesn’t consider this to be demand.
The Arguments
Although true Chinese demand cannot be less than SGE withdrawals
minus distortion, GFMS pretends their arguments can explain the
gigantic gap between SGE withdrawals and consumer demand. Illustrated
in the chart below.
All arguments presented can only explain the size of distortion
(exhibit 4), not the difference between SGE withdrawals and consumer demand!
Actually, I should stop writing here, but I won’t. Let’s briefly go through
these arguments to see if they make any sense.
The chapter in question, “A Review And Explanation Of How China’s
SGE’s Withdraw Numbers Are Impacted By Other Trading Activities” (Gold
Survey 2016), surprisingly lists three new arguments…
- Tax avoidance (page 56).
- Financial statement window dressing (page 58).
- Retailers selling unsold inventories directly to
refiners (page 58)
…and one old argument:
- Gold leasing activities and arbitrage opportunities (in
China gold is money at lower cost) (Gold Survey 2016, page 57, Gold
Survey 2015, page 78)
Given the fact GFMS has gone all out in this chapter one would assume it
to be complete. But strangely, arguments presented in prior Gold Survey
reports and at forums have been abandoned. The following arguments were
presented by GFMS in recent years:
- Wholesale stock inventory growth (Augustus
2013) (Gold Survey 2014, page 88)
- Arbitrage
refining (Gold Survey 2014, page 88) (Reuters
Global Gold Forum 2015)
- Round
tripping (Gold Survey 2014, page 88) (Gold Survey 2015, page 78, 82)
- Chinese commercial bank assets to back investment
products. “The higher levels of imports, and withdrawals, are
boosted by a number of factors, but notably by gold’s use as an asset
class and the requirement for commercial banks to hold physical gold to
support investment products.” (Gold Survey
2015, page 78).
- Defaulting gold enterprises sent inventory directly to
refiners and SGE (Gold Survey 2015 Q2, page 7)
What happened to arbitrage refining as described by GFMS Senior Precious
Metals Analyst Samson Li at the Reuters Gold Forum in 2015? Has this
arbitrage opportunity ever existed or did the market change and now the
opportunity is closed? I
never thought this argument was very compelling. Maybe GFMS changed its
mind on arbitrage refining.
What happened to the round
tripping of gold between Hong Kong and Shenzhen, put forward in the Gold
Survey 2014 and 2015 as a reason that inflated SGE withdrawals? Did criminals
stop using this scheme, or did GFMS find out it never inflated withdrawals
because gold flows through Free Trade Zones are separated from the Chinese
domestic gold market and the SGE system1? In several posts I’ve
extensively shown round tripping does not inflate SGE withdrawals, for more
information click here.
What happened to the argument Chinese commercial banks buy and withdraw
gold at the SGE to back investment
products they offer to customers, a practice which boosts import and
withdrawals but was not considered demand by GFMS? Or is it demand now, as
GFMS dropped this argument from the list? Ok, gotcha.
Now briefly about the new arguments listed by GFMS in the GS2016:
The definition of
tax avoidance is that it’s a legal way to pay as little
tax as possible. However, the scheme GFMS describes in the GS2016
report is tax evasion,
which is highly illegal, and worst case the perpetrator can suffer life
imprisonment. This is not some legal loophole as GFMS purports (page 56).
We initially became aware of the scheme in 2013 when it first
emerged, but based on information gathered from our contacts, the number of
industry participants mushroomed in 2014 and 2015 as other traders became
aware of the potential loophole.
By writing the scheme is a way of tax avoidance and a loophole GFSM is
misleading their readers. In addition, this illegal scheme did not emerge in
2013. The tax rules are now the same as when the SGE was erected in 2002. In
fact, if you click here, you can
read an article about the same crimes in 2009. But as mentioned before, we’ll
save the details for a forthcoming post, when we’ll also address “financial
statement window dressing” and “retailers selling unsold inventories
directly to refiners”.
About gold leasing that would inflate SGE withdrawals, I’ve written
numerous blog posts about this in the past. Best you can read my post Chinese
Commodity Financing Deals Explained. In all the posts I’ve written over
the years on the subject I’ve stated that the gold leased is not likely to
leave the SGE vaults except when the gold will be used for jewelry
manufacturing (which is genuine demand). Effectively, all the gold leasing by
enterprises, investors and speculators to acquire cheap funding happens
within the SGE system and do not inflate withdrawals. Ironically, in the latest
World Gold Council (WGC) report it’s written [brackets added by me]:
Over recent years we have observed a rising number of commercial banks
participating in the gold leasing market. … It’s estimated
that around 10% of the leased gold leaves the SGE’s vaults. The majority is
for financing purposes and is sold at the SGE [and stays within the SGE vaults]
for cash settlement.
So, I hope to have clarified why according to my estimates true
Chinese gold demand in 2015 must have been north of 2,250 tonnes (import
1,575 tonnes, mine output 450 tonnes, scrap supply 225 tonnes). More details
in the next post when we will discuss the tax scheme.
Footnotes
1. Estimating China’s net gold import is difficult. For one, because
China’s customs department doesn’t publicly disclose its cross-border trade
statistics for gold so we depend on bullion export data (HS code 7108)
from the rest of the world. Data from Hong Kong, the UK, Switzerland, the US,
Canada and Australia is publicly available, but for example data from South
Africa is not. Therefor provisional data on China’s net import is not always
fully accurate. Only when the CGA publishes the import amount in their Gold
Yearbook can we know for sure. My estimate is 1,575 tonnes for 2015.
Net bullion exports to China in 2015: Hong Kong 861
tonnes, Switzerland 292 tonnes, the UK 285 tonnes, the US 6
tonnes, Japan 5 tonnes, Australia 124 tonnes, Canada 3 tonnes.
In China gold is not allowed to be exported from the domestic market (SGE
Main Board). However, gold is allowed to be imported into / exported from
China through processing
trade, usually done in Free Trade Zones. This is the only way gold can be
exported from China. Note, processing trade flows are completely separated
from the Chinese domestic gold market. For detailed information read my post Chinese
Cross-Border Gold Trade Rules.
In order to track how much gold China is net importing, it’s
necessary to net out bullion export to China by foreign countries, with
import from China by foreign countries (HS code 7108). Although, it’s also
possible that bullion is imported into China through processing trade
and exported as jewelry (China has a vast jewelry manufacturing
industry), which falls under a separated trade category (HS code 7113).
Suppose, a jewelry manufacturer in Shenzhen import 2 tonnes of gold from Hong
Kong under HS code 7108 through processing trade, processes the gold into
jewelry to subsequently export the finished products back to Hong Kong under
HS code 7113. This would blur our view on net bullion import by China,
however I neglect this phenomenon in my calculations.
The fine gold content in jewelry exported from China (HS code
7113) is very difficult to measure as the total value of the products shipped
also contain other precious metals, gems and includes the fabrication costs.
Hence, the value and weight of jewelry exported from China does not reveal
the fine gold content. The reason why I do not adjust net bullion inflows
into China by jewelry outflow is because the gold content in jewelry exported
from China is roughly offset by imports of gold doré or gold as a by product
in ores and concentrates.
For example, the most recent CGA Yearbook in my possession, covering
calendar year 2014 (exhibit 13), states “Chinese domestic and overseas
gold mining output” was 512.775 tonnes. In the same report it’s
mentioned “domestic mining output” accounted for 451.799 tonnes,
implying overseas mine supply accounted for 60.976 tonnes. And thus,
I net out overseas mining imported into China (60.976 tonnes) against jewelry
exported from China. If I find more information on Chinese
cross-border gold trade flows I will adjust my methodology accordingly.
Last but not least, gold can be imported through processing trade into the
Shanghai Free Trade Zone (SFTZ) where the Shanghai International God Exchange
(SGEI) vaults are located. Potentially, this gold in SGEI vaults, once sold
to foreigners is withdrawn and exported abroad (inflating SGE withdrawals).
However, a source at ICBC has indicated to me that regarding physical
flows the SGEI is mainly used by Chinese domestic banks to import gold into
the Chinese domestic market, at least this was the case until December 2015.
So I don’t see a possibility there were exorbitant large volumes of gold in
SGEI vaults in 2015, or have been withdrawn and exported.
The only noteworthy imports from China (the SGEI) I have observed are by
India, which has taken in 370 Kg during 2015 (source Zauba), and by
Thailand that presumably bought 7 tonnes (source COMTRADE).
Exhibit 14.
For more information on the SGEI read my posts, Workings
Of The Shanghai International Gold Exchange and What
Happened To The Shanghai International Gold Exchange?
2. For the sake of simplicity I have categorized under
“distortion” everything that is not true demand, namely: process
scrap, stock inventory change, arbitrage refining (if it exists), the VAT
scheme, smuggling and SGEI withdrawals.