What came to light as on odd discrepancy between GFMS’ Chinese gold demand
and “apparent supply” has proven to be a tenacious cover-up by the oldest
consultancy firm in the gold market. And not only does GFMS publish
incomplete and misleading data on Chinese gold demand, all their supply and
demand data is incomplete and misleading. As a result, the vast majority of
investors worldwide has been brainwashed to believe total gold supply and
demand mainly consists of global mine output and jewelry demand. In
reality, the supply and demand data GFMS publishes is just the tip of the
iceberg, but it’s reluctant to admit this publicly or their business
model would be severely damaged.
GFMS has denied all allegations about their incomplete Chinese gold demand
statistics by continuously making up false arguments. Therefore,
BullionStar will debunk, once more, such arguments spread by GFMS – which are
supposed to explain how from January 2007 until September 2016 the difference
between GFMS’ Chinese gold demand and apparent supply reached over 4,500
tonnes – in order to expose true Chinese gold demand.
Since 2013 I’ve witnessed GFMS shamelessly present nine arguments in their
Gold Survey reports, but along the way abandoned the arguments that I had
debunked on these pages. Indeed, few of all these arguments have ever proven
to be valid, illustrated by the fact that GFMS perpetually keeps making up
new ones. What’s left is to disparage are the final three arguments from
GFMS’ most recent annual report: the Gold Survey 2016 (GS2016).
Because GFMS chooses their arguments to be ever more complicated, I’ll have
to be precise in my wordings not to allow any margin for interpretation
errors. For detailed information regarding the mechanics of the Chinese gold
market and supply & demand metrics readers can click the links provided.
Debunking Final GFMS Arguments
In
the Chinese domestic gold market nearly all supply (import, mine output,
scrap supply) is sold through the Shanghai Gold Exchange (SGE), and so
Chinese wholesale gold demand can be measured by the amount of gold withdrawn
from the SGE vaults; data published on a monthly basis. As I’ve been
reporting on withdrawals from the Chinese core exchange since 2013, the
debate between me and Western consultancy firms like GFMS with respect to
true Chinese gold demand has centered around these infamous SGE withdrawals
(exhibit 1). Per mentioned above, GFMS has put out nine arguments in recent
years explaining their reader base why SGE withdrawals do not reflect gold
demand. Firstly, let us have a look at the five arguments now abandoned by
GFMS:
- 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 send inventory directly to
refiners and SGE (Gold Survey 2015 Q2, page 7)
No need to discuss these anymore, as GFMS dedicated a full chapter in the
GS2016 report titled, “A Review And Explanation Of How China’s SGE’s
Withdraw Numbers Are Impacted By Other Trading Activities”, in which the
arguments above are not listed, implying GFMS ceased to recognize them as
relevant. However, there are three new arguments listed, and one old one,
that will be discussed in this post:
- Tax avoidance (Gold Survey 2016, page 56).
- Financial statement window dressing (Gold Survey 2016,
page 58).
- Retailers selling unsold inventories directly to
refiners (Gold Survey 2016, page 58)
- Gold leasing activities and arbitrage opportunities (in
China gold is money at lower cost) (Gold Survey 2016, page 57, Gold
Survey 2015, page 78)
Because gold
leasing is an old argument it will only briefly be addressed here.
1. Tax Avoidance
This argument entails an illegal Value-added tax (VAT) invoice scheme.
Although this scheme exists, it can not have the impact on SGE
withdrawals like GFMS wants you to think.
GFMS introduces its special investigation chapter by stating:
TAX AVOIDANCE
The first and foremost factor behind why we believe the SGE’s withdrawal
number differs from the country’s total gold demand is related to China’s
current tax system, with some people exploiting this grey area.
… the number of industry participants mushroomed in 2014 and 2015 as other
traders became aware of the potential loophole.
The GFMS team uses the terms “tax avoidance” and “loophole”. For the ones
that don’t know, tax avoidance and tax evasion are two opposing practices.
Tax avoidance is the legal usage of a tax regime to one’s advantage in order
to reduce the amount of tax payable by means that are within the law (Wikipedia). Tax
evasion is the illegal evasion of tax payable (Wikipedia). In other
words, tax avoidance is legal while tax evasion is illegal. In the
introduction the GFMS team pretends the tax scheme is legal, while this is
anything but true. In
China one can risk life imprisonment or the death penalty when caught for tax
evasion:
Whoever forges or sells forged special invoices for value-added tax shall,
if the number involved is especially huge, and the circumstances are
especially serious so that economic order is seriously disrupted, be
sentenced to life imprisonment or death and also to confiscation of property.
Then, to add to the confusion, further down the GFMS team writes, “of
course, all of the activities are considered illegal by the Chinese
government.” Maybe GFMS doesn’t understand the difference between tax
avoidance and tax evasion, two diametrically different practices, which makes
their professionalism highly questionable.
GFMS writes, “the first and foremost factor behind why we believe the
SGE’s withdrawal number differs from the country’s total gold demand is
related to China’s current tax system”. So we’re supposed to believe that
after all these years – GFMS is operational for decades – and all that has
been written on the Chinese gold market, now GFMS has finally found the
“first and foremost reason” why SGE withdrawals do not reflect demand? Or did
it recently stumble upon this scheme to use in its defence? I think the
latter.
The understand the details of this illegal VAT invoice scheme please
read my post The
Value-added Tax System In China’s Domestic Gold Market, written to
substantiate this blog post.
Regarding using VAT invoices for tax evasion, the GFMS team must have read
this news
article by the Shenzhen Municipal Office. In the news, a company called
Longhaitong used SGE VAT invoices for tax evasion. How does it work? For
example: the prevailing spot gold price on the SGE is 234 CNY/gramme. Company
X tells a mom-and-pop jewelry fabricator that they can supply good
quality cheap gold, say the SGE spot price minus 2 CNY/gramme, but without a
VAT invoice. The mom-and-pop fabricator wants to buy 1 Kg so it gives
232,000 CNY to company X (the mom-and-pop shop will fabricate jewelry from the
gold to be sold covertly without VAT to consumers). Company X buys 1 Kg of
gold on the SGE at the spot price of 234 CNY/gramme, paying 234,000 CNY. Then
company X gives the gold to the mom-and-pop fabricator but keeps the VAT
invoice. Up till now, company X has incurred a loss of 2,000 CNY (bear
in mind, because of China’s VAT system buyers pay the spot price at SGE which
doesn’t include any VAT, but when companies withdraw the metal they receive a
VAT invoice from the tax authority that describes 17 % of the all-in price is
VAT, because the gold leaves a VAT exempt environment). However, company
X can then sell the VAT invoice for 4,000 CNY to, in example, a brick trader.
Company X effectively makes 2,000 CNY. If the brick trader alters the subject
header on the invoice from “gold” into “bricks” he can tax deduct 34,000 CNY
(234,000 / (1+17%) * 17%) from his VAT payable. In this scenario, the brick
trader effectively makes 30,000 CNY (34,000 CNY minus the 4,000 it paid to
company X). Naturally, all exemplar numbers can vary.
For sure this illegal VAT scheme exists and has been used. But, only to a
limited extent – in my conclusion I will tell you the upper bound. Mind you,
in the scenario I just described the gold does meet demand, albeit through an
illegal scheme!
In addition, the discrepancy between the GFMS Chinese demand figures and
SGE withdrawal numbers first appeared in 2008, and have exploded
since 2013.
In the GS2016 GFMS writes:
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.
The GFMS team wants readers to believe that it was the illegal tax scheme
that caused the discrepancy between GFMS Chinese demand and SGE withdrawals
since 2013, but the VAT regulation regarding gold has remained unchanged
since 2002. Is it believable that criminals found the possibility of these
illegal practices 11 years later, exactly when Chinese demand exploded? No.
If you click this
link, you will see a similar incident that happened in 2010 and was reported
at the end of 2011. The VAT scheme has existed for many years and crime
incidents happen, but not like GFMS wants you to think.
If the GFMS team was indeed aware of the illegal practices as late as
2013 and thought that was the year when these practices first emerged, then
GFMS is not properly informed in the Chinese gold market.
More from GS2016:
One of our contacts with some understanding of this activity estimated
that just from Shenzhen alone, such trading activities could have possibly
impacted the SGE’s withdrawal volumes by a few tonnes per day. Approximately
half of the gold being sold in the black market at discounts would eventually
flow back to the SGE.
In my opinion this is speculation. According to the news
available, buyers in the black market are those who want the gold to
fabricate jewelry that eventually is being met by true demand. In contrast,
GFMS wants readers to believe half of the gold involved in the scheme flows
back to the SGE. But bars withdrawn from the SGE vaults are not allowed to
re-enter, only if they’re recast into new bars by SGE approved refineries
(the gatekeepers of the Chinese chain of integrity). For gold involved in VAT
invoice schemes to flow back to the SGE, technically SGE approved refineries
would be complicit. Though the SGE conducts a
campaign to crack down on such illegal tax activities.
As stated above, the VAT scheme is real, though it can not involve as
much gold as GFMS wants you to believe. Unfortunately we can’t compute the
exact amount recycled through the SGE through this practice, we can
only identify the upper bound, which we’ll do in the conclusion.
As background information: when gold is withdrawn from SGE vaults and
promptly flows back to the SGE, this overstates withdrawal numbers
as it creates equal demand and supply that has no net effect on the price.
Therefore, such recycle flows should not be counted in supply and demand
statistics. Readers can click this
post for more information.
Financial Statement Window Dressing
The GFMS team writes:
Some companies attempted to build up their revenues by merely trading and
withdrawing physical gold from the SGE vault so it would appear they have a
high level of business activity, while in reality there is no real genuine
demand behind this.
Trading can build up revenues but why do these companies withdraw gold?
That doesn’t make economic sense. If a company buys gold on the SGE and
leaves the gold in the SGE vault, the gold will be recorded as “inventory” on
the company’s balance sheet. If the company then withdraws the gold, the gold
is still regarded as “inventory”, so what’s point of withdrawing gold?
Changing the location of the gold doesn’t change the accounting nature of the
gold.
It is technically possible to buy gold on the SGE, withdraw, refine it
into new bars, redeposit the bars into SGE vaults and sell the bars. However,
this will incur expenses. When the point is “window dressing”, why incur
unnecessary expenses? More logic would be to leave the gold in the SGE
system. This argument is false.
Retailers Selling Unsold Inventories Directly to Refiners
In this section, the GFMS team writes:
Retailers often prefer to sell a portion of their working stock at a
discount directly to refiners in order to maintain inventories at a desirable
level.
Why waste the fabrication costs of jewelry when retailers can sell the
products at a discount to customers?
GFMS writes:
By selling to refiners, even if such a transaction may result in a
financial loss, it still counts as revenue; but doing the latter only
increases the expense category and provides no benefits to the company’s
revenues or asset value.
Let’s assume an unsold jewelry stock is worth of 1,000 CNY. The retailer
sells it to a refiner at 800 CNY, which results in a loss of 200 CNY. The
inventory item on the retailer’s balance sheet is reduced by 1,000 CNY and
the cash item increases by 800 CNY. The net result is that the total asset
value of the retailer decreases by 200 CNY, then how can this practice
provide benefits to the asset value?
GFMS writes:
As an example, during a field research trip earlier this year, a local
refiner indicated that one jewellery retailer has sold approximately 40
tonnes of unsold jewellery pieces to them in a single two month period.
But this quote doesn’t mention what the unsold jewelry pieces
become in the end. Possibly, these pieces become gold wires, which might be
used by jewelry fabricators instead of becoming gold bars that flow back to
the SGE. GFMS pretend the majority of gold in China is continuously recycled through
the SGE, which is not true. Many refineries are note even approved by the SGE
to supply gold bars.
Gold Leasing Activities And Arbitrage Opportunities
This argument is one of the oldest and most persistent. But we can be
short about this; in the Chinese gold lease market nearly all trades are
conducted within the SGE system. Any speculator borrowing gold for cheap
funding will not withdraw his metal loan, as his incentive is to sell spot
for the proceeds. GFMS fools readers by mentioning high leasing activity, but
it neglects to mention leases aren’t withdrawn from the vaults. Only a
jewelry fabricator would withdraw borrowed gold because he wants to fabricate
products to meet demand. For more information you can read this
post on the Chinese gold lease market.
Even the
World Gold Council has recently stated little borrowed gold leaves the
SGE system [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.
This argument is false.
Furthermore, it’s noteworthy that GFMS writes:
From the perspective of the bank, lending physical gold is an off-balance
sheet item,…
But as I’ve demonstrated in this
and this
post the majority of the “precious metals” on the Chinese bank balance sheets
reflects back-to-back leasing. Meaning banks borrow gold in the SGE system to
subsequently lend out at a higher lease rate. So neither do the Chinese bank
balance sheets influence SGE withdrawals. What withdrawals largely
reflect are direct purchases by individual and institutional investors at the
SGE. True demand.
Conclusion
There is a very limited extent to which the VAT scheme can explain
the difference between GFMS’ demand and SGE Withdrawals. I wrote previously
that indeed there is certain amount of gold being withdrawn from SGE vaults,
which, for various reasons, finds its way back to the SGE in newly cast bars
– overstating SGE withdrawals as a proxy for wholesale demand. Unfortunately
nobody knows exactly the volume flowing through the SGE that distorts
withdraw data. But, we do know the upper and lower bound. The upper bound
is the difference between SGE Withdrawals and apparent supply, the lower
bound is zero.
GFMS only measures consumer demand (jewelry, retail bar and coin,
and industrial demand) and not institutional demand (direct purchases
at the SGE). This is not speculation this
is a fact, and in China everyone can buy gold directly at the SGE so this
explains the immense withdrawals. GFMS is fully aware of this but refuses to
acknowledge it – because
that would ruin their business model. Instead GFMS pretends that the
difference between consumer demand and SGE withdrawals is all caused
by gold being recycled through the central Chinese exchange. But how is this
possible? If the Chinese gold market would simply be a merry-go-round fest,
how come the Chinese import thousands of tonnes of gold that are not allowed
to be exported? What GFMS suggests is not possible. The fact China keeps
importing reveals demand. Another chart:
Theoretically the upper bound for the VAT scheme to have recycled gold
through the SGE equals the difference between SGE withdrawals and apparent
supply (the difference in exhibit 4 between the red and center columns).
That’s the sole leeway we can debate about. As supply equals demand, demand
cannot be lower than apparent supply. I should add, not unimportant,
we know GFMS’ scrap supply data does not include disinvestment (institutional
selling directly to refineries). So disinvestment must be included
in the difference between SGE withdrawals and apparent supply as well. Have
another look at exhibit 3. But, because we don’t know the amount of disinvestment,
neither do we know the amount of distortion (VAT scheme and other
recycling flows).
That’s why in exhibit 1 I’ve disclosed the aggregated difference between
apparent supply and GFMS demand. There can be no mistake about this volume,
it reflects true demand and it has mushroomed into +4,500 tonnes since 2007.
GFSM can present many more arguments in future reports, but it won’t change
the fact that true demand is at least equal to apparent supply.
To be exact, from January 2007 until September 2016 apparent
supply accounted for 11,541 tonnes, and GFMS’ Chinese gold demand accounted
for 6,903 tonnes. The difference, which GFMS has pursued to conceal,
has aggregated to 4,638 tonnes. And
according to my analysis this was not bought by the Chinese central banks.
Let’s see how much longer GFMS can deny reality.
For more detailed information with respect to GFMS’ incomplete global gold
supply and demand metrics view this
post.