China: Awakening Giant in the World Gold Market

In recent weeks, with gold stalled around $1200 an ounce, market pundits have been busy parsing the latest US economic statistic and every word from the Fed to explain each and every wiggle up or down in the metal's price. While most market observers and participants are focusing myopically on the short term, they seem blind to developments elsewhere in the wide world of gold, developments that have very important positive implications for gold's long-term direction.

Indeed, we need look no further than China: The country is the world's leading gold-mining nation, the second-largest gold consumer, and its central bank, the People's Bank of China, continues to buy significant quantities for official reserves. According to the World Gold Council, China last year mined 314 tonnes and consumed 423 tonnes for jewelry and investment though we think these numbers greatly underestimate both supply and demand in the China market.

In addition, last year, the People's Bank of China announced that it had purchased some 400 tonnes over the prior six years - and its total gold holdings stood at 1054 tonnes as of April 2009. We think the central bank continues to add to its official reserves - buying surreptitiously from domestic mines - but chooses not to report these on-going purchases as the news would surely affect the market price and make future purchases more costly.

However you look at it, China is a giant in the world gold market. But it is a baby giant still in its infancy. Not too many years ago, private gold investment was prohibited . . . and the buying or selling of gold was heavily regulated. But in more recent years, private gold investment was legalized, the Shanghai Gold Exchange was established to facilitate private gold transactions, several banks were authorised to deal in gold, and small bars and coins became available at gold retail shops, as well as some jewelry and department stores. Still, imports and exports remained tightly regulated and banks have been limited in their dealings.

Nevertheless, we have long argued that growth in Chinese gold demand for both jewellery and investment would underpin the world gold market in future years - and the country's growing appetite for all things gold would propel the world price to new heights in the years ahead.

Last week's announcement by the People's Bank of China promising important liberalization of the domestic gold market suggests not only strong - but accelerating - demand for gold. As a result of the latest official gold-policy pronouncement, it is likely that:

• more commercial banks will be allowed to buy and sell gold in a variety of physical and paper forms, making gold more accessible to investors across the country;

• the larger banks will be authorized to trade and hedge in the international market;

• the Shanghai Gold Exchange will expand its foreign membership;

• yuan-denominated derivative and paper gold products will be introduced; and

• sooner or later, a local gold exchange-traded fund will be launched on the Shanghai Stock Exchange - greatly expanding investor demand, as it has in the West.

In addition, Chinese banks and larger gold-mining companies are now being encouraged to finance mine production around the world by loans to and direct equity stakes in Western gold-mining companies. These investments will likely include purchase agreements promising China a claim on future production, leaving less gold available in the world gold market for the rest of us.

It is worth repeating - since so many investors, traders, and commentators seem to miss the significance of these liberalizations - future growth in China's gold market will be sufficient, other things being equal, to boost gold to much higher price levels in years to come.

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