One of the main causes many gold analysts assume Chinese gold demand (and withdrawals from the vaults of the Shanghai Gold Exchange) is inflated is because of Chinese Commodity Financing Deals (CCFD).
However, this analysis is incorrect:
Submitted by Koos Jansen, Bullionstar:
When I had discussion the other day with a colleague about how round tripping gold flows in China were completely separated from the Chinese domestic gold market and the SGE, I send him a link to a post I had written on round tripping that explains everything. When I clicked the link myself and read my post (from May 2014) I was of the opinion my writing skills have improved since I wrote it. Time to write a thorough new post on round tripping and other Chinese gold financing deals! Most likely I will rewrite more posts on the mechanics of the Chinese gold market.
Most CCFD are ways for Chinese speculators to acquire cheap funds using commodities as collateral. When it comes to using gold as collateral for CCFD there are two options, round tripping and gold leasing. What is round tripping? Goldman Sachs wrote a report in which the process was properly explained. For this post we will not examine other commodities than gold. From GS:
While commodity financing [round tripping] deals are very complicated, the general idea is that arbitrageurs borrow short-term FX loans from onshore banks in the form of LC (letter of credit) to import commodities and then re-export the warrants (a document issued by logistic companies which represent the ownership of the underlying asset) to bring in the low cost foreign capital (hot money) and then circulate the whole process several times per year. As a result, the total outstanding FX loans associated with these commodity financing deals is determined by:
– the volume of physical inventories that is involved
– commodity prices
– the number of circulations
Our understanding is that the commodities that are involved in the financing deals include gold, copper, iron ore, and to a lesser extent, nickel, zinc, aluminum, soybean, palm oil and rubber.
…Chinese gold financing deals are processed in a different way compared with copper financing deals, though both are aimed at facilitating low cost foreign capital inflow to China. Specifically, gold financing deals involve the physical import of gold and export of gold semi-fabricated products to bring the FX into China; as a result, China’s trade data does reflect, at least partially, the scale of China gold financing deals. In contrast, Chinese copper financing deals do not need to physically move the physical copper in and out of China, so it is not shown in trade data published by China customs. In detail, Chinese gold financing deals includes four steps:
Onshore gold manufacturers pay LCs to offshore subsidiaries and import gold from Hong Kong to mainland China – inflating import numbers
offshore subsidiaries borrow USD from offshore banks via collaterizing LCs received
onshore manufacturers get paid by USD from offshore subsidiaries and export the gold semi-fabricated products – inflating export numbers
repeat step 1-3
Important to understand is that gold in round tripping needs to be physically imported into China and then exported, in contrast to copper. The reason is, something GS fails to mention, is that the trade rules for gold in China are different than for all other commodities.
In essence gold bullion is prohibited from being exported out of the Chinese domestic gold market in general trade. For general trade fifteen banks enjoy a PBOC license to import gold.
Shenzhen Development Bank / Ping An Bank
Industrial and Commercial Bank of China
Shanghai Pudong Development Bank
Agricultural Bank of China
China Construction Bank
Bank of Communications
China Merchants Bank
China Minsheng Bank
Bank of Shanghai
Bank of China
All bullion imported through general trade is required to be sold first through the SGE, and consequently all gold flowing through the SGE is prohibited from being exported. Detail: a few jewelry companies also have a gold trade license for general trade, but this is insignificant.
The State Council is very active in stimulating the Chinese population to accumulate gold; through commercial banks the Chinese people are informed about gold’s function in the economy and able to buy gold granted of the finest quality. They can submit for a gold savings account, speculate in paper gold on the SGE or buy physical gold directly at the SGE, all through a commercial bank as a broker.
Some examples of how state-owned banks promote gold, from the Agricultural Bank China:
Physical gold is both a commodity and a financial product. It can be a gift or collection and may serve as an important investment vehicle for realizing preservation and appreciation. With a distinctive preservation function, physical gold is powerful to defend against inflation.
1. Do not stop when gold price is low. Gold price may go up or down depending on the political and economic conditions and many other factors. Only by constant accumulation will the overall investment cost be reduced.
2. Persistence is the key. Investment risk is reduced by the average cost, the longer the investment period, the better in mitigating the impact of the fluctuation in gold price. When the market rallies, the gain will be protected and increase the investment.
ICBC branch gold
Outside an ICBC branch in Shanghai
ICBC gold products
Inside an ICBC branch in Shanghai
Can you imagine this at JP Morgan in the US?
The State Council’s strategy is to import as much gold as possible and export nil in order to build a strong economic and financial security barrier for China.
However, China doesn’t want to be left out in the global jewelry fabrication market, for which gold is required to be exported. To make China participate in the global jewelry fabrication market Chinese jewelry companies can import and export gold through processing trade. This is how it works, simplified:
In processing trade raw materials from abroad are imported, processed into products and then these products are required to be exported. This processing is usually done (there can be exceptions) in Customs Specially Supervised Areas (CSSA), also called Free Trade Zones (FTZ). Gold processing trade doesn’t require a license from the PBOC, to export gold from a CSSA to a non-CSSA (the rest of the mainland) a PBOC license is required.
The next illustration demonstrates two types of processing trade.
processing trade China gold
An example for a processing trade would be; gold from Hong Kong is exported to Shenzhen (a CSSA just across the border from Hong Kong and well known for its vast jewelry industry; 4000 manufacturers), then the gold is fabricated into “jewelry” (/changed in shape or form/processed) and imported back into Hong Kong. This trade would show up in Hong Kong’s customs report, but it wouldn’t affect Hong Kong net export to the mainland. After one cycle is completed the process can be repeated with the same gold.
In the next illustration we can see Hong Kong (representing the rest of the world), the CSSA in Shenzhen and the mainland (the Chinese domestic god market).
CSSA Shenzhen Hong Kong Mainland
Processing trade is often is done between Hong Kong and Shenzhen; all gold exported from China (CSSA) to Hong Kong is processing trade.
Hong Kong – China gold trade monthly January 2009 – November 2014
Round tipping by Chinese speculators can only be done through processing trade; it simply isn’t possible through general trade, round tripping flows are completely separated from the Chinese domestic gold market and the SGE (round tripping doesn’t inflate SGE withdrawals). Only by bending the rules, set up a fake gold jewelry company in a CSSA, speculators can import and export gold to round trip. Hence, GS notes gold needs to be physically imported and exported for round tripping, in contrast to copper.
In theory the gold tied up in round tripping can be at max the amount of gold yearly exported from China (to Hong Kong), at minimum a far smaller amount that is being used in many cycles, in every cycle being counted as import and export. Round tripping doesn’t inflate net export from Hong Kong to China.
The other gold financing deal often used by Chinese speculators is gold leasing (which is exactly the same as a gold loan). In general gold leasing is a normal market practice. There can be three types of lessees; gold miners, jewelers and speculators. Examples:
A gold miner needs funds to invest in new production goods. It can borrow dollars from a bank for 7 %, or borrow gold for 2 %; the gold lease rate is usually lower than the dollar interest rate. If the miner borrows 10,000 ounces and sells it spot at $1,500 an ounce, the proceeds are $15,000,000. In a years time the miner has mined 10,200 ounces to repay the principal debt plus interest (the interest on gold loans can be settled in gold or dollars, depending on the contract).
A jeweler needs funds to buy gold stock for production. It can borrow dollars from a bank for 7 %, or borrow gold for 2 %. The jeweler borrows 10,000 ounces, with which it can start fabricating jewelry. To hedge itself against price fluctuations the jeweler can sell spot, for example, 10 % of the 10,000 ounces it has borrowed (1,000 ounces at $1,500 makes $1,500,000) to buy gold futures contracts in order to lock in a future price. After a year the jeweler has sold the 9,000 ounces (as jewelry) for dollars and can take delivery of the long futures contracts to repay the gold loan. If you buy 10,000 ounces through a futures contract for delivery in a year, initially you are only required to pay a margin, for example 10 %. When the contract expires and you want to take physical delivery you pay the remaining 90 %.
A trader is looking for cheap funds. It can borrow dollars from a bank for 7 %, or borrow gold for 2 %. He borrows 10,000 ounces, sells it spot at $1,500 an ounce. The proceeds are $15,000,000 and subsequently these newly acquired funds can be used to invest in higher yielding products (> 2 %). If the trader chooses to hedge itself in the futures market is up to him. After a year the 10,000 ounces plus interest need to be repaid, either the trader can purchase gold with the profits made on the higher yielding investment or from delivery of futures contracts.
In China all gold leases are settled through the SGE; both lessor and lessee are required to have an SGE Account. If a lease is agreed between two parties gold is transferred from one SGE Bullion Account to the other, when the lease comes due the gold is returned. At SGE level it’s as simple as that.
There is a big difference between jewelers that lease gold in contrast to miners and speculators. Jewelers lease gold because they need physical gold for fabrication; miners and speculators lease gold because they are seeking cheap funds, they will always sell the leased gold (without withdrawing the metal) spot at the SGE to use the proceeds. Why would a speculator withdrawal the metal?
Therefor, IF SGE withdrawals contain leased gold this is for jewelry fabrication that eventually ends up at retail level. When a jeweler needs to repay the lease it simply buys gold at the SGE, subsequently this gold will be transferred from his SGE Bullion Account to the lessor’s SGE Bullion Account. It’s not likely a jeweler would buy gold off-SGE, which than needs to be refined into newly cast bars by an SGE approved refiner to enter the SGE vaults and to be credited to the lessors SGE Bullion Account.
Phillip Klapwijk, analyst with Precious Metals Insights (PMI) in Hong Kong, previous Executive Chairman of Thomson Reuters GFMS and consultant for the World Gold Council, has stated there is 1,000 tonnes of gold tied up in CCFD. Additionally, he said:
… a good part of the withdrawals represent gold that is used purely for financing and other end-uses that are not equivalent to real consumption.
Needless to say I don’t agree. Am I the only one? No. When Na Liu of CNC Asset Management Ltd., visited the SGE in May 2014 he was told by the President of the SGE Transaction Department:
First, the withdrawal data reflects the actual gold wholesales in China. In 2013, the total gold withdrawal from the SGE vaults amounted to 2,196.96 tonnes. The President of SGE Transaction Department (The President) said: “This 2,200 tonnes of gold, after leaving our vaults, they entered thousands of Chinese households in the form of jewellery and investment purchases.”
… Second, none of the 2,200 tonnes of gold was bought by the Chinese central bank. The President said: “The PBOC does not buy gold through the SGE.”
… Third, the financing deals do not exaggerate SGE’s assessment of China’s gold demand. This is because “the financing deals do not take place after the gold leaves the vaults.”
The President of the SGE’s Transaction Department is clearly stating most leasing happens within the SGE system and the metal is not withdrawn.
The WGC had also stated in a report 1,000 tonnes was tied up in CCFD, based on PMI’s data. But, when I send the WGC an email to ask about the details, they replied:
Gold leasing: Banks have built up this business to support China’s burgeoning gold industry. Miners, refiners and fabricators all have a requirement to borrow gold from time to time. For example, fabricators borrow gold to transform into jewelry, sell and then repay the bank with the proceeds. It is an effective way for the fabricator to use the bank’s balance sheet to fund its business. Banks have strict policies in place for who they can lend to, and these have been tightened over recent years, but during PMIs field research it identified that, in some instances, organizations other than genuine gold business had used this method to obtain gold, which it would then sell to obtain funding [in this case the gold wouldn’t be withdrawn from the SGE vaults]. It would then hedge its position. According to PMI, this can generate a lower cost of funding than borrowing directly from the bank. Our colleagues in China think this would be a very small part of total gold leasing; the majority of it would be used to meet the demands of genuine gold businesses.
Round Tripping gold flows are completely separated from the Chinese domestic gold market (SGE) and gold leasing only inflates SGE withdrawals when used for genuine gold business: SGE withdrawals equal Chinese wholesale demand.