China's Gold Buying Dilemma

Buy Gold from its mines or from the market...?

DOES IT make a difference to the price if a central bank chooses to Buy Gold at the mine-head or from the open market? asks Julian Phillips at the GoldForecaster.com.

Private demand for gold is increasing rapidly in China, and this is likely to continue in line with the growth of the Chinese middle classes. We do not know for sure how much the People's Bank of China took into its reserves in 2010, and are only likely to know in two years' time, if it chooses to announce figures in line with recent patterns. But China currently produces 340 tonnes of gold from its domestic mines each year. This may increase by up to 100 tonnes a year or more. It also imported 210 tonnes in 2010.

Russia meantime produces around 250 tonnes of gold from its mines per annum. It increased its reserves by 152 tonnes in the year to January 2011. These two nations present different requirements from the local and international gold markets. But does it make a difference where the gold is bought?

China's central bank, the People's Bank of China, does not disclose the annual amount it purchases for its reserves, but uses an agency to make these purchases on its behalf. Every five years, this agency delivers the gold bought to the bank, which then announces its increase. The last time it did this was three years ago and it reported an increase of 454 tonnes, averaging out to 91 tonnes a year.

If this amount had been bought from local Gold Mining production, it would equate to the total amount of local production over those five years. And as the People's Bank of China does not want to disclose how much gold is bought locally and how much, if any, is bought in the international market, we will never be sure.

Russia, on the other hand, produces in the order of 250 tonnes (an approximation for 2010, up 38% from 184.49 tonnes in 2009). Russian central bank purchases have been rising steadily – by 25% per annum – over the last two years, but not as fast as local Gold Mining production. There is therefore scope for the central bank to increase the volume of local mine-supply purchases, and keep it at 50% of local production or more.

Vladimir Putin, Russia's prime minister (but the power behind President Medvedev's throne) has previously stated that Russia would be buying on the international market. One of the Deputy Chairmen of the Russian central bank has said the bank had bought its added reserves from local production. Is one right and the other not, or are both right?

Some 90% of the world's physical gold sales in the international market take place in London, transacted through the big bullion banks that quote prices and store metal for the professional wholesale market. The two daily Gold Fix prices account for the vast majority of these deals, taking place at 10.30 am and 3.00 pm London time. Each of the bullion banks has their own clients and does their best to hide their identity from outsiders. But experienced dealers can sense the presence of a central bank in the market.

One of the ways they can tell is by the way the banks deal in gold for them. A central bank does not want to chase prices, so will Buy Gold offered to it, rather than make a large offer, which may well drive prices up. A Chinese central bank official made the comment some time ago that it is difficult for a central bank to Buy Gold in the international market. But a central bank will do it if the amount purchased or sold is not sufficient to affect prices. If it is a large amount, then sales or purchases will be spread out over time so as not to affect prices unduly. This may hide the presence of a central bank.

The moment it gets out that a central bank is in the international market prices will rise or fall more than is usual. This is the deterrent to China in particular, which is very concerned with its privacy. The international gold market is the place to source large amounts of gold, but the People's Bank must work to hide its actions.

1. Any amounts needed above locally produced volumes must come from this market or direct from refiners such as the Rand refinery in South Africa.
2. Purchasing gold outside a nation requires foreign currency from foreign exchange reserves and not the local currency. With a tonne of gold around $45 million apiece, using local currency can be inflationary (it requires the injection of that currency into the local economy).
3. Where a dealer is able to guard its client's identity and purchase large volumes of gold, central banks will do better to use the London gold market, even if it has local production, for it does not have to wait for the local gold to be available.
4. Buying Gold from local production involves a local miner and the central bank, with a price set for each transaction only by reference to international prices, no matter how large the volume of gold involved.
5. There is little to no immediate impact on international prices as the international market does not 'see' the transaction. The only way local deals impact international prices is through the absence of that local supply from the international market.
6. Local production is a certain source of supply. When supply is tight in the international market buyers will have to raise prices to bring out additional supplies. Even when international markets have a tight supply situation local production remains on tap to a central bank.
7. In the case of China where local supply is insufficient to supply the retail & institutional market as well as the central bank, central banks can ensure that they manage their purchases well when they buy locally and leave the retail & institutional buyers to get the balance of their purchases from the international markets via imported gold.

As you can see it generally pays a central bank to Buy Gold from local production if it is there. It is easier, private and more manageable in terms of prices. China in particular appreciates the control it retains over the disclosure of purchases.

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