Whose Gold Is China Buying?

Whose gold is China buying? Its own, of course...

THE PRICE OF GOLD slipped last week, now trading 3.6% off its recent high, writes Dan Denning in his Daily Reckoning Australia.

Old yellow metal is trading a little above $1100 the ounce according to the April futures contract. The sense of urgency over the Greek crisis has eased. And no one thinks China is going to Buy IMF Gold. But why?

Speaking last week at the National People's Congress, China's foreign exchange regulator Yi Gant told a press conference that, "currently a few factors limit our ability to increase foreign-exchange investment in gold."

As we wrote in a note this weekend, most analysts immediately took that to mean China would not be a buyer of the 191.3 metric tonnes of gold the International Monetary Fund announced it would sell on February 17th. And if China were out as a major buyer of gold on international markets, speculators reckon that the Gold Price is in for a fall.

Yet as China bought 454.1 tonnes of gold between 2003 and 2009 – the last purchase reported – it didn't have to go shopping overseas. China can buy its own home-grown gold instead, because for the last three years in a row, it's been the world's largest producer. China produced over 300 tonnes of gold for the first time ever in 2009, according to the China Gold Association.

That also means that last year's domestic gold consumption – from private households alone – exceeded mine supply. Were Chinese authorities buying above ground gold too? The number of producing gold mines in China has fallen from 1200 in 2002 to 700 in 2009. You can see China is scrambling to produce as much gold as fast as it can.

This could be a case of a "Do as I do, not as I say." Why bid up the Gold Price on international markets when you can buy your own domestically produced gold? As a senior People's Bank of China figure reportedly said:

"China should formulate a long-term plan and constantly and secretly increase its gold holdings...The People's Bank should try to buy as much gold as possible from China's annual gold output of almost 300 tons, while the gold needed by industries and residents could be imported."

Look, the case for gold is pretty simple. To paraphrase fund manager David Einhorn, if you believe monetary and fiscal policy across the world are sensible, sell gold and buy Treasuries. If you believe monetary and fiscal policy around the world are bad, sell Treasuries and Buy Gold.

You don't have to a cult follower or a true believer to profit from that kind of trade. Gold made its biggest move in 1980. It peaked at $850 in early January, but what's interesting is that 10-year US Treasury yields didn't peak until more than a year later, hitting around 16% in June of 1981.

The speculators blew the top off the gold market, in other words, well before they were sure Paul Volcker had a lid on inflation. Once it became clear punitive US rates would kill inflation, the gold bull died.

But wait! US rates went up because the Fed was fighting inflation. And it was fighting inflation because...there was inflation! How can we expect gold to rise on higher rates if there's no inflation to fight? The answer is that the Fed's quantitative easing program is set to end this month.

Over the last year, the US central bank has spent over $1.25 trillion buying mortgage-backed securities. This has kept ten-year US interest rates low and mortgage credit flowing to the American housing market. The Fed has said that program will end by the end of this month.

What will happen next? Already we've seen investors crowding into the short-end of the US Treasury market. Treasury notes with maturities of three-years less are a nice, near-cash, highly-liquid alternative to taking any risks anywhere else. Hence lower short-term US interest rates, driven partly by the Fed and partly by the market.

With the Fed set to end its quantitative easing program, we'd expect market forces to assert themselves in the bond market. You'll get a steeper yield curve. Without the government gaming the trade, investors are going to price US bonds based on the soundness of US fiscal and monetary policy. In this scenario, we think gold will attract more speculators (although the big ones like George Soros have already positioned themselves for this move).

Meanwhile in Europe, the news that finance ministers have agreed, in principle, to a bailout of Greece, might take a little of the urgency out of the sovereign debt crisis theme. And that, in turn, might drive the Gold Price lower. But all these things are prelude to a bigger crisis. Papering over the insolvency of the Welfare State can only last so long – and we think the dominos will begin to fall in months, not years.

In the meantime, though, the continued de-leveraging of the private sector means even larger public sector deficits. According to flow of funds data released the by the Federal Reserve last week, both US household and businesses reduced debt in 2009. The government added debt.

In fact the Fed data show that US households reduced debt on an annual basis for the first time ever in the history of the data series, going back to 1946. Household debt levels shrunk by 1.7%, with mortgage debt declining by 1.6% and credit card debt declining 4.6%.

It's obvious at the household level, where the employment picture is awful, that Americans are preparing for less spending and less income growth. They are not borrowing from future earnings to sustain current living standards. The worm has turned.

And you can't blame businesses for reducing debt by 1.8% either. Why borrow if you're not going to increase capital spending or employment growth? There's a political issue here too. You could argue that business investment is cyclical and will go up eventually. But with the US Congress deadlocked over health care legislation (that if passed might be repealed by the next Congress elected in November), there is a lot of uncertainty. You could also call that political risk.

Into the household caution and business uncertainty, the Federal government increased debt by 22.7% in 2009. It was below the 2008 record of 24.2%. But it's clear that as the private sector deleverages, the government – under the misguided Keynesian assumption that it must support demand – is trying to fill the breech with borrowed money.

This sets the stage for the next episode of the US Dollar crisis. Right now, that may look remote, given the easing of tensions in Europe. But don't get too complacent. The underlying fundamentals of the Dollar suck. With the Fed's Quantitative Easing program set to end this month, a veritable monetary Pandora's Box will be opened. Yes, the Fed could just announce it's extending its Quantitative Easing program. But what effect would that have on the Dollar? On gold? On oil...?

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