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China's Gold Investment "Infrastructure"

Gold Investment in China is booming as a store of wealth and form of saving...

EMERGING MARKETS have revolutionized the demand-side equation for dozens of commodities, writes Index Universe managing editor Olivier Ludwig for Hard Assets Investor.

Nowhere has the change been followed quite so closely as in the gold market. China and India have had a taste for gold jewelry for decades, but evolving income distributions and a tumbling US Dollar have turned gold into an attractive financial investment for the first time for millions of new buyers.

The trend shows no signs of slowing anytime soon, says Jeff Nichols, managing director of American Precious Metals Advisors and senior economic advisor to retail Gold Dealer Rosland Capital. Nichols is a widely recognized expert in precious metals and global economics, and has worked with several mining companies on financing and investor relations.

Recently, I chatted with Nichols about his thoughts on the global gold markets, including what's really driving Chinese and Indian demand, why South Americans aren't buying and why he thinks gold could go to $2000 an ounce – or higher – soon.

HAI: So what's your sense of the gold market in general at this time?

Jeff Nichols: I think the Gold Price is going to go much higher over the next few years based on a variety of forces at play currently or in the near future. What's really important, apart from US inflation, are the fundamentals as they're being affected by things going on in India and China, and elsewhere in Asia. Those are trends that will simply overwhelm the gold market in the next few years.

HAI: Are you talking about these countries increasingly turning to gold to park their reserves? Or are you talking about growing industrial demand?

Jeff Nichols: Both. Most important is the nature and size of investment demand in India and China and the potential that demand has to affect the world market for gold.

China, for example, legalized private Gold Investment only about two and a half years ago. For many decades during the Communist era, private citizens were prohibited from investing in gold. That doesn't mean they didn't Buy Gold jewelry and consider that an investment. But there was no real investment market. About 2 1/2 years ago, the government changed all of that and subsequently went so far actually as to endorse private Gold Investment. I think the government sees gold accumulation by its citizens as a form of national wealth.

In the last couple of years in China, we've seen the development of what I call a Gold Investment infrastructure. There were no outlets for gold a couple of years ago. If you wanted to buy a gold bar, there wasn't a mechanism in China for somebody to do that. But now, a Chinese individual can go into a bank across the country and buy a small gold bar or a gold coin. Or the working-class person with not a lot of funds can open up a passbook- or a savings-type account denominated in gold and make very small contributions or deposits into that virtually of any size. You might find somebody adding a few grams every month.

HAI: Are Chinese buyers purchasing gold because they perceive it to be a better investment or a better way to preserve wealth?

Jeff Nichols: Part of it is the cultural phenomena in which gold has for centuries been perceived as a store of wealth and a form of saving. So if income is rising in China, and savings are increasing, then I think there's a natural inclination for some portion of that savings to find its way into gold. It may not be necessarily that Chinese are concerned about hyperinflation or political upheaval. It's simply a natural thing for them to do.
HAI: How does the gold culture in India differ?

Jeff Nichols: For many years, India has been a sponge for gold. But what's happening is that the Indian market was very fragmented and sort of nonrational, until changes begun in the last few years have modernized and Westernized the market.

Still most of the investment demand in India is for gold jewelry at high caratage, often 22 or 24 carat gold. So it's pure gold, but in the form of bangles and bracelets and chains and necklaces and the like. And it's been culturally the custom to give dowries in gold or as a gift on the birth of a child or a wedding or some other important event. It's considered propitious. To have gold is considered to be not only a symbol of wealth but something that brings good luck.

HAI: Is that phenomenon spreading?

Jeff Nichols: Incomes are rising for more and more people. So, as in China where rising incomes find their way into gold, so does it in India. But in India, what we also have is the market going from a sort of archaic form where you would go into a bazaar and stop at a jewelry shop to Buy Gold jewelry, to the popularization of investment products that might be more common in the United States or Western Europe. In Mumbai there's now a gold ETF, and gold is now being offered not just in jewelry shops, but by brokerage firms and insurance companies and over the internet.

Also, small Gold Coins are now being sold through the postal service. In many of the rural and agrarian areas of India, it's really more like a Third World country than a newly industrialized country. In some of these areas, there are no banks or financial service firms. So the postal service is offering gold throughout the country, particularly in these areas that are not serviced by other providers.

HAI: All this spells very real Physical Gold demand?

Jeff Nichols: Right. And that's very important that we speak of it as being physical demand. It means that there is real off-take from the market. Much of this will never come back, at least never in the next few years to come. When an Indian buys gold, or, more importantly, when the Chinese gold buyer accumulates gold, they have a much different view. They're not buying it in order to sell it next week or next month or even next year at a higher price.

And that's truer of China than it is of India. There's always been an important, secondary supply coming from India, with jewelry trading to some extent. So, if prices jump up, you'll see some gold coming back into the market – profit taking, if you will – or if economic circumstances are poor, there may be selling of gold. But these tend to be temporary phenomena rather than people exiting the market permanently.

HAI: But it's not just China and India that matter when we talk about the emerging markets, right?

Jeff Nichols: Given the size of the populations, they're important. But what I've said is equally true for Thailand, Vietnam, Indonesia, Malaysia and Singapore. These countries are all seeing the same sort of rising Gold Investment span that was in China. Even Vietnam has an important Gold Investment interest.

HAI: What about in the Americas, like Brazil, Chile, Mexico? Any significant shift as it relates to the demand pull on Physical Gold?

Jeff Nichols: Not in the sense that it really is a big deal. I'd have to guess that there are people in these countries that are buying more, because their economies are doing well and incomes are rising. But it's not anything that compares to what's going on in Asia.

HAI: What about the supply side in gold? How does that fit in?

Jeff Nichols: That's another building block for the bullish outlook. Mine supply has been decreasing gradually for the last 20 years or so. And even though there was a little hiccup last year and maybe again this year, the trend remains down, at least for the next five years.

Beyond the next five years, there may be a recovery in mine production, prompted by higher prices, affordable deeper mines or more expensive mines. Also, China, which is now the world's largest gold mining country, still has about half the country which has never been explored.

Over the next 10 years and beyond, other countries like Russia are growing in importance as Gold Mining countries and have great prospects for a very long time. But it takes a long time to explore, develop, finance and bring a significant mine that really makes a difference in terms of supply.

So, even though prices have been rising and may rise rapidly in the next couple of years, the consequences of all that is still further out. In the meantime, we have rather limited new supply that is not elastic in the short term, short term being measured in a few years.

HAI: So do you think this run in prices has a good half-decade left in it, at least?

Jeff Nichols: The supply constraints contributing to higher prices now and in the next few years are not going to be overcome, at least for five years, hopefully longer.

The other bullish building block that's quite important is central bank attitudes towards gold. Last year was the first year in a couple of decades that central banks as a group were net acquirers of gold. For the last 20 years prior to last year, they sold on average about 400 tons of gold a year.

In the aggregate, central banks will be acquiring gold over the next several years, in part because of their fears about Dollar devaluation. They hold their reserves in Dollars principally, and so they're worried about the Dollar. To the extent that they can diversify, they will.

HAI: Given all these variables around the globe, where does it all take us?

Jeff Nichols: I think gold can go to great heights, even without the United States seeing double-digit inflation and the Dollar falling through the floor, simply on the basis of rising demand in these foreign markets.

Now, that said, I think we're going to have a significant rise in inflation over the next few years. I think the economy could best be described as moving towards a stagflationary type of scenario, in which economic growth in real terms remains very low and unemployment remains high for an extended period. And inflation is a problem. I don't know that we're going to see double-digit inflation. Maybe we will, maybe we won't. But it is certainly going to be inflation that is a problem. When I look at the growth in money supply over the last couple of years as measured by monetary base, it just leads me to believe there's no way we're not going to have higher inflation.

HAI: How much higher do you think gold could go?

Jeff Nichols: Conservatively, I think in the next few years that certainly $2000 an ounce is very likely.

HAI: On the basis of the demand issue alone?

Jeff Nichols: Yes. Gold has not kept up with inflation over the last few decades, measured from the cyclical price of $870 or $875 per ounce that we saw in January 1980. If you extrapolate that price and adjust it for inflation each year since then, the price of gold today would be approximately $2,400. And, if you believe as I do that actual inflation is higher than the reported statistics, that price today of $875 adjusted for what might be a truer measure of inflation would be several thousand Dollars higher than that.

I'm not suggesting that gold is necessarily going to go to $6000 or $7000 or $8000, but I'm just trying to demonstrate with these numbers that to think of gold at $2000 or $3000 a few years from now is not a crazy idea.

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