Bullion-Buying in China and India, Part 1

Extreme liberalization of China's bullion market has led to rapid increase in retail investment demand for gold in China.
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Recently released data from the World Gold Council shows that retail investment demand for gold continues to rapidly increase in China. Several reasons are put forth to explain this increased demand by precious metals commentators: rising wealth/income levels in China's population, an increasing distrust of debauched paper currencies (or a concern about "inflation" - which is the same thing), and even the explicit endorsement of gold (and silver) as "desirable investments" by China's government.

These are all valid reasons, and all "drivers" of current demand for gold in China. However, an even more important dynamic is either ignored, or simply unknown to most of these writers: the extreme "liberalization" of China's bullion market. Ironically, precious metals writers have reported (in great detail) on the recent announcement by this government of significant moves to open up China's precious metals market. Yet, the much more significant move by the Chinese government which preceded this has been almost completely ignored.

Starting with Mao, China's citizens were prohibited from purchasing bullion. It wasn't until 2002, that this total ban was partially lifted. However, small purchases of bullion were still not allowed. When you combine the (previously) small incomes of China's population with an official ban on small transactions, the effect of this decree was that gold was still totally out of reach for well over 90% of China's 1+ billion inhabitants.

It was only at the beginning of 2009 that all restrictions on bullion-buying by individuals in China were ended. From that time, it only took about one year for China's gold-buying to surge to a level where (depending on whose numbers you look at), China is either tied with India as the world's largest gold consumer -- or has already vaulted into top-spot.

Clearly, the single most important driver for this demand was the lifting of prohibitions on bullion-buying, and yet that dominant factor has been almost completely overlooked by the precious metals community. Why do I continue to harp on this point?

Unlike the other drivers of demand mentioned (which are based upon current factors), the roughly 50-year ban on bullion-buying in China obviously created vast amounts of pent-up demand. Arguably, this pent-up demand must be satisfied first (since it predates those other drivers), before the Chinese market even begins to be driven by the other factors listed. However, even if you reject this "chronological" interpretation of Chinese demand, it clearly represents a major incremental addition to all the other demand-drivers.

This is the reality with the gold market in China: factor in all the current fundamentals which are spurring Chinese demand -- and then adjust projections significantly higher, to reflect the 50 years of unsated appetite for gold. Obviously, I'm not implying that the 50-year prohibition on bullion-buying means that Chinese citizens will end up buying 50 times as much gold. When someone resumes eating after a fast, they don't want/require enough food to make up for all of those missed meals plus that person's normal appetite. But much like the person fasting, Chinese citizens will have a still-significant "residual appetite" from all those years they were locked out of the bullion market.

Up to this point, I have only been examining the quantity of demand in China. However, analysis of the precious metals market in China also suffers from a failure to understand and identify the nature of that demand. We create and categorize Chinese (and world) gold-demand using Western categories for demand, and (more importantly) Western interpretations on how we analyze that demand.

Specifically, in the gold market, we focus on jewelry demand and retail investor demand. Of greatest significance is how we choose to define this demand. We define jewelry demand as an industrial application for gold, leading to the production (and sale) of a luxury good. In fact, arguably the majority of all gold jewelry ever produced in the world (throughout history) has been produced as instruments of savings, not as luxury goods.

Similarly, when we talk about retail investment demand, we are reducing gold (and bullion) to the status of nothing more than an ordinary commodity -- something which we buy low, and sell high. Knowledgeable bullion holders know that nothing could be further from the truth. It is the best "money" known to our species, and we will be extremely reluctant to swap it for grossly inferior, paper currencies (i.e. sell it) -- irrespective of how large a stack of banker-paper we can get for it.

More generally, what people in affluent, Western cultures are oblivious to is that most of the world's population has no access to banks or banking services. Perhaps another way of expressing this is to state that most of the world's population has never seen a need or justification for creating banks? That general subject is (unfortunately) a discussion best left for another time.

For now, what is relevant is that most of the world's population manages to function without banks, begging the question: what do these people do with the "savings" which they are able to generate? The answer (for thousands of years) has been for people to hold/carry their savings in the form of gold (and silver) jewelry.

This fact is of huge significance in analyzing demand. Gold-bashers have consistently engaged in the fear mongering that ever-increasing prices for gold would "kill" demand for jewelry. While demand for jewelry in Western cultures shows considerable price elasticity (i.e. demand falls as the price increases), this has been much less of a factor in Asian jewelry markets (which consume the majority of the world's jewelry).

The reason for this is due precisely to the previous distinction I made in the nature of jewelry demand. In those cultures that use jewelry for savings, there is very little price elasticity (except briefly, in any sudden spike in price). People without banks, who use jewelry for savings, are still going to continue to do so. The only thing that changes is that if their incomes don't keep pace with the rate of increase in the price of bullion, then the quantity of bullion they buy (by weight) will decrease. However, the dollar-value of what they spend on (convert into) jewelry will continue to steadily increase over time -- irrespective of the price of bullion.

Of similar importance is what this implies for the supply of gold (and silver). The other branch of fear-mongering preferred by the gold-bashers is to warn bullion-holders that vast amounts of "scrap" bullion (i.e. old jewelry) would soon "flood" the markets. I've covered this issue to a large extent in a

previous commentary. What the empirical evidence shows is that during this quintupling in the price of bullion, there have been no "floods" of scrap entering the market -- with the exception of the gullible dupes in North America who are being preyed upon by the "we buy gold" vultures.

What the World Gold Council has consistently reported is there have been very brief surges in scrap-sales -- but only at times when the price of bullion has spiked. Supply of scrap rapidly falls off to previous levels, and there has been no long-term trend toward increasing supply in this area.

Once we understand jewelry (and bullion, in general) as a form of "savings", then we should not be surprised by this trend. With our own "money" in our savings accounts, we never contemplate "selling" our money -- since the very concept is ludicrous. We spend our money, when and if we need to, otherwise we simply retain it.

With most of the world's peoples being much, much more prudent with their money (or savings-oriented) than the spend-aholics of Western cultures, these people are not suddenly going to go on spending-sprees simply because the purchasing power of their savings (i.e. their bullion) has increased.

Instead, what the empirical evidence has shown in the economies of the world's two largest populations (and two largest gold buyers) is that spending correlates closely with increases in income rather than increases in wealth.

A second mortgage used to be a subject of shame, something which no one would willingly admit to -- and was generally seen as a last-resort, source of emergency funding. Even a generation ago, people who contemplated using their home equity as some sort of checking account for frivolous spending would be looked upon with disgust by the vast majority.

What this leads to is a fundamental truth in the precious metals market: because most of the "physical" gold and silver purchased in the world (by the vast majority of our population) is being purchased as "savings" (whether in the form of jewelry or bullion), there will be very little decrease in demand for bullion even at extreme multiples of current prices.

Similarly, this same dynamic means that there will never be any meaningful surge in "scrap sales" of bullion -- apart from the small "blips" previously acknowledged. Together, this directly implies that most of the forecasts for bullion demand by "experts" will consistently underestimate that demand, while their estimates for scrap-supply will consistently overestimate real supply -- for the same reasons.

In Part 2, I will shift my analysis to India, and also spend a bit more time on the silver market -- and the different dynamics in effect there.

This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.