Enter the dragon: China and the precious metals

Now that China is a key driver for commodities, the phrase “Enter the Dragon” is increasingly heard at commodity conferences.

China is hugely important to the platinum market in terms of net demand, as it is for copper. However, for gold and silver, the country has an even larger global impact in terms of supply than demand.

Burgeoning Chinese demand is seen as a major positive for all commodities. In the case of silver, however, there are two sides to this story. Silver bulls were bursting with excitement during the late 1990s as China gradually liberalized the domestic silver market. The basic thesis was that limited Chinese mine production growth plus rising demand would see China challenge India to become the world’s largest importer of silver.

Finally, at the beginning of 2000, China abolished the country’s 50-year state silver monopoly and allowed the metal to trade freely. Unfortunately for the bulls, while Chinese imports did rise, this was completely offset by a tidal wave of exports.

This burst of supply was the cumulative result of rising silver production from expanding zinc-lead smelting capacity and a build-up in trader and producer stocks in anticipation of liberalization. Moreover, the People’s Bank of China exported from its silver inventory, which had built up over time from (mandated) purchases of domestic production.

As a result, Chinese exports were a massive weight on the silver market from 2000 and continue to be so today. Indeed, for the year to April, official Chinese silver exports have risen by 56%, year over year, spurred by the sharp rise in silver prices. The continuing rise in Chinese exports, notwithstanding some improvement in official records, appears to confirm that domestic silver inventories remain significant and help explain why silver prices fell back so dramatically as soon as speculative buying dissipated.

We highlight this example, as China’s increasing importance does not necessarily mean that all commodity prices will rise as a result. China is also a significant supplier of commodities, and this must be considered before judging the net impact China is having, or is likely to have, on any particular commodity market.

The Chinese gold market is also liberalizing. Expectation of a large and sustained fall in gold mine supply has been a major theme in the gold market. Strong local currencies, resource depletion, rising production costs and environmental pressures are causing mine output in South Africa and North America to fall, and we expect this trend to continue.

However, global gold output continues to rise as a result of growth in South America, other African countries, and Southeast Asia, and more recently we have seen growth in the former eastern bloc. This growth has offset losses from the traditional producers. Significantly, the potential and current activity in countries such as China and Russia suggests that this trend is set not only to continue but accelerate, particularly given the current level of prices and the availability of both equity and debt financing for project development.

China could potentially become the world’s major producer of gold, given the number of already known deposits and increasing level of foreign interest.

We have been reminded often over the past three years of the following fable: in the early 1990s, a large U.S. cosmetics company very confidently predicted that China would become the world’s largest market for deodorant within the decade — a prediction based on the belief that 2 billion armpits would require a lot of deodorizing! However, by 2000, China still accounted for only a modest proportion of the world deodorant market.

In reality, despite the 2 billion armpits, it appeared that a different climate, diet and attitude to body odour meant that a simple multiplication of the Chinese population (or armpits) by some ratio estimate for demand can result in wildly inaccurate projections. This is simply another version of the “mirage-of-large-numbers” theory, which says that even a tiny probability can become a seemingly likely event should a large enough sample be used — a point that should also be remembered whenever one sees the implications for gold (or any asset) from even a tiny shift in saving patterns.

Part of the explanation for high gold demand in emerging markets is that gold continues to play, in the absence of alternatives, a key role as a hedge against both inflation and currency weakness. However, since the late 1990s, the trend in both China (and, indeed, most Asian markets) has been for currency stability and dis-inflation. More recently, China’s economic growth has resulted in upward pressure on its currency, whereas inflation remains controlled (though it has begun to pick up). This is not typically the environment in which we have seen a gold demand surge in emerging markets.

However, it is not macroeconomics that is used as the justification for there being huge potential growth in Chinese gold demand; it is population. China has the lowest per-capita consumption of gold in the world, and hence the argument is that as gold market liberalization continues in that country, so will per-capita consumption. The typical extension of this is that given similar populations and a traditional affinity to gold, one can assume that per capita consumption in China will rise to a similar level, as in India, and that we will see a nearly three-fold increase in Chinese gold demand.

But rarely is reality this simple. As we explained earlier, the “armpit” approach to demand projections is critically flawed insofar as it does not allow for a consideration of changing domestic spending patterns. A much more insightful comparison, we suggest, can be made by analyzing the percentage of income spent on gold. On this comparison, people in the Middle East, the Indian Sub-Continent and Asian countries clearly and predictably spend a considerably larger percentage of their income on gold. China, on the other hand, is mid-table, whereas countries in the Western World spend the lowest percentage of their income on gold.

The evidence suggests that as economies develop, the range of spending and investing options expands considerably. This helps explain why Chinese gold demand has stalled over the past decade despite the rapid income growth over this period. The reality is that in the competition for growing Chinese disposable incomes, gold is quickly losing market share. Given that China’s economic development is likely to continue and given the growing global influence of Western culture (and this tends to be negative for gold), we can expect that the proportion of China’s income spent on gold will continue to decline. Indeed, this is not just the case for China but for the other large spenders as well.

This trend toward spending less income on gold is why we believe it is crucial to the long-term viability of the gold industry that Western gold demand (both jewelry and investment) be rejuvenated. Not only does the West provide the greatest potential demand growth (for an increase in percentage spent); it will also help reinforce gold’s existing position in emerging economies and hence slow its declining share of disposable income. Of course, such rejuvenation is a far-from-simple task, but that does not make it less vital.

Platinum, of course, is the precious metal that has most benefited from the growing affluence of the urban China consumer. By tapping into the upper-end of the consumer market, platinum is not greatly affected by the recent tightening measures aimed at over-investment in certain industrial and property segments. Furthermore, luxury consumers tend not to be particularly price-sensitive.

That said, it is true that some price sensitivity has appeared in the Chinese market. Chinese demand actually fell 19% in 2003, and there are anecdotal reports that demand levels this year also suggest a reduction in buying. However, it is important to put this in context: SARS affected demand levels for many consumer goods last year, and moreover, anecdotal reports suggest that reductions i
n demand are not the result of end-consumers being discouraged by higher platinum prices but rather that these reductions are the result of the falling profitability of the jewelers that are fabricating platinum jewelry.

Industrial precious metals

We remain positive in our outlook for industrial commodities demand from China, notwithstanding some expected short-term weakness, driven by ongoing industrialization, urbanization and consumerism. As can be seen in the charts below, gold demand is dominated by jewelry and is unlikely to change. The charts below also show the relative size of the markets and help show that the platinum market remains much smaller than that of gold and therefore should not be blamed for the stalling we have seen in Chinese gold demand. However, the prospects of growing industrial demand for silver, platinum and palladium are strong.

It should be noted that we have included photography as an industrial end-use for silver in order to ease the comparison across the four metals. That said, demand for silver in photography accounts only for around 12% (180 out of 1,470 tonnes) of Chinese silver demand, so it does not greatly affect the comparison.

China has, of course, seen extremely rapid growth in manufacturing in many areas, but for precious metals, the key segments are electronics and autos. The medium-term outlook for continued growth in both segments remains strong, though autos is one of the segments that the government is targeting for a slowdown. However, China’s production of a wide range of electronic products, including computers, suggests continuing strong growth in demand for silver (largely used as a contact) and palladium (used in multi-layer ceramic capacitors).

On the auto side, the current slowdown is temporary, and not only would we expect growing production volumes over time (for domestic and, eventually, export markets), but tightening emission levels should also see higher loadings of platinum group metals. We would expect palladium to benefit most from this growth, but it should be noted that diesel engines are gaining market share, and this will also ensure increased demand for platinum.

We do not believe that photographic demand for silver will grow significantly, as we expect many first-time buyers of cameras to move directly to the new digital technology, given the reduction in the cost of these cameras and the rapid increase in ownership of personal computers in China.

The Importance of Beijing

The precious metals markets in China were highly regulated until liberalization began, in the mid-1990s. Before this time, all elements of the precious metals markets, both domestic and external, were controlled by the People’s Bank of China. Silver was the first market to be allowed to trade freely from the start of 2000. Gold followed, marked by the opening of the Shanghai Gold Exchange (SGE) in October 2002. Platinum was liberalized in August 2003, when trading began on the SGE.

Trading of bullion on the Eurex-Societ Gnrale (SGE) is free from both import tariffs and the 17% value-added tax. Silver is subject to the VAT but does receive a 15% export rebate. Exports are still regulated, with the Ministry of Commerce deciding on silver export quotas. Domestic jewelry purchases are slapped with a 5% consumption tax (currently under review), whereas gold and silver jewelry imports are subject to a 23% tariff and other precious metals jewelry are subject to a 35% tariff.

One of the favourite gold bull hopes is that the People’s Bank of China (and the Bank of Japan) will look to substitute their massive and growing reserves of U.S.-dollar-denominated assets for gold. The argument for such central bank buying of gold is based on the view that the People’s Bank has become over-exposed to the weakening U.S. dollar but may be wary of buying either yen or euros.

Quite apart from the various pros or cons of any central bank owning gold, the major problem is that even if the People’s Bank of China wanted to increase its gold reserves to a significant level, the gold market is not physically large enough to allow that without a major price reaction. For example, if the People’s Bank wanted to match the proportion of gold in its reserves with that of the ECB (initially), then 15% would equate to a requirement to purchase more than 4,600 tonnes. This represents nearly two years’ of mine output. Such a purchase scheme is virtually impossible to transact in anything other than a massive off-market transaction. This is not impossible (after all, there are clearly large willing sellers of gold in Europe), but it does seem extremely unlikely at present.

Gold forecast

We have increased our 2004 forecast from US$390 to US$400 per oz. on the basis of short-term upside risks over the coming months. However, we still expect prices to weaken toward year-end.

We see the potential for gold to test higher in the near term but maintain our bearish view for the end of 2004 and early 2005. Our “one last leg higher” arrived much earlier than we expected, with a second 2004 price peak of US$430.40 per oz. occurring, wonderfully and poignantly, on April 1. The price then markedly retraced to US$371 — its lowest point of the year — in early May. However, since then, physical and fund support has seen prices trend back above US$400 per oz.

The risks are to the upside in the short term, given concerns about the slowdown of the U.S. economy (weakening the dollar), ongoing terrorist concerns, the expected launch of the World Gold Council exchange-traded fund in New York, and the extremely high oil price. Over this period, there will be bouts of profit-taking but few will be willing to go short, and this allows a modest amount of buying interest to push prices higher.

However, we see this as a temporary phase. A recovery in global growth prospects will put gold under pressure again, particularly once the threat of a terrorist attack during the U.S. presidential elections has passed. Unlike 2003 and early 2004, sentiment toward gold is much more concentrated on nearby events rather than a continuation of the bull rally that began in 2001. Barclays Capital continues to forecast strong global economic growth, led by the U.S., by the end of this year and into 2005, and this supports a recovery in the U.S. dollar, particularly against the euro, over the coming 12 months. The expectation is that gold prices will be markedly lower in 2005 until inflation becomes a larger threat.

Silver forecast

We have increased our 2004 forecast for silver from US$6.20 to US$6.40 on the basis of performance and short-term upside risks over the coming months. However, we still expect prices to fall back below US$6, on the basis of poor physical fundamentals, by year-end.

We admit we expected that the 16-year peak of US$8.09 per oz., reached on April 2, would not be challenged from some years, rather than some months. However, we have again underestimated the willingness of some investment funds to buy silver, despite its poor physical fundamentals. Silver had retraced even more steeply than its marked rise, falling to US$5.43 per oz., its lowest point of the year, in early May. However, since then, silver has trended steadily higher, reaching US$6.98 on Aug. 20.

Investor interest in silver has been largely based on its traditional role as an investment alternative to gold, with investors seeing silver as of “better relative value.” The speculative appetite for silver has been seemingly ravenous, with Comex long positions only modestly lower than the April record levels that were equivalent to half of one year’s mine supply. We have noted consistently that neither the first peak nor this second surge can be attributed to any significant improvement in silver’s physical commodity fundamentals, which remained challenging. Indeed, Indian traders report to us that demand has been “dead” for most of the year and warn that this will continue unless prices fall back well below US$6 again.

We warn that in the absence of physical demand, with record-low lease rates reflecting a well-supplied market and given the small size of
the silver market, another sharp price correction is likely when, finally, funds look to exit their long positions. Unfortunately, the timing is impossible to predict. However, we do not expect industrial and jewelry demand to provide strong support to the market until prices approach US$5.50. In line with our view on the base metals, we look for silver prices to firm into 2005, but this assumes that the current speculative excess is exited by then.

— A portion of the preceding is a transcript of a speech given at the China Seminar, hosted by the Association of Mining Analyst in London last July. The opinions presented are the author’s and do not necessarily represent those of the Barclays group. For access to all of Barclays’ economic, foreign-exchange and fixed-income research, go to the web site at barclayscapital.com. Queries may be submitted to the author at kevin.norrish@barcap.com