The Shanghai gesture

The Shanghai Gold Exchange is opening just as gold prices are returning to levels they had not seen in five years (neglecting the brief spike at the time of the Washington gold-sales agreement in late 1999). Investor interest in gold is greater than it has been since the early 1990s, and after five years of decline, shares in gold producers have rebounded.

The opening of free-market gold trading in Shanghai has been hailed as the breach of “the last fort of China’s planned economy.” While that may be piling the praise a little high, seeing an open gold market in the world’s most populous country has to be good news for the gold price.

Although the Shanghai exchange will initially serve only producers, member dealers, and manufacturing end-users such as the jewelry industry, the intention is that Shanghai will ultimately be a market for gold investors as well. The People’s Bank of China (the country’s central bank) and the World Gold Council both estimate that trade through the exchange could rise to 500 tonnes annually. And settlement in Shanghai will be all metal, no paper.

If Shanghai does turn a large trade, that could open some doors that have until now been closed to “retail” gold bars and coins. Mainland China’s economy is modernizing, but the man on the street may be more ready for physical gold than he is for financial assets beyond a conventional bank account. Certainly that is the experience in the rest of developing Asia, where gold has remained a trusted store of wealth after being abandoned in the West.

Equally, even in Japan there is a resurgence of retail investment interest in gold, a consequence of the poor state of the country’s commercial banks and the government’s reduction in deposit insurance.

How much difference can Shanghai make? After all, one of the largest gold markets in the world operates in Hong Kong, a market that has served Asia for nearly a century. Whether the two exchanges will simply be eating each other’s lunches may depend on whether China proves to be an expanding market for gold. The gold industry should keep its fingers crossed, because mainland China may be an immense opportunity.

There are parallels here to an event that now dates back 30 years: the opening of futures trading in gold on the Winnipeg Commodity Exchange in 1972. Winnipeg was the first market in paper gold, predating the New York Commodities Exchange by a little more than two years. Then, as now, the price of gold had been weighed down by the perception that above-ground supply could drown any new demand. But the new exchange caught a sudden wave when the 1973 Sinai war and the subsequent oil price shock decked the stock markets and gave new life to investment in commodities.

The result was that paper gold trading came to dominate the gold market, with effects that linger to this day. When large hedged gold producers like Barrick Gold and AngloGold began to pull back from their policy, and other producers got out of the derivative business entirely, the gold market suddenly saw greatly increased demand. A significant turn in sentiment that largely took place in the paper gold market had major repercussions in the physical market too.

But if gold producers were to abandon hedging entirely — which the remaining hedgers are not likely to do — there would still be the need for investment demand. Demand for gold from the jewelry industry, dentistry and electronics wasn’t sufficient to drive the price higher when the hedgers were king, so why should it do that now?

The pressing issue is for gold dealers to develop convenient, transparent, and readily exchangeable instruments for the sophisticated investor. Investors may be looking for safety, but that will mean little without liquidity.