Eastward Ho! Gold Migrates to the Middle Kingdom

When America sprints at full potential it achieves modest rates of real GDP growth, and though China has slowed down recently, it still cruises along at an extraordinary pace for a giant economy. The differential makes the closing of the current gap appear to be inevitable, so experts wonder about the specific date when the torch is passed. Assuming China may grow 6% on average moving forward, far above the more leisurely 3% that the US considers reasonably attainable, and if Chinese inflation rates rise to 4% to the 2% expected in America, it would outrace the US past the $20T mark before 2025. As “The Economist” predicted on August 22, 2014, “the timing of China’s ascent thus depends on five things: its own growth, America’s growth, the evolution of prices in each country, and the exchange rate between them.”
No one should be surprised by this probable restoration of China’s geopolitical and economic supremacy after its emergence from the frequent barbarity that plagued the country during the nineteenth and twentieth centuries. It has always been destined for world leadership. The world’s third largest land mass under one flag, behind only the marginally uneconomic and sparsely inhabited expanse of arctic and sub-arctic tundra, taiga, and forests of Russia and Canada, relatively temperate China contains massive natural gifts deemed essential for an advanced industrial economy, but for its limited supplies of fresh water…a vital input to life and production that is available in abundance in Siberia Russia to its north. Clean air is also at a premium as its coal-intensive heavy industries continue to pour out tremendous amounts of effluents during the headlong rush to increase investment levels in infrastructure, the manufacture of capital goods, and the essential distribution of consumer products for the masses. With twenty percent of the population of the planet, a strong tradition of technical education, a huge and disciplined workforce, and a prime location on the world’s largest ocean, China commands impressive human and natural resources needed to attain economic supremacy.

When it comes to gold, no country can match China’s combination of high mine production and multi-faceted demand for jewelry, industrial products, and investment in physical metal. For thousands of years, gold has been embedded in the texture of Chinese culture, utilized as a store of value, and accepted as a medium of exchange. Despite the legacy of cataclysmic floods, earthquakes, revolutions, purges, colonial encroachment, ethnic or class-based genocide, internecine wars, invasions, political upheavals, and other calamities that have often crippled the integrity and very survival of the country, today’s China remains populous, unified and impregnable. Since 2010 it has been the premier miner of gold. Along with India, it is the highest demander of newly produced gold in the world. The people and institutions of China have great confidence in gold as a timeless store of value. Over its long history spanning many dynasties, paper and token currencies have come and gone by the dozens. But only gold remains from that tumultuous past as the most trusted pillar of its financial system.
What could the spectacular economic ascendancy of China mean for the international gold market? To answer this question, one can isolate three groups of factors including the economic physical realities, the economic context, and the financial flows. All together nine significant sub-factors within those groups shape the expanding role China is playing in the 21st century marketplace for physical metals.

The first group of factors center on the physical realities of immutable geographic and demographic nature.

The Awakening Giant: Due to the demographic imbalance between East and West, it was just a matter of the passage of time and the arithmetic of compounding that the rejuvenated East would overwhelm the relatively sluggish West. With three fifths of humanity living on one continent, the recent rush toward economic parity with the European and North American powers has prompted a rapid eastward tilt of the gold marketplace. Even if there were no changes in the preferences of investors or among industrial demanders of precious metals, this secular shift in the locus of demand from Europe toward East Asia was destined to begin. According to experts in such calculations, the economic center of gravity of the planet was near Madrid in 1965, is south of Sicily today, and will at current rates will be moving eastward across the Iran-Afghanistan border by 2050. To grasp how quickly this transition could occur, China’s current consumption of their own steel in construction and infrastructure exceeded the total annual consumption of steel in the US, South Korea, Japan, Russia, and India combined. And China consumed more than half of all the copper, aluminum, nickel, and zinc produced by the entire world in 2014. In 1803 Napoleon Bonaparte said, “Let China sleep, for when she wakes, she will shake the world.” She has certainly awakened, and all markets including gold are feeling the tremors.

The Rise of China’s Supply of New Gold: The factors on the supply side also presage powerful acceleration toward the East. China has become the largest producer of gold over the last ten years, with steady growth in output that shows no signs of cooling down. The change in the balance of power has been astounding: Consulting data from the World Gold Council, in 1970, South Africa produced 1000 metric tonnes, a staggering two thirds of the world total. By 1990, South Africa still led the world by a substantial margin by producing 600 metric tonnes of gold, accounting for 26 % of the total, while production in China that year was only 100 tonnes. By 2014, the situation reversed, with China at 450t, tripling South Africa’s 150t. Meanwhile, production was on the rise in Russia, Australia, Canada, and Brazil, but declining in the United States, Indonesia, and Peru. On balance, the supply of new gold to the market comprising a total of 3000 mined tonnes per year has migrated steadily eastward. Given the expense of transporting the gold doré and concerns about risk, there are legitimate logistical reasons why the industry would tend to gravitate somewhat toward the regions where production of the precious metals is booming and its demand is robust. For example, South Africa and Russia dominate both the mining and refining of platinum and palladium. This is not a hard and fast rule for gold, for the massive South African Witwatersrand deposit was refined in the most part in Switzerland, 5200 miles north. However, it portends significant economies of agglomeration in the gold industry well into the future as China, Australia, and Russia are anticipated to remain the top three producers, possibly for decades to come. Looming in the background is the colossal gold producing potential of the world’s largest mine, the Grasberg in Indonesia, which is estimated by mining giant Freeport McMoran to contain 28.2 million ounces of gold.

Expanding Refinery Capacity in Asia: A third factor that reshapes the geographic center of power in gold is the rapid increase in gold refining capacity in China and Japan. Japan as of 2015 had eleven refineries fully accredited by the LBMA while China had eight. Hong Kong had two, and there was one each in Korea, Thailand, Indonesia and far distant Australia. This placed 25 of these vital facilities, or fully one-third of the world’s accredited gold refiners, in the Greater PAC-Asia region, with more refineries in the planning stage. With so much refining expertise and facilities in the region, the search for marketing opportunities is moving beyond the industrial and jewelry sectors to the growing province of investment gold.

Upshot: From the perspective of where the economic momentum is building, where the refineries are expanding, and where production and demand are rising in tandem to serve the needs of a huge population, the gold industry is quite predictably moving its center of gravity from Western Europe toward East Asia. The transition may take several decades to work itself out, but the rising power within the gold marketplace of Shanghai, Hong, Kong, and Singapore relative to London, Zurich and Johannesburg, appears to be irreversible.

A second group of factors emerge from the evolving economic context of the gold industry.

The Golden Cultures of the East: The trend toward investment gold is especially apparent in China and India. For millennia, families have accumulated, concealed, and maintained stores of personal wealth in the form of illiquid jewelry and sartorial and architectural ornamentation. With the global spread of digital communication and investment acumen over the last 25 years, the UHNW (Ultra-High Net Worth) families and institutional investors now express heightened demand for a more secure and liquid asset in the precious metals class. Physical gold of proven purity and standardized size and weight fulfills that need far better than stores of bulky, impure, alloyed gold in the form of jewelry that is tedious to inventory and risky to sell. Pure bars and coins can be far more easily stored, shipped, bought, and sold than was ever possible with precious metals in those other forms characterized by uncertain value. Over half of the demand for physical investment gold originates in Asia, with half of that in China. Although it is a slightly smaller economy when measured in current prices, Chinese investment demand for gold is more than four times that of the United States, a country where there is less understanding of the considerable attributes of physical gold within both the culture at large and the investment community. This rise in demand for physical gold in the East has not been matched by a proportionate increase in the West, particularly in the Americas and the GCC (Persian Gulf) region. For all demand sectors, China is likely to soon surpass India as the greatest single demander of physical gold on world markets. And much of China’s unparalleled output of gold goes directly into the coffers and vaults of the state.

The End of Income Equality: A second economic factor accelerating the Chinese gold market is the rise in prosperity of China’s elite upper class, with ripple effects trickling down to the world’s largest bourgeoisie that now rivals and will soon surpass even India’s burgeoning middle class. Investment in gold and jewelry are luxury goods (defined as having income elasticity of demand above 1.0, meaning if incomes were to rise 10%, quantity demanded of gold would increase by more than 10%), so as the last three decades brought extraordinary income growth and accumulated wealth to the world’s second largest economy, Chinese gold demand has soared. It has also created a new class of billionaires and other UHNW investors, as well as a massive financial framework of institutions including corporations, banks, and family offices demanding diversified assets. In 2016, trackers of UHNW fortunes estimated that China had 594 billionaires, second only to the US with 535 billionaires. Its middle class, estimated today above 300 million persons, can be extrapolated to be in range of 900 million members within two decades, a figure representing two thirds of the population. The top echelons of this massive cohort are apt to be prime demanders of physical gold, if past behavioral trends continue as expected, whether as individuals or through their financial institutions.

The Great Chinese Diaspora: A third economic factor involves a demographic group with considerable economic clout: Chinese citizens out of country or ex-patriates, estimated to be over forty million persons, are spread mostly over Southeast Asia. There are more than seven million each in Indonesia, Thailand and Malaysia, with more than three million in Singapore. For comparison, there are three million Chinese ex-pats in the USA, or one percent of the population. This fragmented surge of overseas Chinese is powerful in terms of income and wealth, for many of its members have established lives and businesses abroad several decades ago and avoided the disastrous decades of the twentieth century that made life so treacherous in their mother country. Now they are in a position to reconnect with family interests and rebuild economic ties with the new China, and physical gold as a medium of exchange constitutes a major way of restoring the old links. The overseas Chinese also run a variety of financial institutions, transportation, and vaulting and logistical firms that could serve as intermediaries or destination points for the wealth of Chinese nationals, as soon as exportation of gold becomes legalized, in locations out of reach of the government of the PRC, or in the unlikely event that gold shipments be permitted by the central government via QDII investment arrangements.

Upshot: A substantial amount of economic momentum points toward a continued rise of physical gold in the East, as China likely matures from a large demander of gold for jewelry to a premier demander of investment gold as well.

Financial Flows: The third major cluster of factors accentuating the importance of China to the future of the gold marketplace includes the evolving financial and technological realities sweeping across the world.

Gold as a Reserve Asset: Foremost is the increase worldwide in the stockpiling of official gold reserves by central banks. The sell-off of public gold in Europe prevalent ten or twenty years ago has turned into a campaign of expansion of reserves, particularly in China. There the central bank is on track to more than double its official reserves, although the figures are very carefully kept secret. Indirect evidence reveals that large government purchases of gold from internal and external sources has been underway for several years. Estimates are that the official numbers on tonnes of reserves are thought to be half to one-third of the actual weight of the actual Chinese stockpile of pure gold.

Follow the Leader: A second financial factor is known in the economics of development as the “demonstration effect”, where imitative behavior makes a substantial difference. As China likely soars ahead of the US well before 2025 to become the largest economic system ever in terms of total output or GDP, there will be a tendency for emerging nations large and small to look up to them as leaders of the world, much as the US enjoyed that special status ever since surpassing England. If physical gold is seen as a critical asset in the portfolios of Chinese banks, corporations, public funds, and family fortunes, the other countries on lower rungs of the ladder may emulate details of their investment allocations and strategies. This can be seen already across Africa and Southeast Asia, a trend accelerating in the near future as the US makes a turn inward toward nationalism under President Trump. This will represent a marked change from the disinterest that most world citizens, their financial institutions and UHNW individuals have shown toward gold throughout the American Century. Often this demonstration effect is not a matter of voluntary compliance or unimaginative copying, but is based upon the spread of Chinese business practices worldwide through establishment of global banks, franchises, capital transfers, and overseas industrial facilities.

Decline of the Dollar: A third financial factor results from the probable decline of American hegemony as the new millennium unfolds into its third and fourth decades. As the industrial and financial primacy of the US assumes second place behind the Chinese juggernaut, the role of the dollar as the most trusted international reserve currency will inevitably give way to a more balanced multi-currency world. It may take several years for the yuan to supplant the dollar, if ever, depending on how eagerly the policymakers in China assume the burden of global leadership, with all the sacrifices of control such a posture would entail for the political hierarchy in Beijing. But in the interim there would be great skepticism about fiat currencies of all types, thereby elevating the attractiveness of hard assets over paper, and gold and other precious metals as an asset class over less liquid stores of wealth such as property and paintings.

Upshot: The financial and technological tides indicate an investment milieu encompassing hard assets such as precious metals as the era of the US dollar’s supremacy passes into history. Investors in the new millennium are prone to mitigate their risks by including mobile, dynamic, and tangible assets into their institutional portfolios. Rejuvenated gold, made highly liquid and transportable as a store of value and a medium of exchange, such as the bullion enabled though efficient digital messaging and technology, can serve a unifying role between West and East. Investors rely on clarity of global standards, efficient automation, and the security of the precious metals asset class to be rocks of stability in their allocations of wealth. As the Shanghai Gold Exchange and refiners in the East grow in stature, the old world order in gold where London and a handful of Western bullion banks called all the shots must adapt to a dramatic rebalancing of power. The trend is already apparent. Change is on its way as the gold marketplace modernizes. Investors and governments worldwide should welcome the evolution and stand ready to assist in a peaceful and profitable transformation as the gold marketplace adjusts to the changing geopolitical realities. Eastward Ho!

Roy Van Til, Ph.D.
Vienna, ME
royvantil@mac.com
April 12, 2017