Tuesday, February 24, 2015

Fundamentally Flawed - Chapter 8, 10,000 Tons of Gold...Math Says China Could Have Easily Done It!

by Chris Hamilton, February 2015

July ’11 to December of ’14, China decreased its holdings of US Treasury debt by $71 Billion (according to the most recent TIC data)…while continuing to run record trade surplus' with the US.  China took in excess of a trillion shiny, new, digital dollars since August of 2011 through 2014 and simultaneously sold or rolled off $71 Billion in US Treasury holdings…so China had to find a home for nearly $1.1 trillion new dollars.  The chart below highlights China's annual trade surplus with the US, annual Treasury purchases, and total Treasury holdings.
Source, US Census, Trade, Source, Treasury, TIC report
From ’00 to ’11, China had (on average) recycled 50% of its trade surplus dollar reserves into Treasury’s.  However, as noted above, China has been a net seller since July ’11…why is this date important?  It was the month of the US debt ceiling fiasco…and the date when China’s purported gold purchase binge began.  It’s also August ’11 that gold hit its peak price and has fallen since.  I don’t think these happenings were a coincidence. 

Since we know China didn’t buy Treasury’s over this period, perhaps we should speculate what those new dollars would do if focused on gold purchases?!?  If China rotated the 50% of surplus dollars it had been utilizing to buy Treasury’s and instead bought Gold…at an average of say $1500 an ounce since August ’11…that would buy China 10,000 tons of gold by year end 2014.  Hmmm…Implications abound.

China’s gold demand rose from 300 metric tons up to 1300 metric tons in 2013 and about 1200/mt as of 2014.  This is important as the World Gold Council (WGC) reporting nets all newly produced global mine supply, global recycled scrap, and (based on the above WGC data on Chinese demand) denotes that the gold market is in balance between global supply and global demand.  However, based on the data from the Shanghai Gold Exchange (SGE), the central clearing house for all Chinese gold purchasing, China’s demand is far greater (the chart below highlights the discrepancy).  But if the data from SGE is correct, then where did all the additional gold come from and why did the price collapse on record demand?  The answer is almost certainly, the gold was imported from someone else’s inventories willing to sell something of great value at low prices.  But according to the SGE data, the Chinese demand was about 2,700 metric tons greater than global available WGC available supply since July 2011 (3.5 years) or about 771 tons annually.  In the prior 3.5 years, the WGC and SGE had only diverged by about 600 metric tons or a 171 ton differential annually.  So, China had massive dollar reserves not utilized to buy Treasury’s and someone sold a lot of gold to China and in the process drew down their own inventories as the demand was far greater than mining supply!
Who would have this massive amount of gold in inventory (and willingly sell it at these lower prices) and why would the price of gold collapse on this clear imbalance in demand over supply?  Most sources of potential inventory are audited on a regular basis and this drawdown would be quite noticeable.  Of course, the greatest source of gold holdings are collectively held by the Federal Reserve and the US Federal government…and this is not openly audited.

Some questions spring to mind! 
  • From ’08 could China have been performing the thousands of years old gold window activity of recycling excess US dollars and officially purchasing US Treasury’s but quietly and in secret being paid in some sort of gold arrangement?  This would certainly serve both parties nicely allowing US deficit spending in an economic downturn without spiking interest rates.  China for it's part would continue its export driven economic miracle. 
    • China increased its holdings of US Treasury debt from $65 billion in ’00 to $1,315 billion ($1.3 Trillion) in July of ’11…and in particular, from ’08 to July ’11, China increased its Treasury holdings by $850 billion while the US ran massive budget deficits flooding the Treasury market with new supply…and China’s trade surplus with the US ebbed on lower US consumer demand during the ’08 through ’11 economic slowdown (said more plainly, China bought more when they had less to make those purchases).
  • Since July ’11 China has net sold $71 billion in US Treasury debt on record dollar trade surplus in excess of a trillion dollars. 
    • China as of July ’11 suddenly and violently change course with their dollar surplus even as their trade surplus with the US reached new records annually over ’12-’14?  Did China suddenly decide gold was valuable and begin buying in the open market?  My guess is China believed gold was of value all along but once the gold was no longer available (perhaps the US ran out or simply determined, like Nixon in '71 (who watched almost 60% of US gold depart in the prior decade) that closing the gold window, was essential to save whatever gold and prestige the US had left. 
  • Put it all together…China, the largest buyer of US Treasury’s ceases buying Treasury’s…and US Treasury yields collapse.  The Chinese (and others) buy record amounts of gold and create an imbalance of demand over available supply…and prices collapse.  These are clearly not the actions of a market attempting to find a balance between price, supply, and demand.
So what then is this?  
Of course I can’t prove that China did purchase any amount of gold.  The Chinese authorities haven’t made any updates since 2009 when they last made public a 600 ton increase (to their then official holdings of 454 tons) to the current official Chinese gold reserve of 1054.1 tons.  What I can say is Russia, which likewise has a large dollar trade surplus and likewise to China has been reducing its Treasury exposure since August of 2011…has been busily and openly adding to its gold reserves, now up to 1153.3 tons.  Then again, I (nor the US government?) can’t prove the US truly has 8133.5 tons.  Or the Germans 3384.2 tons or Italians 2451.8 tons.  Still waiting on those open and transparent audits.
All I can say is the above math regarding China’s dollar hoard would nicely support what is visible in the chart below and also support those that claim Chinese gold buying and gold reserves are far larger than advertised. 
As a follow up; I was asked if the large Treasury holdings increase in Belgium could represent Chinese buying?  Here’s my two cents:
No way to know for sure - but China's usual outlets for secondary Treasury purchases were historically through Hong Kong or the UK and potentially also via Canada...however, it was the UK that from June / July of 2011 dumped $208 B in Treasury's and by October of '11 had dumped $240 B of the UK's original $347 B (70% reduction in holdings).  Canada likewise dumped $49 B (50%) from June / July of ‘11.  The UK as of Dec ‘14 has recouped some to $189 B but still only half of what it owned in June of '11...Canada likewise has recovered some to $69 B but still well below its $93 B peak.  Hong Kong has been steady and slightly growing the whole while.  China's official holdings peaked in July of '11 @ $1315 B and suddenly also declined to $1150 B by year end 2011.

It's a pretty safe bet this was China or its agents selling what amounted to $435 B or 35% of China's official Treasury holdings...and it was Belgium who held $34 B in June of '11 that suddenly began its moonshot to its current holding of $335 B...an addition of $295 B.  However, many also want to attribute some portion of Belgium’s rise to Russia whose Treasury holdings peaked in October 2010 @ $176 B and have fallen to their current holding of $86 B ($90 B reduction…or about a 50% reduction).

Was there a connection between the $435 B sold between China / Canada / UK and the $295 B subsequently purchased in Belgium?  Seems a fair bet.  But even more importantly, that would only represent a repositioning of China's Treasury holdings and would still indicate China has been nothing but a net seller since '11 (the other option is China actually did sell and has an additional $400+ billion on top of the $1 trillion in trade surplus all in need of PM’s, stocks, and/or real estate).  The premise that all those dollars in trade surplus from '11 till now need go somewhere still seems valid.
China and the Dollar
Fast forward to China in 2000 running a large trade surplus with the US.  China had taken over the manufacturing leadership from Japan and began accumulating a stockpile of US dollars.  From 2000 till 2011 China recycles on average 50% of this dollar trade surplus into US Treasury’s.  Initially these Treasury’s offered an inflation adjusted positive yield but over the ensuing decade this yield collapses to the inflation adjusted negative yield currently offered.  And since the advent of QE, the Fed has created $2+ trillion dollars to buy US Treasury’s essentially printing new dollars to roll over old debt and allow ever more debt at lower interest rates and essentially at no greater cost to the US (see chart)… unless one considers the potential the US is paying for its deficits via higher energy costs and co-opting the world to likewise pay for America’s debt?
Or factoring in growth in population (Households) and spreading interest costs and oil costs evenly among them to determine how the US is paying for increased debt…see chart below.
And then the July 31st, 2011 debt ceiling debate determined that the US would not reduce its budget deficit nor trade deficit and would instead continue monetization (QE, etc.) indefinitely.  China held nearly $1.3 trillion in Treasury’s and another couple trillion dollars for which it would be paid trivial interest and which the US made clear it had no qualms with printing new dollars to pay back these debts.
It is with this background that the sudden shift in China’s Treasury purchases was noted in 2011.  China continued selling consumer goods to America at record pace but halted their rapid accumulation of Treasury’s and became a net seller.  China and other BRICS nations rapidly increased the pace of building a non-dollar denominated structure for trade.
And China, noting the weakness of their position, holding massive currency of a nation that had just announced to the world its intention to maintain budget and trade deficits via printing new currency, seems to have rapidly and without abandon initiated a program of exchanging something easily diluted (the dollar) for something relatively fixed and stable (gold and likely other hard assets).
And Now?
The importance of China (and Russia) having re-balanced is it affords them an insurance policy against a dollar conflagration.  If (when) the US runs into its next headwind, the only real answer the US has shown it is willing to entertain is more QE or a like program of monetization.  But to be effective, it will need be larger than the previous editions.  This dilution of the dollar (and all major currencies will be forced similarly continuing dilution to maintain “competitiveness”) absent US trading partners recycling dollars into Treasury’s (and thus the US diluting into a de-dollarizing world which will need fewer dollars just as the US pushes the “print” button)…this should mean too many dollars and fewer exporters trading utilizing them.

Some ominous implications arise.  Primarily the estimated $10 - $20+ trillion US dollars sent abroad from the advent of the Petro-Dollar in ’71 till present coming back to the one place they are legal tender; the US of A.  And even a fraction of this amount of money coming back with modest leverage will not go unnoticed…first as a trickle (pushing prices of assets higher) and then as a rush (pushing asset prices into overdrive) likely absent an accompanying economic boost.  This would likely be some sort of asset hyperinflation alongside continued wage deflation (due to structural unemployment and a multitude of factors containing US wages).  As an aside, I’m more than a bit curious if this repatriation of dollars combined with corporate share buybacks made possible by ZIRP and a continued strong Belgium / Cayman Island Treasury bid will continue to push the “markets” higher even absent any additional QE.

China’s gold holdings would act as an insurance policy paying off in the case of a dollar dilution.  Of course China’s economy would be harmed by shrinking exports to the US and Europe but that was the “re-balancing” they’ve been talking about all along.  Now, whether this will work just as China is likely falling into the third great real estate collapse of the last 3 decades (Japan in ’89, US in ’07, China likely now in ’14)…well China may be protecting itself from itself as much as from the US because if they follow the Japanese and US model to print their way out of a real estate collapse…gold may simply be “priceless” in sovereign currencies.