mdef metals defense energy food

What is MDEF™ Investing? Strategy before tactics. Strategic investments dictate tactical actions in the Metals, Defense, Energy & Food sectors.

- Jeffrey C. Borneman

How China Takes Over the Gold Market

Jeffrey C. Borneman | September 1, 2015

Ending years of speculation about its official gold holdings, China’s central bank announced a 57.3 percent increase in its reserves to 1,658 tons since its last disclosure in April 2009, when reserves hit 1,054 tons.The addition, although seemingly large, was a bit shocking to gold analysts who closely follow the market and who estimated China’s holdings to be double that amount.

In fact, economist Stephen Leeb adroitly pointedout that China could perhaps have 10 times this amount through its member banks. Knowing China’s propensity to publish questionable financials, the question becomes: What advantage does publishing misleading gold holdings give China? And, what might we expect from gold pricing in the near future?

Most knowledgeable investors are immune to the onslaught of the “buy gold now” media commercials. Yet they persist, out of various fears of an unstable world and an unknown future. The speculation about gold’s future valuespans a truly diverse universe.

There are doomsday scenarios centering on a collapsing U.S. dollar via an unexpected announcement by China that its currency will henceforth be “gold-backed,” leading to a Weimar-like inflation for all commodities, to the dollar’s replacement as reserve currency with its own.Lately, it seems the more fear there is in the system, the higher the dollar rises, while gold continues its retreat. That trend may nearly be at an end.

What’s China Up To?

First and foremost, the Chinese want respect as an international power and the unencumbered ability to influence its own geographic sphere. It sees its ancient culture and its accomplishments as world class, as deserving of world leadership, which it believes is its natural destiny.

The world’s banking institutions (central banks, supported by the International Monetary Fund (IMF), the Bank for International Settlements (BIS), and World Bank), which evolved in the aftermath of World War II, excluded much of the Pacific Rim region, focusing instead on a U.S./Eurocentric culture. However, in spite of being forced to sit at


Page 2 Financial Intelligence Report September 2015

the banking “kids’ table,” China has amassed $3.8 trillion of foreign reserves. This is very respectable, indeed. China is hardly being unreasonable to ask for a review of a post-war order, now 70 years old. Two well-choreographed events will unfold later this year that are best understood as a two-act play.

Act One: The IMF will meet in October to consider, among other items, whether to allow China’s currency into the Special Drawing Rights pool (SDR). This alone would vault China’s economic maneuverability greatly, while also weakening the status of currencies currently in the pool.

The U.S. dollar holds the largest and strongest weighting in “the basket” at 41 percent, while Japan

brings up the rear at 13 percent. The talk is that China will finally be granted a seat at the adult pokertable

with a weighting of 12 percent. The idea is that all countries would forfeit a few percentage points of weighting to accommodate the yuan. It’s important to note here the U.S. has balked at the yuan’s addition each of the past few years, noting the yuan’s lack of flexibility and convertibility.

The US has veto power over any IMF decision.

The IMF itself welcomes the yuan, however, and has no particular love for the U.S. dollar as reserve currency. Indeed, the IMF threatened to strip the U.S. of its veto power if necessary to get a proper reallocation. This may leave the U.S. as the sole and impotent protester when the IMF votes in October.

Ultimately, though, China doesn’t care what seat or how many chips it receives at the adult table because it intends to change the game.

If this were a one-act play, the addition of the yuan to the SDR would be a welcome event, as it would be mildly inflationary. After all, central banks have so far failed to create the level of inflation needed to spur further private-sector spending/borrowing. But China is much craftier than it’s given credit for because it envisages a second act to its play.

Act Two: China seeks a seat at the world table, with the ability to influence events that favor China and enhance its sphere of influence. China’s response to being denied entry to the U.S./euro-centric banking system was to launch the Asian Infrastructure Investment Bank (AIIB), a clear and present challenge to the world’s central bank structure.

Almost immediately following its November 2012 christening, the AIIB attracted some 50 European countries wanting to become members – some of which are NATO allies/members. But we must keep the AIIB in perspective: China is using it as leverage for a seat at the “adult” table.

China is the world’s largest gold producer and (at times) one of the largest buyers. It is also the hub of the physical-gold trading market, with little influence over the pricing of the metal that mostly trades via derivatives in both New York and London. China rightly sees the New York/London Comex as pure financial repression — of both the metal’s value and of the country’s ability to influence the pricing. China’s preparation for Act Two is also crafty.

It joined the London Bullion Market Association as a major player. Rather than trade “paper gold,” China has moved to trade the real metal through the new Shanghai gold market and shift the “London Fix” to the Shanghai-Fix.

This bypasses the pricing distortion by the banks that we have seen in the swooning gold prices of the past year. To date, the price of paper gold has fallen, but we are seeing some trades of the physical metal at prices far over the paper spot.

Alan Greenspan made a stunning admission last fall that would have spooked markets had he uttered it while Fed chairman: “Gold is a good place to put money these days given its value as a currency outside of the policies conducted by governments.”

So Greenspan has come full circle (now that he is not paid to defend the dollar). He agrees that gold is money, and China has announced that a re-pricing of gold will take place late in 2015 via its Shanghai-Fix in the physical market.

What Gold Investors Need to Know

So the inclusion of the yuan into the SDR basket and China’s new role setting gold prices will be pivotal for investors worldwide. But it would be unwise to panic over these events yet. China still holds $1.2 trillion of U.S. Treasurys and needs the American market as a buyer of its products.

If the U.S. dollar were to collapse, it would become worldwide within hours. Chinese leaders are not stupid. They are not about to blow the bottom out of a boat they are sitting in by destroying the value of the dollar. However, both events will be inflationary.

Adding the yuan to the SDR will decrease the percentage of all five existing currencies, and with the U.S. as the largest player, it will hurt the value of the dollar all the more.

Regarding the repricing of gold, consider the statement of China’s new gold boss, SGE Vice President Shen Gang, at the LBMA Bullion Market Forum in Shanghai in June: “We will be introducing a yuan-denominated fix at the right moment. We hope to introduce [it] by the end of the year.”That “right moment” to “adjust” the price of gold is meant to coincide with the IMF’s admission of the yuan as a real, stable alternative to the U.S. dollar. This is the absent point from all discussions on China and gold.

The introduction of the yuan to the SDR coupled with China’s ability to influence the price of gold is nothing short of a shift in the balance of power the world hasn’t seen since the Bretton Woods Agreement in 1944, just before the end of World War II.

Aside from the mandatory rebalancing and inflation expected by the yuan, the world will discover later this year whether the U.S. claim of holding 8,133 tons of physical gold is real, how much is owned outright by the U.S. Treasury, how much is hypotheticated (borrowed out) or rehypotheticated (the assets of others borrowed out in the name of someone else), and how deep those contracts go.

The fear of an Enron-like collapse of the paper gold market as traders flock to sell paper gold and own the physical via the Shanghai market is very real. But again, it does China no good to be too disruptive at the outset of its new role. Gold prices will rise, but it’s a safer bet that China will allow only a slow inflation of “hedge to world currencies.”

The Twist Ending to Act Two

China must make sure the yuan is included in the SDR before it reveals its true gold holdings. It would not surprise any analyst if China were to state its reserves topped 15 or even 20 thousand tons. An announcement of reserves near this size would immediately cause gold prices to rise substantially.

China’s endgame — replacing the U.S. dollar as the global reserve currency — would be apparent to

all. How far and how fast would gold rise? Is this the scenario the “gold bugs” in the media envision? The possibility of an SDR currency addition and the Shanghai Fix raising gold prices is a scenario no media has yet mentioned, but is a strong possibility.

Investors may see the potential described above as analogous to David vs. Goliath in that such a shift would cause an immediate division in the SDR, pitting the dollar against the yuan. The dollar position, no matter how far lowered to allow China in, would be at least three times as large as the yuan.

This would leave investors the world over with a choice of currencies: one backed by gold, and the other, oil. Gold looks great in a vault, but it will not power aircraft or tanks. But America’s problem is that a gold-backed currency sitting on 15,000+ tons of gold can buy a lot of petroleum from Russia.

Of course, there are some potential pitfalls for China. China has no substantial oil assets. The U.S. arguably has trillions of barrels of oil in the lower 48 states. China has purchased petroleum assets around the world, but the U.S. controls the seas while China is years away from a true blue-water navy. China’s only source of oil on the continent is Russia.

Pitfalls go both ways. If the U.S. loses its reserve status to a gold-backed currency, the flood of dollars coming back to the Treasury could be inflationary to the point of threatening to social stability. This would be especially true to equities. Imagine the future earnings of any company not producing essentials like metals, defense, energy, and food. We can expect a rotation of investment capital out of non-essential companies into essentials in a way never seen.

Caught in a trap and looking for any scapegoat, it is possible the U.S. will resort to the time-tested war scenario: We will pick a fight with a real or perceived enemy that we’ve spent the past few years demonizing — possibly even Putin’s Russia.

The U.S. has the biggest hammer (military) in the world and commands NATO. The temptation to use them will be great. The old adage of “all wars are bankers’ wars” should be updated for the times: All wars are currency wars.

Of course, our leaders have planned for this as well as scads of other possible scenarios, so all may be fine by Christmas — a new alternative currency the world welcomes with only a slight rise in gold prices.

The question then becomes, will that please China or will it want to run the table and end the game immediately? Either way, China will be setting the physical price of gold soon. No one has a clue whether there will be a hard or soft landing. 

Jeffrey C. Borneman had a career on Wall Street that spanned nearly three decades trading equities, debt and commodities. Mr. Borneman began working independently in 2003, and developed the MDEF™ strategy, designed on the Value at Risk (VAR) model, for equity investors. Mr. Borneman is CEO of Rampart Portfolio Partners, LLC.

comments powered by Disqus