The Round Tripping Myth And Why It Doesn’t Hurt Chinese Gold Demand
Much has been written lately about the influence of Chinese commodity financing deals (CCFD) on Chinese gold demand. An often perceived analysis is that CCFD have been inflating Chinese demand/import figures and thus balance the surplus of physical gold supply in China.
In 2013 the mainland net imported 1158 metric tonnes through Hong Kong, the Chinese do not disclose total net gold import, and domestic mining output was 428 tonnes. Without counting scrap supply and net gold import through other ports than Hong Kong, total supply was 1581 tonnes (according to me total supply was 2197 tonnes, as Shanghai Gold Exchange withdrawals equal total supply and demand, more on that later). Most institutions, like the World Gold Council (WGC), the China Gold Association (CGA), and GFMS state Chinese demand was lower than 1581 tonnes in 2013, forcing themselves to explain where the rest of the supply ended up. I disagree with their explanations that are often based on CCFD, also referred to as round tripping.
Many reports I read on CCFD simply don’t take into account Chinese laws on gold trade and the structure of the Chinese gold market. These are a few of the pieces I stumbled upon regarding this matter, from:
What are Chinese commodity financing deals?
Simply put Chinese commodity financing deals are trades to acquire low cost capital using a commodity as collateral. There can be many ways to do this, but for now we will focus on round tripping as I would like to demonstrate this does not influence Chinese net gold import or demand. Let’s walk through the reports linked to above and get an understanding of such deals with regard to gold in comparison to other commodities. Goldman Sachs stated a few important facts:
While commodity financing deals are very complicated, the general idea is that arbitrageurs borrow short-term FX loans from onshore banks in the form of LC (letter of credit) to import commodities and then re-export the warrants (a document issued by logistic companies which represent the ownership of the underlying asset) to bring in the low cost foreign capital (hot money) and then circulate the whole process several times per year. As a result, the total outstanding FX loans associated with these commodity financing deals is determined by:
- the volume of physical inventories that is involved
- commodity prices
- the number of circulations
Our understanding is that the commodities that are involved in the financing deals include gold, copper, iron ore, and to a lesser extent, nickel, zinc, aluminum, soybean, palm oil and rubber.
…Chinese gold financing deals are processed in a different way compared with copper financing deals, though both are aimed at facilitating low cost foreign capital inflow to China. Specifically, gold financing deals involve the physical import of gold and export of gold semi-fabricated products to bring the FX into China; as a result, China’s trade data does reflect, at least partially, the scale of China gold financing deals. In contrast, Chinese copper financing deals do not need to physically move the physical copper in and out of China, so it is not shown in trade data published by China customs. In detail, Chinese gold financing deals includes four steps:
1. Onshore gold manufacturers pay LCs to offshore subsidiaries and import gold from Hong Kong to mainland China – inflating import numbers
2. offshore subsidiaries borrow USD from offshore banks via collaterizing LCs received
3. onshore manufacturers get paid by USD from offshore subsidiaries and export the gold semi-fabricated products – inflating export numbers
4. repeat step 1-3
Making a clear distinction between gold and copper round tripping is very important. Though Goldman Sachs mentions the difference – gold needs to be physically round tripped, copper not – they desist to explain what’s causing this difference. The reason is that the trade laws for gold are different than for every other commodity (because the Chinese government has chosen gold to be a part of China’s economic backbone and likes to have firm grip on this metal). A quote from myself from a post I wrote a few weeks ago:
A very long and complicated story short: In the mainland there are two types of trade; general trade and processing trade. General trade can be considered as normal trade. However, if gold is imported in general trade this is required to be sold through the Shanghai Gold Exchange. Only 12 banks have general trade licenses for gold from the PBOC (though for every shipment they need anew approval).
1. Industrial and Commercial Bank of China
2. Shenzhen Development Bank / Ping An Bank
3. Agricultural Bank of China
4. China Construction Bank
5. Bank of Communications
6. China Minsheng Bank
7. Bank of Shanghai
8. Industrial Bank
9. Bank of China
It’s not likely the PBOC would approve bullion gold to be exported in general trade.
Additionally there are a few jewelry companies that have PBOC licenses, but these also have to ask for permission for every trade they conduct. The PBOC has a very firm grip on gold trade.
Processing trade is something else. In this trade form raw materials from abroad are imported, processed into products and then these products are required to be exported again. This processing is usually done (there can be exceptions) in Customs Specially Supervised Areas, or CSSA. Processing trade doesn’t require a permit from the PBOC, as the gold that is imported will be exported after being processed. To export gold from a CSSA to a non-CSSA (that’s the rest of the mainland) a PBOC license is required.
An example for a processing trade would be; gold from Hong Kong is exported to Shenzhen (a CSSA just across the border from Hong Kong and well known for its vast jewelry fabrication industry; 4000 manufacturers), then the gold is fabricated into jewelry and imported back into Hong Kong. This trade would show up in Hong Kong’s customs report, but it would not affect Hong Kong net export to the mainland.
Copper trade in China is also done through general or processing trade, the difference being that for copper general trade there is no PBOC license required and imported copper is not required to be sold through the Shanghai Gold Exchange (SGE), or any other exchange. This explains the difference in copper and gold round tripping.
Now let’s jump to what the World Gold Council had to say in it’s latest report China gold market progress and prospects. In my opinion they made some conflicting statements, not only regarding CCFD:
Imported gold is being used via gold loans and letters of credit to raise low cost funds for business investment and speculation.
Most of this has been built up since 2011, when gold has been increasingly used as the basis for a variety of financial operations [CCFD] in China that have required the importation of very large quantities of physical bullion. These operations fall into two broad categories, although there is some overlap between the two. Firstly, there is the use of gold via loans and through letters of credit (LCs) as a form of financing. Secondly, there is the use of gold for financial arbitrage operations that will also be based upon gold loans or LCs. In most cases the gold is quickly re-exported to Hong Kong, often as very crude jewellery or ornaments to get round tight controls on bullion exports. (This is the practise commonly referred to as ‘round-tripping’. Moreover, because nearly all gold flowing into China goes through the SGE, round-tripping can inflate the SGE delivery figures.)
In theory only jewellery manufacturers or others active in the gold trade can take out gold loans, although it appears that the rules can be circumvented either by setting up a ‘gold enterprise’ or by using the services of an existing company in the gold trade. The same is true for foreign currency LCs that are used to import gold. The gold borrowed/imported is usually sold spot and repurchased forward to create a synthetic currency loan well below market rates for cash. This is because the short-term interest rates on gold or Hong Kong/US dollars are well below renminbi ones and, moreover, the gold contango is very low. (Most users of these gold loans and LCs want to eliminate gold price risk.) In addition, it may be that it is not just the price of, but also access to, credit that is motivating the borrower: the firm may not otherwise obtain loan finance from the formal banking system. Gold loans or LCs used to import gold therefore offer wealthy individuals and companies a form of cheap short-term financing either for business or speculation. They can also be used to circumvent capital controls to bring funds into China. In some instances gold is being used as low-cost collateral by borrowers to fund financial operations in China.
The WGC is correct when it states the CCFD are conducted by gold enterprises (and wealthy individuals). These are allowed in processing trade to import gold (in a CSSA), later to be exported. But then they claim this round tripping inflates SGE deliveries, which is false. First of all the term they should use is SGE withdrawals, that is the amount of gold leaving the SGE vaults entering the Chinese market place, whereas deliveries merely relate to the settlement between longs and shorts after a trading day, that is the amount of physical gold changing ownership in the SGE vaults. Second, although they got the term wrong it’s quite remarkable they don’t spent any more attention to SGE withdrawals; they don’t even disclose withdrawal numbers. How can it be it’s common knowledge in China what the significance is of SGE withdrawals, yet the WGC refrains from discussing this topic? Last but not least, only the 12 banks mentioned above can import gold, in general trade, which is required to be sold through the SGE (supply) and subsequently can influence withdrawal numbers (demand). These banks are not involved in round tripping, they don’t need round tripping because they have direct access to the cheapest funding in the world, and gold enterprises are not involved in SGE withdrawals, as gold enterprises can only import gold in processing trade that doesn’t flow through the SGE.
For me there was also some great information in the WGC report, but when it comes to supply and demand I found numerous errors. One other example:
Only banks with PBOC-issued import licenses can import gold. They can only import LBMA good delivery bars and these must be traded through the SGE.
This is true except for the part that they can only import LBMA good delivery bars. The specifications for LBMA good delivery bars is that the weight must be in between 10.9 and 13.4 Kg, while PBOC license holders have imported at least 1100 metric tonnes in 1 Kg bars in 2013. The correct statement should be: “Only banks with PBOC-issued import licenses can import gold. They can import gold bars made by LBMA-approved refiners that meet SGE specifications and these bars must be traded through the SGE”. Additionally their original statement is self-contradictory with what they (and Goldman Sachs) wrote on gold enterprises importing and exporting gold for CCFD. I repeat the WGC: “In theory only jewellery manufacturers or others active in the gold trade can take out gold loans, although it appears that the rules can be circumvented either by setting up a ‘gold enterprise’ or by using the services of an existing company in the gold trade. The same is true for foreign currency LCs that are used to import gold…”. Just an example on the WGC’s lack of knowledge about the Chinese gold market.
Looking at demand by country China tops the list for the first time (based on our data series) as Indian consumption struggled under the government’s import restrictions, higher taxes, a weak rupee and subsequent high domestic premium. Indeed, China consumed 1,283 tonnes of gold in 2013, 28.2% of global physical demand and substantially higher than India at 987 tonnes and 21.7% of global demand. Chinese imports of gold, and deliveries from the Shanghai Gold Exchange (SGE) were also considerably higher than this owing to growth in pipeline stock, increased holdings by commercial banks to back paper products (a legal requirement in China) and some double counting of gold that was involved in round-tripping to Hong Kong or refined within China to a higher purity and subsequently resold via the SGE.
Also GFMS briefly mentions SGE deliveries (withdrawals) and acknowledges physical supply transcended demand, which they inter alia explain by “double counting of gold that was involved in round-tripping to Hong Kong”. Though round tripping has no effect on Chinese net gold import (read the Goldman Sachs quote above). Round tripping is only done by Chinese gold enterprises that import gold into a CSSA and soon after export the gold. The problem these institutions (WGC, GFMS, etc.) have is this:
There has been so much gold flowing into the mainland since 2007 of which they don’t know were it ended up (the accumulative difference 2007-2013 was 1989 metric tonnes in total). When I called the SGE a few months ago to ask where the difference as shown in the chart above was going, they told me these are withdrawals from individual SGE account holders. If these individuals are secretly jewelers trying to avoid VAT rules or institutional buyers I don’t know. I do know these 1989 metric tonnes haven’t been used for stock increases at jewelers or banks. In 2012 the accumulative difference accounted for 983 tonnes. With so much gold “in stock” why would they add another 1051 tonnes in 2013? Their third argument is that: “holdings increased by commercial banks to back paper products (a legal requirement in China)”. Ok, so that has got nothing to do with demand? That gold is just brought into a vault, laying there soon to be obsolete? No, they’re referring to Chinese buying gold on paper that oddly enough has to backed by physical gold in China – I know, it’s unbelievable. According to me all three arguments GFMS presents to explain the large amount of SGE withdrawals, of which they refuse to disclose the numbers, are untenable.
Reuters disclosed a very important quote in their article:
“I do not think there is large scale gold trade-financing deals like in copper,” said Jiang Shu, an analyst with Industrial Bank, one of the few gold-importing banks in China. Import quotas and a limited number of banks allowed to import meant gold would not be a popular choice for commodity financing deals, he added.
This gentleman can know because he works at one of the banks that is allowed to import gold in general trade and it’s very likely he knows a thing or two about the Chinese gold market.
From Goldman Sachs:
…However, we don’t know how many tons of physical gold are used in the deals since we don’t know the number of circulations, though we believe it is much higher than that for copper financing deals.
So in theory the number of circulations can be in between one and x. But for sure these circulations do not influence Chinese net gold import or wholesale demand, the latter equals SGE withdrawals.
In Gold We Trust