Gorillas in the mist

Goldman Sachs Asset Management chairman Jim O'Neill popped up in the news this week, releasing a note to clients with some revised thinking on prospects for China's economy.  With still a favourable overall view, O'Neill considered several likely outcomes for Chinese growth, including a "pessimistic" outlook of 7% GDP growth.  An interesting point in his analysis - that in any worst case growth scenario, the Chinese government is "surely to step in", attracted some comment as many noted that given certain conflicting undercurrents and factional conflicts within the administration and the Chinese Communist Party, the Chinese authorities may not be willing or able to intervene.

Similar to the reaction when various large Chinese cities announced vast new spending programs, some observers were sceptical as to whether bold political action will be as likely be delivered as in 2008.  O'Neill's fund meanwhile has been promoting a new set of fast-growing MIST countries (Mexico, Indonesia, South Korea and Turkey) which have been the star performers in the fund's popular Next 11 fund. And the failure to even consider a less than 7% GDP growth outcome (when some commentators consider that growth may be negative) suggests O'Neill might just be missing a gorilla in the room - Asian (and Chinese) slowdown which others believe may not be priced in by the market.

A very strategic resource
The last couple of weeks saw a renewed debate considering the return of a gold standard as a way to restore stability to the global economy and encourage growth (and end America's money printing), even while the balance of opinion believes such a standard is a false hope or otherwise likely to result in the stagnation currently seen in the Eurozone (which as Peter Coy explained arguably is committed to a new gold standard).

There is an interesting angle for China in this debate, as it has been active in the gold markets.  As you may recall China has been trying a basket of different measures to manage its economy including Keynesian stimulus in 2008, enormous foreign exchange reserves, capital controls and now liberalising exchange rates (which may be countering each other in effectiveness).  In fact reports have emerged which provide detail of China's activities in gold as well.

In addition to outright purchases of the metal, interest was also expressed from Chinese companies in acquiring gold producers.  In its report of China's largest gold producer, China National, considering the acquisition of a majority stake in the African subsidiary of the world's largest gold miner, Barrick, the Beyond Brics blog reported that the company's president, Sun Zhaoxue believes that China should view gold as a "strategic resource as important as petroleum energy".  That might partly explain why there is a gold mining division in the Chinese internal security forces (the People's Armed Police).

As well as its value as a metal, reserves of gold have been argued by some as a better store of value for a national central bank than government bonds, especially in a low inflation environment where the government issuer of the bonds is engaging in monetary easing (which depresses the yield as the price increases from the asset purchases).  In China's case it is looking for an alternative store of value to offset its huge holding of US Treasuries (US government bonds) which earn low rates of interest because the US is engaging in Quantitative Easing (printing money by buying US Treasuries) and which it cannot liqidate easily.  The liberalisation of the Renminbi (i.e. the process of opening the Chinese currency to full convertibility) is seen as one step that can counter-balance China's US dollar holdings (as the greater volumes of Renminbi will be used and deposited internationally).  Sun Zhaoxue alludes to this in his article.

However it is questionable whether holding gold ipso facto will ensure greater security for China.  How so? Well looking into some of the debate around the merits of a gold standard suggested that the credibility of the system might be more important than the physical holding itself.

I hold therefore I am
Outspoken financial journalist Max Keiser, has looked at a number of commodity stories, including possible manipulation of the silver market by JP Morgan and its high frequency trading (HFT) business (background here).  In a recent broadcast Keiser examined some of the justifications given by gold bugs (especially libertarians in the US), who he found often confuse their libertarian values (such as objectivism advocated by Rand) with the behavioural principles of the "Austrian school" (advocates of a gold standard).

A key question in the discussion was the degree to which financial institutions could issue credit secured against their gold reserves - it is only physical gold which is the "ultimate extinguisher of credit", but the use of fiat (paper) money removes the gold from credit making it easier to expand credit (which if prolonged can cause inflation and is exaggerated by quantitative easing).

In his article Peter Coy blames the First World War for causing the inflationary expansion of credit which destabilised the gold standard, however according to the Cato Institute (which is apparently libertarian) in a paper on this topic, von Mises, a key figure in this analysis, believed that instead of the war, it was the attempts by bankers to get around the gold standard and increase credit in the economy, when, from the 1890s the world's central bankers relaxed the standards of inter-central bank credits:

 It was'' not the old classical gold standard, with effective gold circulation,'' that failed after 1929; what failed was'' the gold 'economizing' system and the credit policy of the central banks of issue'' 

What von Mises proposed (to address this inherent conflict) was that the gold standard should be operated completely independently of monetary matters and essentially gold should be valued at production cost.  And this is interesting because it seems to be a call for independence, similar to that underlying the Bitcoin digital currency, which operates free of any government and is instead backed by the power of the computing network of Bitcoin users (with no centralised issuing authority).

All of this would suggest that credibility is important.  As well as the amount of gold which the People's Bank of China (the central bank) or other bank may hold, financial market participants will also assess how credible those banks are in administering and valuing such reserves.  This may not be as simple an assessment as it seems.

In gold (and tungsten) we trust...

Frauds of the week
Mentions must go out to:  the Chinese Art market (worth $13 billion according to Forbes magazine) and  China Sky One Medical and its chief executive (which the SEC charged with securities fraud this week for overstating financial results).

Ending a super-cycle

Metals update
Following the last post there were some more signs of China-related noise in the copper and commodities markets.  The ever vigilant FT Alphaville team reported on a note out from Standard Chartered detailing their visit to a warehouse in Shanghai which was stuffed to sinking with copper and aluminium (with some revealing photos).  Meanwhile there were reports today of new research from Nomura's China metals and mining analysts which found that after adjusting for GDP (rather than usual per capita bases) they predicted flat or low growth in China for metals.

As always, the picture for commodities is not unanimous, with teams at RBS and Barclays Capital positive to bullish on prospects for the materials sectors.  But as reported previously there do seem to be growing distortions in the commodities markets.  For the copper market, this was discussed in detail by BBC Radio back in 2011 (who spoke to industry users, staff at bursting warehouses and analysts at both bullish and bearish institutions) while FTAlphaville recently had some helpful background on unusual moves in the copper and oil markets.

Looking across different reports there seem to be four factors which could have been driving the stockpiling of metals in China (until recently):

i) domestic loan collateral and financing schemes: As set out in the last post, Chinese financial authorities have tightened the limited availability of bank credit making alternative financing schemes through informal lending popular.  Many schemes use warehoused copper or other metals as collateral for loans.

ii) schemes to arbitrage price differentials in commodities markets:  There has been specific comment on the price differential between the London and Shanghai prices for copper, and that arbitrage trades can impact on the price.  As explored in the last post, market based schemes can involve "re-export" of surplus copper from domestic warehouses in Shanghai, but in fact the copper only travels to other bonded and private warehouses which hold non-domestic (bonded) stocks.

iii) schemes to manipulate market prices of commodities: As explained in this piece by Reuters, it is a "time-honoured technique" amongst commodity traders to use private and non-disclosed inventories to restrict the apparent (and official) supply of a commodity, gain control of a substantial portion of the remaining "official" supply and then squeeze prices higher.  The article mentions current suspicions that certain traders are engaging in the practice and shifting large volumes into private warehouses, "off-warrant", creating the appearance of tight supply.

iv) schemes to arbitrage differentials between domestic ("onshore") and foreign ("offshore") exchange rates: Although China is undergoing financial liberalisation, with the movement to a more flexible yuan/renminbi rate, there still exist discrepancies between deposit rates and currency prices which can be exploited with stored metals used as collateral.  The previous Reuters investigation gave some detail on this.

End of the commodities super-cycle
With such distortions as excess inventories and incomplete price discovery it is not surprising that headlines have referred to an end of the commodities "super-cycle" - the continuation of high commodity pricing trends beyond levels suggest by fundamental indicators and drivers (which included sustained high Chinese demand).  An article in the Australian mentioned the example of one mining company topping up its own production with market purchases to meet demand, while the Financial Times considered outcomes for mining sector investments following a downturn.

Aside from the immediate hit to shareholders, there could be a couple of other impacts.  First it could be argued that in addition to the commodity traders, a number of large banks, including JP Morgan, Barclays and BlackRock could be exposed to kickback from inventory shielding schemes as they have significant warehousing and commodity investment operations.  Some have argued that certain banks which have large commodity ETF funds predicated on rising commodity demand are keen to maintain high prices to encourage subscriptions to their ETFs, regardless of fundamentals.  Hence some of the derisory comments on social media as to the slightly concerning tone of a Blackrock client blog this week which argued that it is "critical for the global economy that China lands softly".  The related growth of commodity backed structured financing does carry some risks as discussed here.

Also, it seems possible that speculation and arbitrage in the Chinese currency between offshore and onshore markets may complicate the liberalisation of Chinese exchange rates and the economy.  Martin Wolf explored the risks and complexities of liberalisation back in February, and it will be looked at in more detail in posts to come.  Meanwhile Fraser and Howie in their book Red Capitalism noted that non-convertibility of the Chinese currency is one of the pillars maintaining financial stability, with uncertain consequences if removed.

Thanks to the reader who identified the BBC Radio link!