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December 2021

China is behind gold rally

Gold's record rally has been attributed to everything from worries about inflation, the dollar and the emergence of exchange-traded funds. One big factor many may have missed: huge buying from China.

Data cited Thursday by China's state-run Xinhua news agency showed that China imported 209.7 metric tons of gold in the first 10 months of the year, a fivefold increase compared with the same period last year.

That surpassed purchases made by ETFs and surprised analysts, who until now had no clear insight into the size of China's buying.

"Everybody in the gold market knew there was a surge in investment demand, but they didn't know it was China," said Jeff Christian, managing director at CPM Group.

China's import growth is a reminder of the country's huge but nascent purchasing power.

It comes as the government loosens its restrictions on gold purchases by financial institutions and individual investors. In August, the country began allowing more banks to import and export gold, opening up the gold market to the institutions and their clients.

Then this week, the Chinese securities regulator approved the country's first gold fund designed to invest in overseas-listed gold ETFs, a move analysts interpreted as another bullish sign for gold.

"The big picture is that China is continuing to relax the rules governing the domestic gold market," said Martin Murenbeeld, chief economist of DundeeWealth Inc., which oversees $69.9 billion in assets. "What we are seeing is the latent demand that has been there all the time and now can be exercised in the market because now the market is freed."

The World Gold Council estimates that China's gold demand could double in 10 years as more investors there embrace precious metals.

Until several years ago, China's gold market was strictly controlled by the central bank, which bought all the gold mined domestically. It then sold the metal to jewelry makers. The country, which is now the largest gold producer, remained largely self-sufficient in gold, with imports at a meager 31 metric tons in 2009, according to GFMS Ltd.

This year, fears of inflation have driven many Chinese investors to include gold in their portfolios as a store of value. At the Shanghai Gold Exchange, trading volume increased 43%, to 5,014.5 tons, in the first 10 months of 2010, exchange Chairman Shen Xiangrong said, according to Xinhua.

At a speech at the China Gold and Precious Metals Summit in Shanghai Thursday, Mr. Shen detailed the size of China's imports this year, Xinhua said. Those purchases were big enough to absorb all the gold that the International Monetary Fund had shed during that time period, which stood at 148.6 tons. It also dwarfed the SPDR Gold Shares, the world's largest gold-backed ETF, which added 159.48 tons of gold into its holdings in the same period.

China also is home to a booming gold-mining industry that keeps it as the world's largest gold producer. Wednesday, China's Ministry of Industry and Information Technology said the nation's gold production reached 277.017 metric tons in the January-to-October period, up 8.8% from the same period last year.

China's 2010 gold production is expected at about 350 metric tons, according to Standard Bank head of commodity strategy Walter de Wet.

Pace of RMB appreciation likely to pick up

So far this year, Chinese RMB has appreciated 3.1% against the US dollar. But it has depreciated against majority of other currencies (especially the currencies of the emerging market) on trade-weighted basis. 

Marty Feldstein forecast that with domestic inflation rising, China is likely to accelerate the pace of its currency appreciation so to achieve at least two goals: 1) contain domestic inflation through lower import prices of commodities; 2) increase real income of domestic consumers again through lower prices of foreign imported goods.

Link to the full text of Marty's piece.

Gold boosted by China’s investment rule

According to WSJ, China's securities regulators are allowing mainland Chinese to invest in foreign exchange-traded gold funds for the first time, unleashing the full buying power of the world's second-biggest economy on funds that already own more gold than most central banks.

Is Spain the next Lehman?

Country, unlike firms, can never go bankrupt. Lehman became “too big to save” for Washington, but will Spain become “too big to fail” for Europe?

Fed over-confident in its exit strategy

Robert Barro shares his thoughts on the Fed's QE2 operations on Economist.  This is by far the most damaging piece I've seen from a renowned macro-economist.  His main point is that raising interest rate on excess bank reserves will be equal to raising interest rate through the normal open-market operations, which is highly contractionary.  As Allan Meltzer argued many times before, if the Fed does that when the unemployment rate is still high, the Fed will face very strong opposition on the political front.

I am skeptical about Fed's exit strategy for another reason.  I think the Fed will never get the timing of exit right.  With so much excess reserves in the system, liquidity most likely will skyrocket through shadow banking system, which will coincide with a rapid pickup of money velocity. The Fed will have to raise interest rate quickly and sharply, otherwise, it risks a hyperinflation.

Now let's digest Barro's piece.  The highlights are mine.

A LOT has been written recently, pro and con, about the Fed’s new round of quantitative easing, dubbed QE2. But, frankly, much of the discussion on both sides lacks a coherent analytical framework for thinking about the key issues. I try here to provide such a framework.

The Fed, personified by its chairman, Ben Bernanke, is concerned about the weak economic recovery and, particularly, by the possibility of future deflation. To counter this tendency, the Fed plans a new round of monetary expansion. The main conclusions that I reach are:

In the present environment, where short-term nominal interest rates are essentially zero, expansionary open-market operations involving Treasury bills would do nothing (a point with which the Fed concurs).

• Expansionary open-market operations featuring long-term Treasury bonds (QE2) might be expansionary. However, this operation is equivalent to the Treasury shortening the maturity of its outstanding debt. It is unclear why the Fed, rather than the Treasury, should be in the debt-maturity business.

The most important issue, of which the Fed is keenly aware, involves the exit strategy for avoiding inflation once the economy has improved and short-term nominal interest rates are no longer zero. The conventional exit strategy relies on contractionary open-market operations, but the worry is that this strategy would hold back an economic recovery. The Fed believes that paying higher interest rates on reserves gives it an added instrument that will help the economy recover more vigorously while avoiding inflation. I think this view is incorrect. I find that:

• In an exit strategy, raising interest rates on reserves to match rising interest rates on Treasury bills is equivalent to a contractionary open-market operation whereby the Fed cuts reserves along with its holdings of bills. Therefore, increasing interest rates on reserves is just as contractionary as the standard exit strategy.

• We can compare instead with an exit strategy whereby the Fed reduces the quantity of reserves and its holdings of long-term Treasury bonds. This operation is equivalent to the above strategy plus a lengthening of the maturity of the Treasury’s outstanding debt, something the Treasury can accomplish or avoid without help from the Fed.

As a background, the Fed has, since August 2008, expanded its balance sheet by around $1 trillion. Thus, the Fed has roughly $1 trillion more in assets (dominated by mortgage-backed securities, but that can be the topic of a different column). On the liability side of the Fed’s ledger, excess reserves that pay close to zero interest have expanded by about $1 trillion. Institutions are willing to hold this vast amount of non-interest-bearing claims because of the weak economy; in particular, the financial crisis dramatically increased the demand for low-risk assets, such as reserves held at the Fed. Because of this rise in demand, the dramatic expansion of the quantity of "money" has not yet been inflationary.

For institutions that can hold reserves at the Fed, excess reserves are essentially equivalent to Treasury bills. Therefore, interest rates paid on these two forms of assets have to be nearly the same; in the present environment, both rates are close to zero. If the Fed carries out a conventional expansionary open-market operation, whereby it buys more bills while creating more reserves, the private sector ends up with fewer bills and correspondingly more reserves. Since institutions regard these two claims as essentially the same, there are no effects on the economy; that is, no effects on the price level, real GDP, and so on.

If the Fed does QE2, then it essentially adds to the conventional open-market operation a sale of Treasury bills and a purchase of long-term Treasury bonds. Bills and bonds are not the same, as evidenced by the difference in yields—bills are paying 0.1% while ten-year bonds are paying almost 3%. The hope is that the smaller quantity of long-term Treasury bonds outstanding (outside of the Fed) will tend to raise their price or, equivalently, lower the long-term yield. This reduction in long-term rates might spur aggregate demand. This reasoning may be correct but, as already noted, it has to be the same as the Treasury changing the maturity structure of its debt; that is, funding with more short-term and less long-term debt.

The exit strategy comes into play when and if the economy has improved and, hence, institutions no longer have an enormous demand for low-risk excess reserves that pay zero interest. If the Fed kept the interest rate on reserves at near zero and had no contractionary open-market operations, the extra $1 trillion of reserves would become highly inflationary. To avoid the inflation, the standard policy would be contractionary open-market operations that reduce the quantity of "money".

The Fed thinks it can improve on the exit strategy by instead raising the interest rate paid on reserves. For example, if rates on Treasury bills rise to 2%, the Fed could pay around 2% on reserves to induce institutions to maintain the excess reserves of $1 trillion held at the Fed. However, at that point, it would still be true that open-market operations involving reserves and bills would not matter. That is, the Fed’s selling off $1 trillion of Treasury bills (if it had that much) in exchange for $1 trillion of reserves would have no effect. This reasoning implies that the exit strategy of raising the interest rate on reserves in tandem with the rise in interest rates on bills is equivalent to the standard contractionary open-market policy. That is, the effects on the real economy are the same.

In practice, the alternative to raising interest on reserves is not a massive sale of Treasury bills (which the Fed does not possess) but, rather, selling off a large portion of the assets accumulated since August 2008. After QE2, this would likely be mostly Treasury bonds but it could also be mortgage-backed securities. When compared to selling bills, the sale of bonds has the reverse of the effect discussed before—the extra bonds would likely require a reduction in price, corresponding to a higher long-term yield and, thereby, an added contractionary force. But, again, the Treasury could offset this effect by changing the maturity structure of its outstanding debt (by shifting toward bills and away from bonds).

My conclusion is that QE2 may be a short-term expansionary force, thereby lessening concerns about deflation. However, the Treasury can produce identical effects by changing the maturity structure of its outstanding debts. The downside of QE2 is that it intensifies the problems of an exit strategy aimed at avoiding the inflationary consequences of the Fed’s vast monetary expansion. The Fed is over-confident about its ability to manage the exit strategy; in particular, it is wrong to view increases in interest rates paid on reserves as a new and more effective instrument for accomplishing a painless exit.

Locate China’s housing bubble

Housing market tends to be local.  It’s rare to see a nationwide price decline.  The recent US housing bubble is an exception and often considered a black swan.

People have been talking about China’s housing bubble for a few years now (see my previous post on China’s housing bubble debate), but where exactly is the bubble located?

The recent NBER research sheds some light on the issue.  The graph below shows the price-to-income ratio of China’s eight major cities, from 1999 to Q1 of 2010.

(click to enlarge, source: NBER w16189)

Beijing and Shenzhen are clearly in bubble-shape — the typical and familiar parabolic surge in price, and they are followed by Shanghai and Hangzhou.

Now, let’s have some comparative perspective.  How the same ratio compares to the major cities in the United States.

The graph below (courtesy of Infectious Greed) shows the price-to-income ratio of US cities. San Francisco, Los Angeles, Seattle were among the highest.

(click to enlarge)

At the peak of the housing bubble between 2006-07, the same ratio for San Francisco, the highest among all US cities, was around 11.   In contrast, Beijing has a ratio of 18, and Shenzhen at astonishing 22.

Silver – poor man’s gold

Year to date, silver price has increased by over 50%, and gold by more than 20%.   The out-performance of silver relative to gold is a good indicator that gold bubble is entering a new stage, where retail investors poured in and started to grab the alternative to gold , i.e., silver, at a much cheaper price.  In essence, silver has become ‘poor man’s gold’.   Gold ETF (GLD) is traded around $130, while silver ETF (SLV) is traded around $25.

(click to enlarge)

The out-performance of silver started to kick in right around the Fed’s announcement in late August of their intention to ease monetary policy further.  To show this, the following chart looks at the relative price between silver future contract and gold future contract, YTD.

Jereme Grantham: Fed’s policy culprit for boom and bust

Everyone should watch this video: