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Gold earns back its weight
Asia’s retail demand driven by growing regional affluence
Oliver Jones 1 Apr 2014
 
   

The past 15 years have witnessed a spectacular rise in assets under management (AUM) of exchange-traded products (ETPs) – across asset classes.


Fifteen years ago, ETFs were solely an equity story – with the US$11.2 billion AUM of all 36 exchange-traded funds tracking equity indices. Today, equity ETFs account for less than 80% of over US$2 trillion ETP AUM (See chart 1).


AUM of fixed income and commodity ETPs combined first rose to account for more than a fifth of ETP AUM in 2008 before peaking at 28.8% in 2011 then falling back to about 20% last year.


Commodity ETPs have been a key driver behind this growth. The AUM of commodity ETPs passed US$100 billion in 2009, just five years after the launch of the first commodity ETP – SPDR Gold Trust (GLD), sponsored by World Gold Council (WGC) subsidiary World Gold Trust Services.

 

   
   

Shift in demand
Albert Cheng, the WGC’s Far East managing director, recalls “a big shift in the perception of gold after the Lehman crisis particularly…creating a big jump in demand for gold after 2008”, notably from hedge funds and institutional investors.


He argues that speculative buying post-2008 crowded out fundamental buying of the metal, adding that Chinese investors in 2008-2009 “wanted to get in, but the Wall Street people had moved the price so high”, prompting them to wait for prices to stabilize.


Since gold is not an interest-earning or dividend-yielding asset, it is difficult to value. “The fundamentals of that metal [gold] are more focussed on supply and demand metrics, what’s happening in the global economy,” says the global head of an ETF provider.


Last year, the start of tapering by the US Federal Reserve highlighted the central bank’s confidence in an improving outlook for US growth. Higher interest rates raised the cost of holding the metal and gold ETFs saw outflows of 808.8 tonnes for the year including 402.2 tonnes in the second quarter alone. In contrast, retail investment demand for physical gold bars and coins hit an all-time high of 1,654.1 tonnes (See chart 2), driven by emerging market demand.


Referring to Chinese investors, Cheng remarks that, “last year, they said: these [Wall Street] guys have left, the price has come down, it’s a good time to get in”. The US dollar price of gold declined 27% in 2013, marking the biggest price drop since 1981 and ending a 12-year long bull run.

 

 
   

Back in January 1980, the price of gold peaked at US$850 – or US$2,400 in today’s prices (the average price over the month was US$1,700 at current prices). Gold’s average price last year was US$1,411 – down from a US$1,669 average over the whole of 2012. Before the sharp decline in the gold price in April and June 2013, there had been a steady rise in its price since the turn of the century.
Cheng explains: “Hedge funds or speculators, when they get into something, it has potential upside but they have a time horizon, a target. They evaluate this asset in comparison with many other asset classes. Last year, they moved out [of gold] in big quantum again, causing a tremendous shift in the gold price. That’s why the price came down by this amount last year, because of these people who came in six or seven years ago and these people leaving.”


He sees the shift as a return to normal. “What’s happening in the past few years has been the market returning to fundamental demand and supply” after the abnormal post-2008 crisis years, he says. “The market has taken off this layer of speculators coming in and out.”

 

Retail investors
While institutional investor demand is reflected in ETF flows, retail demand in Asia is driven by purchases of physical bars and coins, which are a popular means of investing in gold in China. This is shown by a rising demand trend over the past decade (See chart 3). China became the world’s largest gold market in 2013, overtaking India. Demand was underpinned by a 38% rise in gold bar and coin demand. “The underlying driver is wealth created in the East over the past 10-15 years,” says Cheng.

 

 
   

Last year, China and India accounted for 46% of global bar and coin investment demand and an even higher share (68%) of global gold jewellery demand. Back in 2001, the two countries accounted for just over a quarter of total gold consumption.


More broadly, while speculative investment demand diminished as global growth prospects improved, consumer demand – defined as jewellery and small bars and coins by the World Gold Council – rose by 678.4 tonnes to a historic high of 3,863.5 tonnes.


“Last year, over 300 tonnes of gold – almost 400 tonnes – were going through the banking system [in China]” says Cheng – out of 1,065.8 tonnes China gold demand overall. “Availability is a very important factor for the Chinese who want to buy gold,” he notes. In contrast, “in the US, if you want to buy [physical] gold, it’s actually a hassle. You have to call up a coin dealer, agree on a price, send money to them and then they send the coin to you”.


He stresses: “In the US, no banks sell gold. In India, no banks sell gold. Even in Japan, no banks sell gold. Only in China, in this scale” although Germany, Hong Kong and Singapore also feature as markets where banks engage in the gold business to some degree.


“In the US, when the market opened up in the 1970s, coin dealers and bullion people were already there so no banks participated. In India, jewellers are doing it. In Japan, it’s the bullion houses.” Since 2004, when banks were first allowed to conduct gold business in China, more options have been introduced, such as gold savings accounts.


Additionally, mainland China saw the first four gold-backed ETFs approved in 2013 – with two launched in July followed by a third in December. Combined, the three ETFs raised 2.1 billion yuan amid weak demand. Gold import licences for foreign banks were also issued for the first time, interbank swaps introduced and the trading hours on the Shanghai Futures Exchange were extended.

 

 
   

New creation
This year, gold ETFs have seen renewed inflows as expectations for stronger GDP growth have been checked and the rising price of alternative stores of value, such as the renminbi, has paused.


“GLD – a barometer for this market – has started to have new creation [this year]” observes Cheng. “If they [investors] cannot get enough in the secondary market, then we see new creation. It’s a signal that some people, some institutional investors, are rebalancing their portfolios – adding some gold in their portfolios”, he explains. (See chart 4)


There were some 266 million units of GLD outstanding at end-2013, 182.3 million less than the 448.3 million outstanding at end-2012 as units were created and redeemed through the year to ensure that supply and demand in the secondary market reflected the underlying value of the asset. Adjusting the number of units in the primary market helps guarantee that the secondary market value price does not trade at a premium or discount to net asset value (NAV) of the gold held (See chart 5).


SPDR Gold Shares are listed on five stock exchanges around the world – in Hong Kong, Singapore and Tokyo as well as New York and Mexico. “GLD in this marketplace has been a huge success, especially because gold markets are open 24 hours” says one market participant. “The challenge sometimes, if you cross-list US equity in Asia and the market’s closed for the whole time you’re open, then there’s no price discovery – not true price discovery. You can make markets based on what’s happening in Asia, but the spreads are going to be wider.”


Since gold is traded over-the-counter (OTC) 24 hours a day, there’s no closing price on an exchange. Instead, the gold benchmark price is set twice a day – in the morning and afternoon – in London by a panel of five banks. The process involves the chairman of the panel declaring an opening price that is then adjusted according to bids from the banks, which are presently all market-making members of the London Bullion Market Association. The London gold fix is published after each conference call and then used to value the assets of ETFs, such as GLD.


In January 2014, Deutsche Bank put its seat on the gold fixing panel up for sale, spurring speculation that a Chinese bank may become a panel member.


Physical cost
ETFs buy gold at the wholesale price. In contrast, there is a cost to buying physical gold. Cheng observes that in Hong Kong, physical coins are priced at a 6% premium an ounce – rising to a 15% premium for half ounce coins.


The premium covers the cost of remoulding gold, with refiners working overtime last year converting standard 99.5% purity, 12.5 kilogramme (kg) London good delivery bars into the more popular Asian standard 99.99% purity, 1 kg bars as well as 400 ounce bars into smaller denominations.


The unprecedented flow from Western vaults was reflected in a large amount of OTC gold trading – some 580.8 tonnes in the second half of 2013 – as market participants in Asia replenished stocks.
Supply restrictions saw volatile premiums for physical gold in China last year. As gold ETFs were sold off, the metal was transported to Asia to meet demand in the region. In Vietnam, premiums are consistently around US$200 per ounce – over 14% of last year’s average price. The premium charged for physical gold rose above US$150 per ounce in India in the final months of 2013, as import restrictions took hold.
India – which accounted for 974.8 tonnes of demand last year – witnessed a 63% decline in gold imports between July and October 2013, pushing up premiums as gold was sourced from unofficial imports, domestic production and recycled gold (where consumers sell old jewellery).

 

Consumer sentiment
If ETF in/outflows reflect institutional investor sentiment, recycling mirrors consumer sentiment on the price of gold – with consumers in China and India seen as relatively sensitive to the price of gold when it comes to recycling, dampening the prospect for sharp increases.


At the same time, the amount of recycled gold put back on the market has increased at half the pace of price rises over the past decade, as consumer expectations for prices to fall have diminished. Between 2002-2011, recycling averaged 1,225 tonnes a year. The figures for 2012 and 2013 – 1,591 and 1,371 tonnes respectively – were above this average, with 2013 seeing a year-on-year decline as the gold price came down. The other source of supply – mine production – accounted for an average of 2,591 tonnes a year between 2002-2011, rising to 2,824 and 2,969 tonnes in 2012 and 2013 respectively.
On the demand side, 2013 marked the fourth consecutive year of net buying by central banks albeit at lower levels than those seen in 2012. That year was exceptional, however, marking the highest level of central bank buying in almost 50 years. Cheng sees the slower pace of foreign reserve accumulation experienced by emerging market central banks as having underpinned lower levels of central bank buying last year.

 

Official holdings
As of December 2013, reported official gold holdings for Germany, France and Italy amounted to 8,274 tonnes – 5x the amount of gold held by China and India’s central banks (1,612 tonnes). Combined, Japan, Taiwan, the Philippines, Thailand, Singapore, Korea, Australia and Indonesia’s official holdings are 1,924 tonnes. The trend has been for more stable official holdings since the UK sold over half of its gold reserves between 1999-2002. That action was followed by an agreement between European central banks to limit gold sales (with the first 1999-2004 central bank gold agreement renewed to cover 2004-2009 and then 2009-2014).


Official holdings of gold may help shore up a country’s perception as a relative safe haven in times of market stress, just as foreign reserve holdings do. And, despite an increase in inflation-linked investment options, gold is still perceived by many as a core holding to hedge against price rises. The prospect of a return to inflation in Japan is attributed by some experts to that country seeing a return to positive retail investment in gold last year, for the first time since 2005.


The trend continues to be for more gold ETFs to be listed and traded. As well as giving investors access to gold at wholesale prices, gold ETFs can trade at a discount to the NAV of the underlying asset, in cases were the supply of units available in the secondary market exceeds demand and vice versa (See chart 5).
 

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