Tuesday, January 29, 2013

Developments in China explain the end of gold's rise

Arguably, there have been three major developments in the global economy in the past decade: 1) the Chinese economy has posted 8-10% annual economic growth; 2) China's foreign exchange reserves have soared from $170 billion to $3.3 trillion; and 3) the price of gold has sextupled. It's likely that all three are related, and that the outlook for gold is diminished as a result. 

China's economic growth has been truly impressive. There has been huge progress and prosperity gains, thanks to the introduction of free market reforms and investment-friendly policy.

China's decision in early 1994 to peg the yuan to the dollar was a key factor driving China's growth, since it brought Chinese inflation rapidly down to the level of the U.S. The prospect of a stable currency not only reduced inflation and its multiple distortions, it also increased the market's confidence in China, and helped boost investment in the country since it all but eliminated foreign exchange risk. Indeed, since the yuan has only appreciated against the dollar since 1994, foreign investors benefited from strong Chinese growth and yuan gains. China was the boom of the century.

As the first of the two charts above shows, the huge capital inflows that helped China grow needed to be sterilized or accommodated by the Bank of China, otherwise they would have caused the yuan to soar, and that could have short-circuited China's ability to grow. Massive inflows of foreign capital seeking to benefit from rapid Chinese development essentially forced the BoC to buy over $3 trillion of foreign exchange, with a commensurate increase in the Chinese money supply. Converting capital inflows into yuan is the only way foreign capital could actually enter the economy, because you can't build a factory or hire workers with dollars—the dollars need to be converted to yuan, and it is the proper role of the BoC to buy those dollars and issue new yuan in the process. Yet despite massive forex purchases, which relieved pressure on the yuan to appreciate, the BoC still had to allow the yuan to float irregularly upwards. A stronger yuan helped to keep the inflationary pressures of rapid growth under control. 

As I explained in this post, it now appears that this process of forex purchases and yuan appreciation is at an end. This is a big deal. China's foreign exchange reserves have not increased for almost two years, and the yuan has been stable against the dollar for the past two or three months. Capital flows and trade flows appear to have reached some kind of equilibrium, just as Chinese and U.S. inflation have converged.

I find the above chart fascinating. It compares the rise in China's forex reserves with the rise in the dollar price of gold, both of which have been impressive to say the least. China's central bank started buying up capital inflows in earnest in early 2001, right about the time that gold was hitting a multi-year low. This came to an end in early 2011, as net capital inflows approached zero, and shortly thereafter gold peaked. Both forex purchases and the price of gold increased by many orders of magnitude over roughly the same period.

Is there a plausible explanation for the strong correlation between these disparate variables? I think there is, but I can't say so with authority.

Gold bugs (and some supply-siders) will argue that gold rose because both the Fed and the BoC were "printing money" with abandon. The global monetary base exploded during this period, so naturally gold rose—because the world was being flooded with fiat currency. Gold was the only port in an eventual inflationary storm.

But we know that Chinese and U.S. inflation rates are still relatively low. There has been over a decade of impressive expansion of bank reserves and yuan, but inflation has so far failed to show up—outside of some impressive strength in commodity prices.

Don Luskin, a good friend, got me started down the path to an explanation for how China's forex reserves are connected to the rise in the price of gold. He argues that the outstanding stock of gold is relatively fixed—growing only about 3% per year—but that the demand for gold has jumped by orders of magnitude since China, India, and other emerging markets have enjoyed explosive growth and prosperity gains. In other words, the number of potential buyers of gold has risen much faster than the supply of gold, so naturally gold's price has increased. This is not a story about massive money printing and hyper-inflationary consequences, it is a story about a one-time surge in the demand for the limited supply of gold.

And that surge in demand for gold stopped almost two years ago as China's capital inflows have settled down to more manageable levels. Since capital is no longer flooding into China, China's growth rate is subsiding. Instead of purchasing massive amounts of foreign exchange reserves, China will in the future be purchasing more goods and services from the rest of the world as its economy continues to expand. This is "organic" growth, not super-charged, foreign investment-led growth.

Meanwhile, as the chart above shows, gold prices in real terms have reached very high levels. Should it be surprising that demand for gold is no longer accelerating now that its price has reached historically high levels relative to other goods and services? Gold is very expensive relative to other things at today's prices. Demand has its limits. At the same time, the very high price of gold is undoubtedly stimulating all kinds of efforts to increase gold production, thus bringing supply and demand into balance. As we approach two years of relatively stable gold prices, it is reasonable to conclude that the heydays of gold are now a thing of the past.

To sum up, the slowdown in Chinese growth and the end to China's massive forex purchases are good signs that the boom in gold is over.


McKibbinUSA said...


Benjamin Cole said...


According to the World Gold Council, China has also been the largest consumer of actual, physical gold. It is largely sold for jewelry. Indian and China dominate the demand side for gold. They also buy bar and coins. There are many traditional and cultural reasons for this. The Far East outside China is also a large market, probably reflecting overseas ethnic Chinese.

I think the connection between gold and Federal Reserve Board policy has been dead for years. This is demented fantasy of gold nuts.

The Fed went to QE, then sustained QE and gold died. So what connection? The more money the Fed prints the flatter gold gets.

The world has changed in the last 40 years and commodities prices are moved around by ETFs (with a global investor base), China, India, sovereign wealth funds and black pools of money.

The only thing about commodities is that they have already had their inflationary run. They can't go much higher as they are hitting ceilings. The trouble for commodities going forward will be maintaining their price levels.

Oil at $90 may not be sustainable--too much supply and weak demand.

wesley mouch said...

You do not show the important chart of Chinese gold imports from Hong Kong. Has that gone down as you imply? Chinese gold acquisition is from three sources including: Chinese mine production, Gold imports from Hong Kong and gold bought surreptitiously by the Chinese government. You also don't indicate Indian gold imports which is important since it is the second largest gold buyer.

wesley mouch said...

One other point. You say that "gold is very expensive relative to other things at today's prices". In fact gold has along historical relation with oil. Its average price is 16x the price of oil. Given that it is about 16x the price of oil today this implies that gold is priced in line with historical averages. Its fine to bash gold just be more informed about it.

theyenguy said...

Scott, thanks for the article. You make an important statement As I explained in this post, it now appears that this process of forex purchases and yuan appreciation is at an end. I have to agree.

Your article does have a number of excellent analysis, but from a gold bug, that is a physical gold bug position, and from a Christian Dispensationalist position, it has some statements that deserve a presentation of a contrary position.

First of all, I suggest that one read, the Austrian Economist gold bug authored China averts $482 Billion in local bank defaults via massive Rollover Scheme; Extend-and-Pretend Chinese style … http://tinyurl.com/bghawmv … where Mike Mish Shedlock correctly writes the obvious. “The Chinese banking system is insolvent”.

Yet stunningly, on the day he wrote this Chinese Financials, CHIX, rose, illustrating what a Unified Monster of Authoritarianism that China has become; it is now through mandate, a Regional Beast of central banking, industrialization, CHII, infrastructure, CHIX, small business operations, HAO, and Banking, CHIX. China’s Rollover Scheme, is an example of bible prophecy of Revelation 6:1-2, being fulfilled, where Jesus Christ has unleashed the First Horseman of the Apocalypse, to effect a global coup d etat passing the baton of sovereignty from nation states to an Authoritarian, Totalitarian Collectivist, and Regional Governance Regime, replacing the current Liberal, Banker, and Nation State Regime, as foretold in Revelation 13:1-4, where diktat, not democracy, wll rule in all of mankind’s ten regions and in all of mankind’s seven regions. Yet this development is unseen to practically everyone, as the Beast Regime has the feet of a bear, the mouth of a lion, and the coat of a leopard. In other words, the Beast Regime, is the ultimate predator, having feet which enables it to stand its ground as well as root out its enemies, a mouth to make authoritative statements, and a coat whereby it blends in with all of mankind’s media, technology, banking, educational, banking, government and religious and think tank institutions.

Jesus Christ is at the helm of the economy of God, Ephesians 3:10, pivoting the world from fiat asset appreciation to fiat asset deflation, as the dynamos of a Flattening Yield Curve, FLAT, ZIRP, global growth, corporate profitability, are failing, on the exhaustion of the world central banks’ monetary authority, and are winding down Crony Capitalism and European Socialism and Asia Exports.

Liberalism’s choice, credit and prosperity, is being replaced by Authoritarianism’s diktat, debt servitude and austerity.

The dynamos of a steepening Yield Curve, STPP, a higher US Ten Year Note Interest Rate, ^TNX, regional stability, security and sustainability, are winding up Regional Governance, Totalitarian Collectivism, and Regional Private Public Partnerships.

Definitely China’s growth will slow as will all of Asia’s, as Foreign Investment, EFA, SCZ, and Emerging Market Investment, EEM, VWO, and Global Producer Investment, FXR, has came to an end, as the Yen Bomb went off starting Competitive Currency Deflation. Japan in its efforts to stimulate inflation, has sunk the Yen, FXY, and has succeeded in producing Liberalism’s last inflationary World Stock, ACWI, Major Currency, DBV, and Emerging Currency, CEW, rally. Now these currencies are no longer rising, they are sinking, and are longer able to provide appreciation in Global Stocks, VT, Bonds, BND, and Commodities, DBC.

And yes, China will not be sucking up FX Currencies, But an investment demand for gold, will once again commence as all forms of fiat weatlh will trade lower in value as the Age of Fiat Asset Appreciation has come to an end and as the Age of Fiat Asset Deflation commences.

William said...

Scott - It is widely know that Chinese companies are buying foreign assets especially natural resource equities and properties, like the on-going purchase of the Canadian oil firm, Nexen. Certainly a major portion of their rationale is to assure availability of such resources for their future needs. But I have suspected that the Chinese believe natural resources are a better investment - and provide a hedge against inflation - than simply purchasing foreign currencies.

How do these purchases effect the measurement of the flows which you discussed? Are they accounted for just like a purchase of a foreign currency? Or do these purchases not show up in the data you discussed?

Gloeschi said...

So simply overlaying one chart (Chinese FX reserves) with another (gold price) makes you deduct the gold price rally is over?

I can overlay the gold price with US debt, number of cars on the roads in china, squirrel population in my backyard etc.

PS: One more quarter and US is back in recession.

McKibbinUSA said...

Scott's analysis above is intriguing -- I spent several hours into the wee hours of the night digging into gold prices, inflation, and Forex -- I'm unsettled by gold prices today -- Scott's explanation of what is happening is candidate explanation that is useful -- I am not a fan of precious metals (no dividends or rents), but must confess price changes in gold require explanations beyond the obvious -- nice work, Scott...

McKibbinUSA said...

PS: If equated to gold values, unit labor costs in the US have plunged since 1970 -- more at:


Clearly, labor costs in the US have been regressing to global norms for many decades now...

Jeff said...

Very interesting Scott. This is one of those variables I have just never seen as we've focus on central banks, money supplies, value relative oil, etc.

Yet I have to wonder, what is China's share of forex reserves globally. At $3.3T, they are large, but aren't total reserves $15-$20T?? How have total forex reserves changed over time?

But key to me (to date anyway) is the relationship of total government debt over time and it's correlation to the price of gold.

Put a global debt chart next to gold prices...what does that look like? Or just a chart of total US government debt to gold?

Here is a chart of of US Debt Limit to Gold Price:

I get this relationhsip. Having trouble understanding the China forex relationship. But I'm just an amature at his.

Anonymous said...

One of the mechanics is U.S. importers of Chinese goods paid and continue to pay in USD. The Chinese vendor takes the USD he got paid in and exchanges it for Yuan, right there at his bank where the USD was wired to. Now the China central bank gives the Yuan to the local bank and has possession of USD. They would have entirely too much USD if they didn’t have a place to put them. That place was buying U.S. Treasuries.

If the U.S. didn’t run a deficit, China would have too many USDs, and would have to reduce the number of Yuan they give to the Chinese vendor for his USD,that is, change the exchange rate. This would be inflation in China as said. This would mean the Chinese vendor would have to raise his prices to the U.S. importer.

Had the U.S. not run fiscal deficits to provide an outlet for China’s USD foreign reserves, China would have not grown nearly as they did. The U.S. would have had higher import prices. Who knows, maybe higher employment too. And maybe lower gold prices. I just wonder if the Chinese will substantially reduce their buying of Treasuries and how that is going to affect the U.S. economy.

Jeff said...

So I guess Obama and Biden are right, we can spend our way to prosperity!

Rakesh Kumar said...

You are right, Even there are many more reasons that effects on the rise of gold price. The prices are being many times double in the recent few years. So people think that this is the best investment buy now the prices of gold are slipping. Lets see what will happen.

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