08 January 2015

Chinese gold demand and SGE withdrawals: the role of leasing and inventory changes

Following on from my and Koos posts on leasing (here and here), Koos and I have been discussing leasing and SGE withdrawals. Koos says that when the gold is leased it’s transferred from the lessor’s SGE bullion account to the lessee’s SGE bullion account. It can then be:
  1. sold spot on the SGE by the lessee (ie miner, or speculator).
  2. withdrawn from the vaults. In this case it’s very likely the gold is leased by a jeweler for production - why else get your hands on the physical?
In this post I'm interested in the second point and what it means for interpreting SGE withdrawal figures. In short, to the extent that manufacturers are building inventory to support increased demand (or vice versa), SGE withdrawals will overstate (understate) the real amount of demand that affects gold prices. Now for the long version.
In my opinion, when looking at demand (or supply) figures what we are really interested in is getting a handle on what is affecting the gold price, that is, how many people are in the market to buy or sell gold. From that point of view we aren't interested in gold flows which don't involve any buying and selling. For example, if I told you that a huge amount of gold was going into Switzerland that is certainly interesting, but if all that gold was just people moving allocated from vaults in London to vaults in Switzerland then it wouldn't be as useful, because such actions didn't affect the gold price as no one was selling or buying. There might be some secondary information value in that fact, eg maybe it indicates that those holders are worried about the London market and are more likely to hold on to their gold and less likely to sell in the future, but it isn't impacting current price discovery.
In the same way, when manufacturers lease gold it doesn't impact the gold price. In effect, gold investors are moving their gold from a vault and placing in the factory of the manufacturer - no buying or selling goes on. It does have a secondary feedback impact, in that leasing activity affects the lease rate market, which in turn affect futures/forwards (ie GOFO), which impacts the attractiveness of shorting gold, but this is in the future and probably of marginal impact.
A few years ago I tried to explain unallocated within a manufacturing business using the analogy of water and pipes. Many thought it was more confusing than clarifying but its the best way I can explain it. Leasing is like pumping water from a dam into a long pipe to a town. Nothing flows out at the other end until the pipe is full. Only then water starts coming out (eg jewellery being sold) and results in water being pulled in at the other end from the dam (eg buying gold bars). The initial filling of the gold production "pipe" has no effect on the gold price market until the production processes are full and gold can start flowing out as finished product.
In the case of China and the SGE, any leasing for physical use by manufacturers will impact withdrawal figures. As a simplified example, consider someone starting a new jewellery business which takes 1 month to turn bars into finished jewellery. At the beginning of the year they lease 100oz, take delivery from the SGE and make jewellery. At the end of January they sell this 100oz of jewellery and then use the cash from their sales to immediately buy 100oz of bars on the SGE, which they withdraw so they can make it into jewellery to sell in February.
In January, the SGW would report 200oz of withdrawals - 100oz from the lease and 100oz from the replacement buying. In February they would just report 100oz of withdrawals. Over the whole year SGE withdrawals would therefore be 1300oz when actual, real, price impacting demand was only 1200oz.
If business picked up for our enterprising jeweller half way through the year and they wanted to double production, they would borrow another 100oz. This would give them 200oz of inventory which they could turn into 200oz of jewellery. The result would be 1800oz of jewellery sales (6 months of 100oz and 6 months of 200oz) but SGE withdrawals would be reported as 2000oz.
This simplified example should show that wholesale demand figures are inflated and don't correspond to actual end consumer demand, which is what is actually driving gold prices. How far apart they are will depend on industry inventory turnover, production efficiency, scrap/wastage rates and how they are settled (on SGE or as toll refining) and other factors. I don't have a handle on these figures and I don't want to overstate the impact, as I'm sure Chinese manufacturers turn their inventory over pretty quickly, but this inventory build and reduction needs to be considered in respect of seasonal consumer demand patters (eg Chinese new year), certainly on a monthly basis.
The other point is that over the past few years as China has opened up (at least internally) its gold market it has grown substantially and accordingly, the size of the jewellery and minting businesses have also grown and with it the amount of gold tied up in their inventories. That amount in aggregate is not insignificant and in my opinion means accumulating SGE withdrawal figures over multiple years is misleading - I'm looking at you Nick and this chart of yours that the blogosphere loves :p


  1. Nice to have more people digging into the details of the Chinese gold market.

    I agree with you SGE withdrawals do not match end consumer demand, that's why I have always called them "wholesale demand". How much is truly stuck in inventory is hard to say.

    The chart of Nick is misleading coz "aggregated withdrawals" 2010 - 2014 were at least supplied by about 1,300 tonnes of scrap supply. Additionally, before 2009 the Chinese market also existed. Therefor the "aggregated withdrawals" section of the chart is useless.

  2. Happy New Year, Bron.
    A year ago ANZ correctly predicted Chinese imports would decline in 2014. Now they're saying the opposite for reasoning you discuss: "Thianpiriya explained that one of the reasons why gold imports, and demand to China, were low in 2014 was because there was already a significant build-up of reserves as a result of weaker prices in 2013. However, he is expecting Chinese imports to pick up in 2015 as most of the onshore supply has been reduced."
    I disagree with your comment about about the gold flows because these include investment demand, which the WGC appears unable to measure directly, e.g. the thousands of tonnes imported into the UK from 2001-12.