PBOC paper recommends leasing its reserves to manipulate gold price

“PBOC paper recommends leasing its reserves to manipulate gold price” should have been the headline Koos Jansen used for his blog post on a paper produced within the People’s Bank of China which recommended that China “consider employing some of the PBOC’s gold reserve for market operations and as a macro-control tool.”

 

For some reason, Koos instead thought that the “key takeaway” from the paper was that in China “the gold on lease is not double counted, leveraged or fractionally backed, as is often the case in Western gold markets” (which is incorrect, but more on that later).

 

Now saying what the headline should have been (from a Winklebottom point of view) isn’t the same as saying it is true. The reason is because the PBOC paper is focused on what I’d call “good” leasing, that is, leasing to businesses involved in manufacturing gold products, and not leasing for short selling purposes. We can confirm this by the quote “gold leasing is a no-leverage, low-risk transaction”, which only make sense in the context of inventory financing and not short selling. Within that context this quote provides more detail on what was meant by “market operations” and “macro-control”:

 

“Therefore, while restricting gold export, taking part of PBOC reserve gold to participate in leasing operation is a win-win policy. Specifically, the PBOC may select commercial banks as counter-party to lease out reserve gold when supply is tight. Gold lease rates may be established through bidding, PBOC participation would increase liquidity.”

 

The paper noted that the supply of physical gold to industrial users was limited at the time, so recommended utilisation of PBOC’s reserves when “supply is tight” and to “increase liquidity” within the lease market to support the gold industry. Assuming the PBOC did implement these recommendations it is likely that today their leasing may be minimal given that the PBOC did implement the recommendation “limitation to imports should be loosened in favor of a policy that is ‘easy in, strict out’” and as such today physical supply to Chinese industry is being met by significant amounts of imported gold.

 

However, in some sense my headline is true, although not that PBOC is explicitly short selling gold. In the paper they recommend that “enterprise participants can be left to commercial banks to be evaluated for risk of doing business, not unlike evaluating business loans.” In other words, you can trust the banks to be prudent in choosing who to lend gold to. Subsequent events indicate that Chinese banks weren’t so prudent, the result being “bad” leasing for short selling.

 

By September 2012 we first hear of abuse of improved liquidity in the Chinese leasing market with growing round tripping and collateral trades (the gold tied up in such would be financed/hedged by leasing). Business Week reported “rapid growth” in precious metals leasing business in September 2014. Koos’ sourcing of PBOC paper also confirms the observation in a WGC report that “most of the gold stuck in financing deals has been built up since 2011” (note the PBOC paper is dated January 2011) and provides evidence that PBOC paid attention to the paper’s recommendations. Later we find out how individuals and non-gold businesses were using gold loans in risky leveraged transactions. How much of Chinese bank leasing was for such short selling we don’t know, but given that the paper recommended

• “increasing gold reserves optimizes the makeup of China’s assets which will lay a good foundation for RMB internationalization” and
• “when gold in the domestic market is sufficient, or for strategic needs, PBOC may purchase gold from commercial banks to reach its gold reserve target”

it is probably not unreasonable to expect that the PBOC wouldn’t be too worried that a light touch approach to regulating gold leasing may result in downward pressure on gold prices.

 

Back to Koos’ statement that “the gold on lease is not double counted, leveraged or fractionally backed, as is often the case in Western gold markets”. Regarding double counting, the IMF paper Koos quotes is referring to how many central banks report physical gold and gold loans as one line item. When done this way, the addition of such figures with other figures of gold holdings will result in double counting of physical gold.

 

However, Koos incorrectly thinks that the SGE rulebook that possession/title of gold from lessor to lessee somehow gets around this problem. The very same transfer occurs in the situations the IMF is referring to, and this doesn’t solve the problem. It is not about transfer but about reporting. To the extent that Chinese bank’s financial reports do not break down physical gold stocks from gold loans, there will be double counting. To the extent that banks following accounting standards, like the Reserve Bank of Australia does, there won’t be double counting.

 

In respect of Koos' claim that Chinese gold leasing is not fractional backed, well, by definition gold leasing results in a bank being fractionally reserved. As Koos notes, the SGE rules result in transfer of physical gold from the bank, in which case, they no longer have physical gold backing their gold liabilities! Hence they only have a fraction of physical gold against all their gold liabilities. Hence “the gold on lease IS … fractionally backed”. Chinese bullion banks are no different from their Western counterparts, as Koos himself reported: “ICBC launched gold accumulation schemes, swaps, forward hedging, lease/financing, collateralized loans and other financial services ahead of time”. That sounds exactly like what bullion banks do in Western gold markets to me.