Wednesday, August 14, 2013

Gold, China, And The Austrian Business Cycle

by Olav Dirkmaat via GoldRepublic,
The Chinese account for over a third of total gold demand. We know therefore that any development in China - either positive or negative - has a rippling effect on gold, as well as other commodities that were bid up to new record heights during the Chinese credit bubble.

But the problem in China is not only an overextension of credit and an urgently needed deleveraging of its banking sector. It is, more importantly, the cleansing of a miscoordination of economic resources. The issue at hand is therefore not the total level of credit, but the micro-economic catastrophy that an inflow of excessive credit causes.

The magic of capitalism is that profit margins are driven by (derived) consumer demand: higher consumer demand leads to higher profit margins that in turn attract investors. The benefiting industries expand at the expense of other industries that experience lower consumer demand.

Excessive credit, however, provides investors with the very same signal as if consumer demand has increased. Yet this is not the case. Investors will make investments that are not sustainable and will turn into lousy investments as soon as prices throughout the economy readjust to the new amount of credit.

How does this process work?

When central banks distort the healthy clearing process between commercial banks by using their bottomless wallet, an excess of credit over savings develops. This credit ends up in the hands of entrepreneurs that bid up certain market prices: they exercise their increased buying power in some sectors of the economy. They bring about a price increase in some goods, above the level at which they would have settled without the inflow of new credit, but that remain uncompensated by a decrease in prices of other goods. They cause an increase in profit margins and free cash flow in markets to which the additional credit flows; an irrefutable micro-economic signal for investors to invest in these lines of production. A temporary boom ensues.

This boom cannot continue forever. The new credit - in the form of bank deposits - will eventually bid up prices throughout the entire economy. All prices readjust upward over time. As money trickles down, other people will bid for the goods they desired and desire with their newly obtained increased nominal buying power. Instead of entrepreneurs bidding up prices of production goods, consumers now bid up prices of consumer goods. The credit-driven demand in some sectors stalls, while all other prices rise to reflect the impact of the newly created credit on the broad money supply.

This is exactly what happened in China. Massive amounts of credit went into the real estate sector. Prices were bid up and an unsustainable boom developed. And as long as the amount of new credit outstrips the upward readjustment of prices following from the previous credit injections, the party continues. But as soon as the amount of new credit inevitably dwindles, the readjustment of prices to the new credit comes to a closure by means of a full-blown recession.

The key to understanding this theory is the fact that the real problem is not about the credit supply. It is about the miscoordination of production due to an excess of credit over savings. When banks are no longer limited in their credit expansion by the competitive clearing process, for example because of a significant increase in base money by the central bank, saved-up (unconsumed) resources have in fact not increased, but entrepreneurs invest as if saved-up resources, available to production, have increased. The boom is temporary and will inevitably burst into a recession as soon as the market readjusts prices again.

Sharp observers can see the unravelling of this process in full force in China. The CPI indicates rising consumer prices, while production slumps with a PPI revealing declining producer prices. Recent PMI-figures are also abysmal. It is an undeniable sign of a credit bubble ready to burst.

But what does this mean for future gold prices?

The Chinese demand for gold essentially comes from three segments: (1) the People’s Bank of China; (2); the banking sector; and (3) Chinese citizens.

We can count on the Chinese central bank to pursue the same steady course they have been pursuing for a while: buying additional gunpowder by increasing their gold reserves. The PBoC has been very secretive about the pace at which they expand their gold hoard. Analysts estimate that the PBoC bought as much as 490 tons gold on the market in 2011. With declining prices, who believes that they are buying less now?

In 2009 Yi Gang, Vice Governor of the PBoC, commented that Chinese gold reserves equalled about 1.000 tonnes then, and could reach 6.000 tonnes by 2013 and even 10.000 tonnes by the end of the decade. That presupposes an increase of approximately 1.000 tonnes annually. Chinese gold production is roughly 400 tonnes, so that leaves us with 600 tonnes to be imported each year. Given recent price declines, China might decide to take advantage of such an opportunity. According to the World Gold Council, gold demand equals give and take 4.500 tonnes, thus PBoCs influence on gold prices is considerable at around 13% of total gold demand.

On the other end, Chinese commercial banks themselves are of little relevance for gold. As the banking sector has to deleverage - with Chinese authorities insisting on taking some pain — banks will try to exchange their assets for hard (how ironic) currency. Yet interest rates paid for savings deposits are still pegged by the PBoC to its own benchmark.

More importantly, it is very likely that the deleveraging will be accompanied by, for instance, a significant cut in interest rates or a lowering of the reserve requirements to offer the banking sector a helping hand.

This could have a major impact on gold. We’ll see why by observing that the bulk of Chinese gold demand comes from its third source: Chinese citizens. China has one of the world's highest saving rates, and the public faces few investment options. With negative real interest rates, in case the PBoC does lower rates to support the banking system, gold seems to be an opportune alternative. In this light, it is interesting to see a close correlation between the gold price and changes in Chinese consumer prices (with the exception of the past few months). From 1993 to 2013 correlation between the gold price and the Chinese CPI was .80, while over the past ten years it equalled a stunning .97! We should nonetheless reiterate the often heard mantra that correlation does not equal causation.

The main driver of increasing gold demand from China should therefore be the general public. Gold demand of the Chinese public equates to around 800 tonnes a year, but could increase in accordance with the Chinese slowdown.

Yet we should also consider the other side of the coin. In the short run things might take another turn. Interest rates on bank deposits are capped to 110% of the discount rate offered by the PBoC. When an economic slowdown inevitably sets in, consumer prices might get dragged down in an ensuing recessionary offshoot, increasing the real return on bank deposits. Inflation and PBoC rate cuts, however, would avoid this scenario.

It will be undoubtedly interesting to see how the Chinese slowdown will unfold. Chinese gold demand will be key to gold prices in the near and more distant future due to sheer size. It is unfortunate that most pundits nevertheless choose to focus their attention on the cherished Western world.

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