Only verdant gold market observers would claim that high level of headline inflation is correlated with higher gold prices. When food and energy prices rise in response to supply constraints, consumers’ disposable income is initially reduced. Until the price pressure seeps into core inflation, household’s ratio of consumption and investment to savings is more likely to slow down than increase. The PPI/CPI ratio, if accurately measured, provides some solace as a guide to show how quickly the demand conditions allow producers to pass on higher input prices. Until then, deceleration in the rate of growth of gold demand (as well as demand for other products with significant retail component) should be expected.
But there is no denying that gold remains the most sensitive of assets in the rush to offset the expected reflationary cycle. One of the unfalsifiable correlations is between nominal gold prices and the growth of money supply as measured by M2. In the US, M2 is “held” by individuals in terms of cash, deposits and in the money market. Although over the long term, gold’s trajectory correlates strongly with M2 trend line, in certain periods, gold tends to outperform it.
For example, the aggregate has doubled over the last decade, from $4.5 trillion in 2000 to some $9.0 trillion currently. Over this period, gold’s nominal price in US dollars has more than quintupled. On the other hand, in 1971-72, when the gold market became untethered, M2 crept by 13% per annum, but gold jumped 46%. In the following two years, while the money supply fell to single digits, gold’s gains continued, at nearly 70% annually.
Much of the acceleration in M2 growth in the US during the market dislocations of 2008-2009 was bound to offset the spectacular collapse in shadow money aggregates (estimated by CS as outstanding securities market less repo haircut in percentage terms). Even though the rationale for these offsets has now abated, another source of money supply growth has come from the side of an economy which back in the 1970s had hardly anything to offer bar little red books.
Whatever our view on the real economic growth in the People’s Republic, it is difficult not to be awed by the growth in money supply in the recent years. China’s M2, which covers cash in circulation and all deposits, grew at 17% last year. The accumulated stock was worth 73.61 trillion RMB or $11.24 trillion. This is a quarter more than the M2 of the US economy, which continues to be 3 times larger than China’s. To the extent that Chinese currency remains pegged to the US dollar and that some of its monetary supply leaks to the global market, this rapid rise in M2 matters for the rest of us, and it matters for gold too.
The question remains how big the cross-border flows are? Chinese state, in the guise of “improving people’s lives” has been pretty efficient in controlling the capital account outflows (as opposed to inflows – which amplify upward pressure on the Renminbi). With $500bn worth of trade, $60bn in overseas FDI, $110bn of overseas loans provided by EXIM Bank and China Development Bank, whatever foreign investments made by SAFE and CIC, and of course the massive purchase of US, European and Japanese Treasuries, China’s wealth does leak massively through the Great Renminbi Wall over and above the gamblers’ collateralized punts in Macao. By comparison, the Hong Kong/China gold imports’ contribution to offset the trade surpluses is tiny, but the statistics here are unreliable, given the secretive nature of the flows in what remains the world’s largest gold mining country.
And so, any deceleration in the growth of money supply in China will have an impact on monetary conditions globally. There are reasons to believe that M2 growth, which clicks at double the GDP growth in China will, indeed, slow down. First, the aggregate is already showing signs of cooling – it rose 15.7% year on year (February data), still impressive, but much slower than a year ago. Secondly, Chinese trade surplus has fallen by over 35% in the last two years, largely due to higher (and sustained) commodity prices. Over time, this could mean buying less dollars to buy from exporters. Third, the narrower M1 – advocated by some in China as a policy target – is decelerating even faster than M2.
In the meantime, tightening credit conditions in China are beginning to affect not only mortgage discounts and flows to local UDICs, but have also laid bare the stockpiling of certain commodities as collateral for loans. With PPI growth outpacing (the statistically re-jigged) CPI, there is now a danger that the lack of meaningful monetary, tax and credit reforms may force the stewards of this supply-driven economy to focus on value chain control. Failure in this endeavor may force some Chinese wealth to leak overseas in search of better, inflation-adjusted returns. However, it is unlikely that this process will offset the mighty impact of official outflows, which have so far helped us keep low long-term interest rates and thus facilitated the monetization of public debt in the West. Much of the continued gold story depends on how long this trend can be sustained.
(due to heavy, intercontinental travel schedule, the posts will appear with less regularity, until further notice)