HAPPY CHINESE NEW YEAR

Last week I drew your attention to the importance of following the patterns of the changing correlations between the gold price and the EUR-USD currency pair.  As I argued, the fall in this correlation should be viewed as an important signal.  And lo and behold – gold has rebounded significantly since the drop-off in the correlation to Euro.  As a result, on Wednesday this week, gold hit an all time high in Euro terms.

This event is often lost on US investors who see the world exclusively through the lenses of the US dollar.  But the US dollar has been used for accounts in America only since 1830s and its dominance as a denominator of international trade and capital flows may have already peaked.  It is therefore crucial to understand how gold behaves in other currencies, as this relative performance has an impact both on the decisions affecting the supply of gold as well as on the demand for the metal.

For the moment, gold denominated in Euro is in a league of its own.  So far, no other major currency has seen the gold price peak since December 3.  Globally, from the perspective of the gold market, currencies fall into two categories.  On the one hand we have the classic “commodity currencies”.  In three of them – Australian dollar, Brazilian Real and South African Rand, gold peaked already a year ago, between February 18 and February 20, 2009.  In the second group we have most of the other significant currencies, including the Yen, the Pound, the Swiss Franc, the renminbi, the US dollar and, interestingly enough, the Canadian dollar, usually considered to be just another “commodity currency”.  All these currencies saw the gold price peak between December 2 and 3 of last year.  Most importantly, this was also the case of the Indian rupee – still the most important currency for physical gold demand, given the Chinese renminbi’s stiff peg to the US dollar.  Contrary to the Chinese demand for gold (more about it below), Indian gold demand is notoriously price elastic.  Encouragingly, the gold price in Indian Rupee is now 8% off its December peak – and some revival of demand could be expected around traditionally auspicious dates.

An investor in gold will naturally pay attention to the currency exposures of his or her own balance sheet.  But s/he is also well advised to look at gold prices in other currencies.  As a rule of thumb, high gold prices in commodity currencies (Brazil, Australia, South Africa) and stable gold prices in gold demand currencies (such as Rupee, but also Swiss Franc) are positive both for gold equity margins and for the underlying floor under the gold price.  Importantly, fat operating margins allow producers to focus on lower grade areas in the mine, assuming that the mine design allows for such flexibility.  This leads, ceteris paribus, to lower volumes of production – and on aggregate should offset the impact of the supply growth from other producers’ rush to push through new projects.

The Chinese demand is a different animal altogether.  In fact, the Chinese gold buying patterns have been the gold bug’s best friend.  Chinese gold demand exhibits strong Veblenian characteristics – typical of the so-called “conspicuous consumption” goods.  Over a hundred years ago, economist Thorsten Veblen developed a novel, “cultural” theory of consumption.  Through his research, he found that much human consumption is driven by habit, convention and irrationality.  Remarkably, Veblen demonstrated that in early, predatory cultures, unproductive consumption was often a proof of prowess and dignity.  Hence the ostentatious attachment to extravagant goods, feasts and gifts, which conferred on the consumer the aura of wealth and importance.

In some extreme cases – as in Africa or among many indigenous populations of the Americas – this ostentation has led to poor capital accumulation and squandering of resources.  But not in China, where the group of common interest is well defined and limited to the concentric circles of families and clans.  Given the unique demographic position of this “one-child economy”, the resources of as many as three generations may now be directed towards the young professionals who live and work in Beijing, Shanghai or Shenzhen.  And much of those professionals’ consumption would go precisely toward ‘status’ goods and investments – among these: a high-end apartment, a big black Buick and… gold.  If you drive these days down the brand new highways of Yunnan, Sichuan or Chongqing, you will be struck by just how empty these high speed routes actually are.  The Buicks are nowhere to be seen because they were bought to show them off to neighbors, not to drive them to another province, where unfamiliar people speak a different language and eat different food.  Last year, the Chinese bought 13.5 million new cars (up from 8 million in 2008), but the gasoline consumption barely budged.  This new vehicle is either parked, or inches around in the main cities’ monumental traffic jams.  Cars are bought because they can be afforded and flaunted as status symbols.  And it is no different with gold – an ultimate aspirational good in a country whose emperor used to wear huangpao – a golden robe.

When at the beginning of this century I studied the elasticity of gold demand to incomes, I was stunned by how steep the demand curve was in China.  PRC gold demand was unlike in any other country because, precisely, it was upward sloping – the more expensive the gold, the more the Chinese bought of it.  The trend has not changed since then, but what has changed is the Chinese consumer power.  For all the bemoaning of the falling contribution from consumption to China’s GDP, in absolute value terms, Chinese consumers have increased their overall spending 3.7 times over the last ten years.  During this formative period of nascent consumption, gold offered them a 10.5% annual return, in renminbi terms.  While the Chinese economic “miracle” may not necessarily outlive the development model based on cheap factor endowment, it has still some way to go.  And this is good news for long term gold holders.

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Tags: Chinese gold demand, commodity currencies, conspicuous consumption, gold demand currencies, upward sloping demand curve, Veblen