China’s Commodity Speculation: From Copper to Gold

Why the country was responsible for last year's drop and this year's pop
March 26, 2014 Updated: December 31, 2015

Investors should always be cautious about recommendations from Goldman Sachs. There is a saying on the Street: The firm always takes the other side of the trade it is recommending to clients, as it did with subprime mortgages.

Now, Goldman thinks it’s a good idea to sell gold. “We see potential for a meaningful decline in gold prices … and reiterate our year-end $1,050 gold price forecast,” reads a recent report.

In yet another report, Goldman digs into the mystery of Chinese commodity speculation and comes to the same conclusion. However, the logic is unsound.

Just as with copper, traders use gold to short dollars, buy Chinese yuan, and make a gain on the interest rate differential. While the extent of the speculation is well-known regarding copper, gold’s role has been underestimated so far.

So far, China’s import of 1400 tons of physical gold from Hong Kong since 2011 (worth roughly $70 billion) has been attributed to demand from savers for investment or jewelry. The central bank was also rumored to have built up gold reserves in order to diversify its holdings of U.S. Treasury bonds.

In fact, it appears that the importing (and re-exporting) of all this gold had a much simpler motive. Profit.

Because of capital controls—you cannot buy yuan on the open market—traders devised an elaborate scheme involving Chinese and foreign banks to funnel dollars into the Chinese credit system. They would earn a much higher interest rate in China and also profit from the appreciation of the Chinese yuan.

Copper was used extensively because of its availability, but gold was popular because you can move larger notional sums and use up less space during shipping and storing.

2013 Drop

Last year saw a record amount of these deals happening, although the speculation started in 2009. Despite the record imports—buying of physical gold—prices dropped 30 percent in 2013.

The reason: Traders don’t want to be exposed to price swings in gold. So while they bought physical—plundered from the Spider GLD ETF, as Jim Rickards notes—they sold futures to offset the risk.

Alongside alleged manipulation of the futures price, like selling into an illiquid market, this depressed the price of paper gold (the paper “gold price” is the futures price) and led to shortages on the physical market.

2014 Pop

In 2014, two things have changed and we see the price of gold rallying, very much against Goldman’s expectation.

First, regulations against these types of financing deals have been put in place over the course of 2013. But more importantly, the People’s Bank of China recently started playing hardball and is intervening to weaken the yuan.

With the yuan getting weaker, traders are suddenly subject to the risk of losses when converting their yuan back into dollars. So they are exiting the trade.

Physical Versus Paper

In order to exit the trade, physical gold has to be sold and paper gold (futures) has to be bought.

For obvious reasons, the paper price of gold has to go up if people exit their short positions. What happens to the selling of physical though? The market of physical gold is much more stable, because it is not driven by margin debt, unlike the futures market. So we have not seen a decline in price, rather the opposite of what happened in 2013. And there is more to come as more trades are being unwound.

Many hundred tons of physical can change hands without the paper price moving much, like the recent transaction of India buying hundreds of tons of IMF gold. There is always a buyer. This is not the case for other commodities, such as copper, which depend on now declining industrial use.

So ultimately Goldman’s analysis is sound, but the conclusion is incorrect. Maybe they just want you to sell out your paper gold.