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Magazine Issues » April 2011


BuddaGold is considered a safe-haven investment and that's not about to change. But the market could see more such funds coming out of China as demand in the region increases. George Mitton reports

When investors are worried, they buy gold, whether they fear political unrest, natural disasters or a debt crisis. Though uncertainty pushes investors to the asset class, the promise of increasing demand from Asia remains the precious metal’s greatest boon.

Senior gold specialist at consultancy Mercer Investment Consulting, Dennis van Ek explains: “Over the last decade, gold has been less volatile than bonds, less volatile than oil, less volatile than equities, less volatile than everything.”

Given gold’s past behaviour, it is a safe bet that today’s high gold prices indicate a lack of faith in the economy. Investors in Europe are worried about monetary inflation, government finances in the Eurozone and the debt situation in the United States. As a result, many of them are flocking to buy it to safeguard their assets.

But these worries are not the only part of the story. In addition to European demand, gold prices are being driven by unprecedented demand from Asia.

A centuries-old love affair

“The Chinese and gold have a love story that dates back centuries,” says Andrea Gentilini, senior portfolio manager at UBP, whose Swiss-domiciled gold fund has attracted many Asian investors.

The Chinese appetite for gold is startling because it is growing so quickly. The country is the world’s biggest gold producer and for years merely consumed its own production. But the latest figures from analysts at asset management firm UBS suggest it imported 200 tonnes of gold in the first two months of 2011.

This is partly because retail investor demand is catching up with deregulation that began nearly ten years ago with the founding of the Shanghai Gold Exchange. Like their Western counterparts, Chinese investors buy gold as a safe haven and as a hedge against rising prices.

But there are other factors pushing them towards this asset class, such as domestic constraints on buying bonds and equities and the Chinese government’s efforts to
limit property speculation. Gentilini says: “The only thing that is really left is gold, and with inflation on the horizon it’s a very sensible investment.”

Another driver is central bank demand. Asian central banks, particularly China’s, have historically kept less of their reserves in the form of gold than central banks in Europe. This is now changing as they begin to buy large quantities.

Adam Taylor, assistant portfolio manager at Liongate Capital Management, says: “The exact decision-making process is opaque but one would imagine it is driven by a concern of a devaluation of other currencies.”

Demand from China’s central bank is part of a general trend for central banks to switch from being sellers to becoming buyers. In the past, central banks were net sellers of about 400 tonnes of gold a year, but last year they swung to buying 87 tonnes, according to the World Gold Council. This trend is helping push up demand and forcing up prices.

Given the speed of Chinese demand growth, the country could soon catch up with the world’s biggest importer, India. China and India now account for more than half the world’s gold demand, though China has some way to go before its reserves match India’s. Indian households own the single biggest stock of gold in the world, about 18,000 tonnes, which is nearly eight times annual mine production.

Unquenchable demand

Given current growth trends, it seems likely that gold demand from Asia will continue to increase, especially as more gold investment products hit the market.

China’s first mutual fund to bet on gold prices abroad, the Lion Global Gold Fund, only gained approval from state authorities in November last year. It used up its entire allocation by raising CNY3.2bn (€340m) in its first fund and has now gained approval to double its investment. Experts expect more Chinese fund managers to launch gold funds in the near future.

The Lion fund was launched under China’s Qualified Domestic Institutional Investor (QDII) scheme, which invests Chinese money overseas. Z-Ben Advisors, a Shanghai-based consultancy, says it hopes Lion’s strategy will “jolt the industry out of a reliance on Greater China offerings for their QDII funds”. If so, this could lead to more QDII funds investing in global gold markets.

Another factor is that the Chinese government is encouraging banks to devise gold investment mechanisms to help sidestep the threat of a housing bubble. State-owned bank ICBC rolled out savings accounts linked to physical gold last year and now says more than a million customers have signed up, buying a total of 12 tonnes.

The scheme has huge potential for growth as ICBC alone has more than 200 million separate account holders. Toronto-based hedge fund Sprott Asset Management, which has $8.5bn under management, estimates that if the scheme is extended to all ICBC customers as well as those of China’s three other main banks, it could boost Chinese gold demand by 300 tonnes.

As Chinese investors flock to gold, they ape investors over the border in India, who are already enthusiastically investing in gold funds. According to data from the Association of Mutual Funds in India, assets of gold exchange-traded funds in India more than doubled year-on-year in January 2011 to INR35.8bn (€544m). The country continues to buy more gold than anyone else, with demand rising by two thirds to 963 tonnes last year. The World Gold Council predicts that by 2020, Indian gold demand will be 1,200 tonnes.

Booming Asian demand for gold comes as global supply starts to wane. Mine production is on a steady decline since its peak in 2001 and major firms such as Newmont Mining Corporation are forecasting another decline this year. The problem is that gold is scarce and takes a long time to extract.
Marcus Grubb, managing director of investment for the World Gold Council, says: “You can have a six- to ten-year wait before a deep mine will come into production.
“Gold is also expensive to produce, depending on the depth of the mine. There are some in South Africa where the marginal cost of production is more than $1,000 (€710) an ounce.”

Price and supply

Even at today’s prices of $1,400 an ounce, this leaves a disappointing profit margin. Its scarcity is a reason it can behave differently to other metals, such as copper, where there is no shortage of supply. Another difference is that it has practically no industrial applications, meaning its price is unaffected by manufacturing cycles.

Given strong demand and short supply, gold seems set to grow in price. But how high will they go? “$2,000 in the next couple of years, and possibly higher,” says Angelos Damaskos, chief executive officer at Sector Investment Managers, which invests in oil and gold production companies.

He thinks events in Europe could have dramatic effects. “If we have another financial debacle, especially with the European debt problems, there is a chance that the Eurozone might break down, in which case there would be a real flight to safety.”

This, then, could push the price of gold much higher.

Interestingly, the $2,000 figure Damaskos estimates is the same as that quoted by Deutsche Bank strategist Michael Lewis, who claimed earlier this year that if gold prices reach this level, it would create a bubble.

Damaskos is more cautious: “You can never call a bubble until you see it in the rear-view mirror.”

However, it would be foolish to dismiss the possibility of a bubble forming.

This unquenchable Asian demand is likely to push gold prices even higher. Low interest rates, inflation and economic uncertainty will only serve to drive this trend.

©2011 funds europe