DRIVERS OF THE SHANGHAI/LONDON GOLD PRICE DISCOUNT AND OUTLOOK FOR 2021

DRIVERS OF THE SHANGHAI/LONDON GOLD PRICE DISCOUNT AND OUTLOOK FOR 2021

The COVID-19 pandemic has had a significant impact on China’s gold market, leading to a 27% y-o-y drop in the nation’s gold demand in 2020. One consequence of such weakness was the widest Shanghai/London spot gold price discount. Historically, Shanghai has traded at a premium: since the Shanghai Gold Exchange (SGE) was established in late 2002, the spot gold price in China, a net gold importer, has been US$6/oz more expensive, on average, than the equivalent LBMA Gold Price in London.

A combination of factors, notably the domestic gold supply surplus and the restrictive nature of China’s gold exports has led to a negative and long lasting local Chinese gold price discount in 2020. But as Chinese gold demand revived towards the end of 2020, this discount has narrowed. As China’s economy is expected to recover further in 2021, Chinese gold consumption is likely to increase, thus potentially leading to a higher Shanghai/London spot gold price spread.

Examining the Shanghai/London spot gold price spread
Drivers of the Shanghai/London spot gold price spread include:
• Costs of Gold Import
• Restrictions on China’s gold imports and exports
• China’s domestic supply and demand conditions.

A positive spread: a natural consequence of China’s gold market dynamics

China has been a net gold importer since the early 2000s. According to the China Gold Association (CGA), with gold demand rising China’s domestic gold supply has not been enough to meet local demand since the local gold market’s liberation in 2002. As a consequence, imported gold has become a vital source of China’s gold supply. Between 2015 and 2019, 62% of China’s annual total gold supply, on average, came from imports. Western markets have played a major role in China’s gold imports. For instance, gold from Europe and North America accounted for nearly 50% of the total imported into the country in 2019.

Restrictions on gold flows into China constitute another key element of the spread. Normally, Chinese authorities allocate controlled quotas to qualified gold importers (mostly commercial banks) for each period. Such a mechanism has made gold a scarcer commodity in China, due to the shortage in supply of domestic gold, relative to markets where there are less restrictions for gold flows. As such, a positive spread is added to the Chinese gold price in addition to the costs of importing gold.

Local gold demand drives the spread
As China’s domestic gold supply usually remains relatively stable, local gold demand significantly affects spread. For instance, driven by bargain-hunting consumers, demand for gold bars, coins and jewellery in the second quarter of 2013 surged to the highest ever as the local gold price registered its largest quarterly fall in history; in turn this led to the largest quarterly domestic gold supply deficit in decades. Consequently, the Chinese gold price premium averaged US$24/oz in Q2 2013, the highest on a quarterly basis. In general, there is a positive relationship between the Chinese gold price spread and the local gold demand and supply conditions. The logic is simple: holding other conditions constant, gold’s scarcity increases as the domestic gold supply tightens, usually driven by higher demand, leading to a higher local gold price spread and vice versa.

An anatomy of the record discount in 2020
The Chinese gold price spread reached record lows in 2020. After turning negative in February, the spread kept falling. In August, it averaged US$69/oz, the lowest ever. Even though it started to narrow after August, the local gold price discount remained throughout Q3 and Q4 2020. On an annual basis, the local gold price discount averaged US$26/oz in 2020, the widest since the SGE’s establishment in 2002.

China's gold market in 2020: significantly weakened demand and relatively ample supply
China’s gold consumption plunged in 2020. China’s gold consumption in Q1 was the weakest since Q2 2008, down by 60% y-o-y. Despite some improvements in following quarters, Chinese consumers bought the lowest amount of gold in 10 years during 2020. The COVID-19 induced social activity restrictions in Q1, a rallying local gold price, and a reduced real disposable income for consumers amid the coronavirus economic fallout, were main contributors to such weakness in China’s gold demand last year but China’s domestic gold supply in 2020 was ample. Over 90% of major Chinese gold mining projects resumed production in mid-late March as the spread of the pandemic reduced significantly, leading to stabilisation of China’s mined gold supply. Meanwhile, as the local gold price rallied, many consumers and jewellers took profits on their gold holdings, increasing the supply of recycled gold. Additional recycling flows came from some retailers either putting the brakes on plans to expand operations or exiting the market during the economic hardship. Consequently, China’s domestic gold supply in 2020 remained at similar levels to 2019 while its gold demand witnessed sizable y-o-y declines. As the scarcity of gold reduced in China, the local gold price spread turned negative.

A surplus tends to be more influential on the local gold price spread
China’s gold imports and exports are asymmetric. According to available Chinese Customs’ data, the annual average gold imports between 2017 and 2019 were 67 times greater than exports. Such asymmetry can happen for a variety of reasons, including stricter restrictions on gold exports from authorities and the fact that China has been a nation with gold shortages since the early 2000s.
A shortage in China’s domestic gold supply can be addressed by importing gold relatively swiftly. Even though there are quota controls on China’s gold imports, authorities seem to make their determination based on factors such as the local gold demand. For instance, when China’s gold demand soared to a record high in 2013, its gold imports also surged to their highest level on record. A relatively sufficient gold imports quota allocation historically has helped stabilise the local gold price spread, limiting the impact on the spread of a gold shortage. However, due to stricter restrictions on exporting gold, the surplus-induced discount in China’s gold price can only be narrowed by the recovery in local gold demand (which in turn increases gold’s scarcity in the country). The slow revival in China’s gold demand led to a local gold price discount that lasted throughout 2020.

Outlook
The local gold price discount started to narrow after Q3
After reaching a record level in August, the gold price discount began contracting. On a monthly average basis, the discount narrowed from US$69/oz in August to US$18/oz in December. The key driver for the contraction was the recovery in China’s gold consumption as there were no major changes in the nation’s gold imports and exports policies in the second half of 2020. As China’s GDP growth recovered to 6.5% in Q4 from -6.8% in Q1, consumers’ inflation adjusted disposable income kept rising. Coupled with a relatively lower local gold price after mid-August, the nation’s gold demand witnessed sizable q-o-q growth in Q3 and Q4, leading to a contraction in the local gold price discount.

Chinese gold consumption outlook for 2021: improving but could be capped
There is room for improvement in China’s gold consumption in 2021. To strengthen the foundations of a steady economic recovery going forward, policy makers stated at the annual Central Economic Work Conference in late December 2020 that fiscal and monetary policies will remain supportive. This could mean a further recovery to consumer disposable income, potentially leading to higher gold consumption in 2021 than in 2020. In addition, the conference positioned domestic consumption stimulation as a key task for 2021. Similar stimulus to promote local consumption in various Chinese cities has been shown to contribute to a recovery in jewellery consumption during 2020, and further stimulation in 2021 would likely bode well for China’s gold consumption.

The spread has turned positive in January, as monthly trading volumes of Au9999, a high-frequency proxy of China’s physical gold demand remained above their 2020 average. Anecdotal evidence from our trade partners in China’s jewellery industry also suggests positive sales growth and a strong start to 2021. Despite the possibility of a gold consumption recovery this year, its upside potential may be limited. First, interest rates in China have been increasing since the economy started to recover in Q1 2020. Rates in China could remain elevated throughout 2021 as its economy is expected to revive further, pushing up the opportunity cost of holding gold. Second, with the RMB appreciating, the economy recovering and advancements in the rollout of the COVID 19 vaccine, the risk appetite of Chinese investors has been rising, weighing on the safe-haven demand for gold from local investors. For instance, data from the Asset Management Association of China, equity funds’ asset under management increased by 50% (RMB611bn or US$101bn) between Q1 and Q4 last year.
Furthermore, the trend for lightweight pieces in China’s gold jewellery industry could also limit the local gold consumption in tonnage terms. More and more gold jewellery manufacturers and retailers have recognised Chinese youngsters’ preference for more stylish and lightweight pieces at affordable prices, and this has led to increased efforts in producing and promoting such products over recent years. Jewellery retailers have also seen the advantage of increasing the percentage of lighter-weight products in their inventories in order to lower their costs of capital. Coupled with the fact that many jewellers’ expansion plans were slowed by the pandemic, the potential room for further recoveries in China’s gold jewellery tonnage demand could be limited. In summary, while a relatively positive outlook for China’s economy in 2021 could extend the recovery in local gold consumption, challenges arise from the possible lower investment demand for gold and the lightweight trend in the gold jewellery sector. But without doubt, China’s gold consumption will continue to play a significant role in driving the Shanghai/London gold price spread throughout 2021.

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