How China became the '800-Pound' Gorilla in the Gold Market

With prices testing their record high of $1,033 an ounce set last year gold has again become the hot topic of conversation.

But while many analysts are focusing on threat of inflation - which could be a byproduct of the U.S. Federal Reserve's reluctance to withdraw monetary stimulus - investors should really be watching China.

"In the post-financial crisis global economy, China is quickly becoming the proverbial '800-pound gorilla' - the player that has to be courted, but that can't be tamed," said Money Morning Contributing Editor Peter Krauth.

In a recent article for Money Morning, Krauth said that he believes the stage has been set for gold to make a lasting run above $1,000 an ounce, in no small part because of China.

For the past six years China has quietly been stocking up on gold, boosting its holdings of the yellow metal to 1,054 metric tons from 400 metric tons in 2003.

What's more is that earlier this year, the government finally made it legal for Chinese citizens to make their own purchases of the yellow metal.

As recently as 2002, the private ownership of gold was prohibited in China, with jail as the penalty for possession.  But now the government executed a stunning about face and removed all such restrictions. In fact, Beijing is actually encouraging its citizens to purchase the precious metal through state-run media.

China's Central Television, the nation's main state-owned television company, is now running news programs, which strongly resemble infomercials, explaining just how easy it is to purchase gold and silver as an investment.

"Simply put, the Chinese government is trying to trigger a national gold craze...and it's working. The Chinese public now has gold trading platforms on steroids," Paul Atherly, managing director at Leyshon Resources Ltd. (OTC ADR: LYRSY), said in an investor presentation in London.

Physical gold demand from private Chinese households rose 9% in the first half of this year, due to an "unprecedented" sales push across rural China, according to Gerry Chen, the World Gold Council's local business development manager.

Most banks in China already offer customers gold and silver bullion bars in four different sizes ranging from one to five kilograms.

A Golden Opportunity?

Of course, it's not just the Chinese public that is interested in stepping up its gold purchases. Even though China has nearly tripled the size its gold reserves in the past six years, the declining value of the dollar has given the Red Dragon even more incentive to stock up.

China has about $2 trillion in foreign currency reserves. The vast majority those holdings are in dollar-denominated securities, and therefore are susceptible to the declines in the value of the greenback.

The dollar was been in a precipitous freefall for years before the financial crisis hit in full, sending droves of investors flocking to shelter of the U.S. currency. But now that the global downturn is being to abate, many investors have regained their appetite for risk, and the dollar has resumed its decline.

The dollar has lost 2.5% to a basket of six currencies this month and nearly 5% since early July.

China's Cheng Siwei, former vice chairman of the Standing Committee of the Chinese Communist Party, recently told Great Britain's Telegraph newspaper that "If [the Fed] keep[s] printing money to buy bonds, it will lead to inflation, and after a year or two, the dollar will fall hard. Most of our [Chinese] foreign reserves are in U.S. bonds and this is very difficult to change, so we will diversify incremental reserves into euros, yen and other currencies."

Gold provides China with an excellent opportunity to diversify away from the dollar. Many of the nation's top policymakers agree, but there's a question of timing.

"When we buy, the price goes up," Siwei noted. "We have to do it carefully so as not to stimulate the markets."

From 2003 to 2009, China spread out its gold purchases over a long period of time and relied heavily on Chinese producers.

But this time around there may be a shortcut, because the International Monetary Fund (IMF) has formally endorsed a plan on Friday to sell 403.3 tons of gold - equal to about one eighth of its holdings - to central banks or in the gold market. Gold demand was 3,880 tons last year, according to the World Gold Council.

That presents China with a tremendous opportunity, because if it decided to buy the gold, China would be able to seek a discount from spot prices, since a market sale would put downward pressure on bullion prices.

"China only has about 1,000 [metric tons] of gold reserves and the investments in other assets are performing not very well," one official, who declined to be named, told Reuters. "I think we should build up more gold with foreign reserves, but when to buy is the key. It's a good idea if China can buy the gold from IMF at prices well below market level."

The Chinese are currently being converted from being the lowest per capita gold consumers in the world to a nation of small precious metals investors. By next year, Chinese gold consumption will likely overtake India, which has been for years the world's biggest gold market.

With global gold production at best flat and probably in decline, even a small increase in Chinese buying could have a substantial impact on gold prices.

"The lesson here is clear: China's growing appetite for gold is a powerful trend that will benefit gold investors for years - even decades - to come," said Money Morning's Krauth.

According to Krauth, "the biggest bang-for-buck still lies with the junior gold sector. The best proxy for this is the S&P/TSX Venture Composite Index (CDNX)," otherwise known as the Toronto Venture Exchange. It consists of about 75% resource stocks.

The CDNX has been steadily carving new highs almost uninterrupted since March, now posting a whopping 80% gain since its December 2008 low. That's an impressive performance.

The players in this sector promising the best returns are the junior gold-and-silver companies either already producing, or with near-term production.

"With gold breaking and sustaining the $1,000 barrier, junior gold and silver miners are the place to be for explosive returns," said Krauth. "Just hold onto your hat."

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