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When Gold Demand Awakes A Sleeping Dragon

Tuesday, 26 November 2013 17:07 Byron King

This article was written by Byron King and originally published at The Daily Reckoning

“Never laugh at live dragons,” wrote J. R. R. Tolkien in his classic book The Hobbit, published in 1937.

Tolkien was on to something, I believe. His words come to mind because I keep seeing more and more news about China — the national symbol of which is the dragon — and its many citizens buying more and more gold. It’s fair to say that China and the Chinese hoard yellow metal.

Not long ago, for example, I saw video of Chinese rioting over access to a gold-selling mall in Shanghai. Evidently, some Chinese are desperate to convert their currency into gold. It’s a gold-lust much like that of Tolkien’s gold-loving dragon named Smaug:

“There he lay, a vast red-golden dragon, fast asleep… about him on all sides stretching away across the unseen floors, lay countless piles of precious things, gold wrought and unwrought, gems and jewels, and silver red-stained in the ruddy light… [The] hobbit could see his underparts and his long pale belly crusted with gems and fragments of gold from his long lying on his costly bed.”

If you’re looking for gold, I don’t recommend walking into the lair of a fire-breathing dragon. But I’m okay with accumulating gold and gold shares via less dangerous means, and today I’ll explain my logic.

In fact, despite a generally “down” market for gold this year, I’ve got my eyes on cheap miners. Some of these shares are set to be a great buy at current, beaten-down gold prices. And looking ahead – in the long-term — what if gold prices rise?

Considering an economy marked by low interest rates and all manner of bizarre government policies, long-term gold fundamentals are still holding true.

First, let’s take another look at Chinese gold-buying. It’s just astonishing. The Chinese government and people are buying gold by the tonne (metric ton). See the nearby chart of Chinese gold imports from Hong Kong, showing strong, steady accumulation over the past two years.

Chinese Gross Gold Imports from Hong Kong, Sept. 2011-Present

In specific numbers, since September 2011, China has imported 2,116 tonnes of gold. That is, in just over two years, China has imported almost the equivalent of the entire gold reserves of France (2,435 tonnes) or Italy (2,451 tonnes).

According to the World Gold Council, about one-third of China’s gold imports are due to individual Chinese buyers who want to own “personal” gold, as bullion and/or jewelry. That is, the buyers are people who don’t want to tie up their wealth in the Chinese yuan — the national currency. There’s also a modest amount of imported gold going for industrial use in electronics and such.

Much of the rest of the gold going to China — well over half — is, apparently, destined for the Chinese central bank. This gold is intended to back up government monetary policy.

Like Smaug the dragon, the Chinese do what they do. Or look at it another way. Here in the West, monetary players and many mainstream media pundits heap disdain upon gold. The conventional wisdom is to sell gold.

We see that conventional wisdom reflected when nominal gold prices fall and large gold holders like SPDR Gold Shares (GLD) liquidate holdings. Of course, for every seller, there’s a buyer, and right now, on net balance, the Chinese are buying every ounce sold, and then some.

It’s not far-fetched to believe that despite the harsh words of Western “experts” against gold, the People’s Bank of China (PBOC) is making good on its quietly stated long-term goal of creating a gold-backed national currency. Meanwhile, China is making trade deals with a host of nations in which those nations trade with China using their own national currencies and the Chinese renminbi (the currency used in international trade). This cuts the U.S. dollar out of the cycle.

There are deep issues to ponder here. Why are Chinese people and their government so eager to buy and import gold? What do they know? Why does the Chinese government make so many bilateral trade deals? Why don’t the Chinese want to use the dollar? What’s the strategy at work?

Really, don’t the Chinese know that yellow metal is just a so-called “barbarous relic” in the eyes of many Western economists and political gurus? Are the Chinese trying to take the world back to the days of Middle Earth and hobbits?

Let’s follow the facts and look at gold price charts. As you can see in the chart below, the price of gold declined this year, after a long run-up over the past decade:

Gold Price Run Up, 2000-2013

See the close-up chart below, of gold prices this year, showing the 2013 decline in more detail. It’s a steady price deterioration, although perhaps we’re near the end of this downturn. Could gold prices fall further? I hope not, but never say never.

In the past year, the price decline for gold has dragged down share prices across the gold-mining sector too. Here’s a 10-year chart for the Market Vectors Gold Miners ETF (GDX: NYSE). For the sake of comparison, I’ve thrown in the Market Vectors Gold ETF (GLD: NYSE) as well.

GLD vs. GLX Gold Funds, 2005-2013

So here’s what we know. China is importing large amounts of gold. Western holders are selling gold, as evidenced by the GLD decline and outflow. And gold miners are hurting, as we see from GDX.

In short, 2013 has been a strange year for gold. China lit the physical gold market on fire with overall purchases and imports. But you’d never know this from gold’s price, which has fallen more than 20%.

After all of this, what do we really know? In the Western world, large holders are selling gold — GLD and the like. In the East, multitudes of Chinese are buying. What should you do?

On the one hand, beware plunging into a turbulent gold and mining share market. Gold is not the latest investing fad, to be sure. Gold lacks that sexy allure of the latest high-tech vaporware or the aluminized hand-held device that will be obsolete in eight months.

On the other hand, if you foresee rising gold prices over the long haul in an era of volcanic government spending, there’s nothing wrong with buying into the best of the best mining plays while they’re beaten down.

Remember, the Chinese are hoarding gold. Demand in the Middle Kingdom has far surpassed gold mine production in the rest of the world. The only way for the global gold market to meet Chinese demand is to sell stockpiles — the GLD stashes of the world.

Sooner or later, the wheel will turn for gold. And when that happens, the markets will encounter a supply deficit unlike anything we’ve ever seen. When that deficit hits, we should see gold prices spike upward. When that time comes, it’ll be good to hold your favorite mining plays – they’re certainly cheap right now.

Until next time. Thanks for reading.