What China Wants more than Physical Gold

What China Wants More Than Physical Gold

By Steve Sjuggerud
Wednesday, March 10, 2010

“A few factors limit our ability to increase [our] investment in gold,” China’s Chief foreign exchange regulator Yi Gang said in a speech this week.
Investors have long speculated China will start buying gold and selling its hoard of U.S. dollars at some point. (China’s hoard could be literally trillions of U.S. dollars.) It would be the first step in a “Doomsday” scenario…
China trades in its dollar reserves for gold… The value of the dollar crashes… And U.S. interest rates soar, as China is no longer willing to buy U.S. government Treasury bonds.
Some investors have said China has a perfect way to do it, available right now. The International Monetary Fund (the IMF) has a near-200-ton hoard of gold that it wants to unload.
But if China actually used all its dollar reserves to buy physical gold, it would completely overwhelm the market. It would end up trying to buy about a third of all the gold ever mined in the history of the world. There’s no way it could get all that gold without sending the price to outrageous levels.
It seems Mr. Yi recognizes that. He essentially said gold is too volatile, the historic returns aren’t that great, and any gold buying by China would “certainly” increase gold prices.
If Mr. Yi is to be taken at his word, in short, China doesn’t have plans to buy much gold in the open market.
Mr. Yi’s comments are in line with recent comments from the China Gold Association, who told The China Daily newspaper that it is “not feasible for China to buy the IMF bullion, as any purchase or even intent to do so would trigger market speculation and volatility.”
So how would China acquire gold if it doesn’t buy it?
This is where it gets interesting…
Instead of buying physical gold in the open market (where China would be the 800-pound gorilla in the room), China plans to buy gold mines around the world.
An official from the China Gold Association told The China Daily that rather than buy gold from the IMF, China would buy gold directly by buying gold mines “abroad.”
If that’s true (and there is some sense to it), then how should you play it? Dennis Gartman reported on this yesterday, in his Gartman Letter:
Perhaps we are to begin owning gold mines rather than gold futures of gold ETFs. We have avoided owning mines for years, preferring the “purer” play of owning gold rather than the mines, for we fear being exposed to poor mine management, or accidents in a mine that might do damage to the equity while gold itself moves higher. But if the Chinese authorities want to own mines, perhaps we have to consider doing so also…
I’ve done more than consider buying gold mining companies… In the latest issue of True Wealth, I recommended buying gold mines as the best way to have exposure to gold right now.
The reason is simple. This chart sums it up:

Gold is up 70% since the summer of 2006. Meanwhile, gold stocks (as measured by the Gold BUGS Index) have done nothing.
Usually, a 10% move in gold would mean a 20% move in gold stocks. But this relationship broke down in the financial crisis. Now, either the price of gold needs to crash… or the price of gold stocks needs to soar to correct this anomaly.
The timing might be just right… Gold mining stocks are down, and it’s just coming to light that the Chinese prefer to buy gold mines (which give the country a permanent supply) over buying gold in the open market.
Time to buy gold stocks.
Good investing,

Steve

Further Reading:

Back in December, Steve got spooked about gold. But in last week’s DailyWealth, he showed you why gold stocks look like a great bet again. Get the details here: Why I’m Buying Back into Gold Stocks Now.
We’ve never seen anyone trade gold and silver stocks as well as DailyWealth contributor Jeff Clark. If you follow his advice in this essay, you’ll always make money trading gold stocks: My Secret Gold Stock Timing System.