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What will be the role of China in the precious metals market?

August 17, 2012, 12:00 PM Przemysław Radomski , CFA

With hedge funds and others very negative on gold, it seems that gold and silver have had many buyers at certain levels and it is no secret that the primary suspects for those buyers are far eastern entities. Somewhat like “Hail Mary” saves on important S&P levels in the last few minutes before the market closes.

The 800 pound gorilla has been planning an active role in precious metals and all metals trading for a long time. They bought the LME (even though it's a lousy business based on returns) to control more of the metals trades, establish warehouses in China for the LME, etc. They have planned the Shanghai gold exchange for a long time and will open it at the end of August, apparently. With China it's all about becoming a major player in this area and also about saving face. It would not gain new customers, nor would it look good for the idea and their timing if leveraged investors were handed large losses right off the bat. They need new tonnage to support any physical deliveries through the exchange. A fraudulent scheme in China recently attracted $60 billion or over 1,000 tons worth of gold futures (that's how much was lost!) so there is a lot of demand out there. For this reason it is highly unlikely the Chinese will allow gold to crash, or (perhaps) in the event of a major world market crash, to perform much worse than other investments. Something like the 'Chinese put' under the price of gold.

Perhaps a fast trip down. Western vaults would be emptied pretty quickly at low bargain levels. This is not technical, but fundamental.

We agree that this positive fundamental factor could put upward pressure on gold prices going forward. However, the short-term action doesn't have to be bullish. Please recall what happened to the price of silver after the SLV ETF was launched (definitely a positive factor for silver's long-term performance) - silver plunged. It rallied based on it being formed (rumor) and when it became a fact, prices tumbled.

We don't think that China would lose face if gold didn't rally immediately after the launch of the exchange. It is quite easy for any official to say that prices are unpredictable and that the launch of the exchange was a success based on some turnover measure. Moreover, we have heard (unconfirmed) rumors that China might want to try driving commodity prices lower just to acquire more of them for future growth. This suggests that the launch of the new exchange might not be bullish for gold at all. We do believe that opening yet another exchange for gold will be positive in the long run.

We are of the opinion that fundamentals don't really provide target levels - they explain what will likely happen in the long run.

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