Entering the Hall of Mirrors: Illusion and Reality in China’s Influence on Precious Metals Demand

Beware the Armpit Theory

The expectation of a large and sustained fall in gold mine supply has been a major theme in the gold market. Strong local currencies, resource depletion, rising production costs and environmental pressures are resulting in falling mine output in South Africa and North America, a trend we expect to continue.

However, growth in South America, other African countries, Southeast Asia and more recently the former East bloc is offsetting the losses from the traditional producers. Importantly, the current and potential activity in countries such as China and Russia suggests that this trend is set not only to continue but accelerate, particularly given the current level of prices and availability of both equity and debt finance for project development. China as the potential to rise towards becoming the world’s major producer of gold, given the number of already known deposits and increasing level of foreign interest.

This all brings to mind a marketing fable. In the early 1990s, a large US cosmetic company very confidently predicted that China would become the world’s largest market for deodorant within the decade due to the presence of two billion armpits.

In reality, differences in climate, diet and attitude to body odour meant that a simple multiplication of the Chinese population (or armpits) by some ratio estimate for demand gave a wildly inaccurate projection. By 2000, not only did China still account for only a modest proportion of the world deodorant market, but deodorant itself accounted for less than 2% of China’s RMB44.6 billion ($5.4 billion) cosmetics and toiletries market.

Is there a valid comparison between deodorant and the gold market? Some factors to keep in mind: first, China is already the world’s third-largest consumer of gold jewellery. Second, it has actually already experienced a surge in gold demand – it increased fourfold from 40 to more than 210 tonnes from 1989 to 1992, driven by general market liberalisation, income growth, and depreciation of the renminbi. Notably, Chinese demand has stagnated around these levels ever since.

The Chinese experience was remarkably similar to that seen during the Indian gold demand boom that followed later in the 1990s, the difference being that Indian gold demand rose from around 200 tonnes to more than 700 tonnes, before weakening to its current apparent plateau of roughly 600 tonnes per year.

Part of the explanation for high demand in emerging markets is that, in the absence of alternatives, gold continues to play a key role as a hedge against both inflation and/or currency weakness. However, since the late 1990s, the trend in China (and, indeed, most Asian markets) has been for currency stability and disinflation. More recently, China’s economic growth has resulted in upward pressure on its currency, while inflation has remained controlled until recently – not typically the environment in which we have seen gold demand surge in emerging markets.

However, macroeconomics is not generally used as the justification for huge potential growth in Chinese gold demand: population is. China has the lowest per capita gold consumption in the world (see chart) – hence the argument is that, as market liberalisation continues, per capita consumption will grow. The typical extension of this is that given similar populations and a traditional affinity for gold, per capita consumption in China should rise to a level similar to India, which would represent a near three-fold increase.

However, rarely is reality this simple. As explained earlier, this ‘armpit’ approach to demand projections is critically flawed, as it does not take into consideration changing domestic spending patterns. A much more insightful comparison can be made by analysing the percentage of income spent on gold. In this comparison, the Middle East, the Indian sub-continent and other Asian countries clearly and predictably spend a considerably larger percentage of their income on gold. China is mid-table, while the western world countries spend the least of their income on gold.

Evidence suggests that, as economies develop, the range of spending and investing options expands considerably. This helps to explain why Chinese gold demand has stalled over the past decade despite the rapid income growth over this period. In the competition for growing Chinese disposable incomes, gold is very quickly losing market share. Given that China’s economic development is likely to continue and the growing global influence of western culture (which tends to be negative for gold), we can expect China’s income spend on gold to continue to decline. Indeed, this is not just the case for China but for the other large spenders as well!

This trend towards lower income spend on gold is the reason why we strongly believe that it is crucial to the long-term viability of the gold industry that western world gold demand is rejuvenated – both as jewellery and as investment. Not only does the west provide the greatest potential demand growth (for an increase in percentage spend), but it will also help to reinforce gold’s existing position in emerging economies – and hence slow its declining share of disposable income. Such rejuvenation is a far from simple task, but that does not make it less vital.

The Birth of a New Luxury Empire

We noted with great interest comments in a recent feature article in The Economist concerning the rise of Chinese luxury consumers:

“The industry estimates that there are now around 10m-13m mainland customers for luxury goods … whereas people in the West are buying more discretely branded luxury goods identifiable only by those ‘in the know’, the Chinese favour prominent logos that shout, ‘Look, I’m rich.’ ”

Platinum is of course the precious metal that has most benefited from the growing affluence of the urban China consumer. By tapping into the upper end of the consumer market, platinum is not greatly affected by the recent tightening measures aimed at over-investment in certain industrial and property segments. Further, as the comments in The Economist suggest, luxury consumers tend not to be particularly price sensitive, as it is the expense of the item that is a large part of the exclusivity in owning it.

That said, it is true that some price sensitivity has appeared in the Chinese market. Chinese platinum demand actually fell 19% in 2003, and anecdotal reports also suggest dampened levels of buying this year. However, it is important to put this in context. First, SARS affected demand levels for many consumer goods last year and, second, reports also suggest that it is not end consumers that are being discouraged by higher prices, but the falling profitability of the fabricators of platinum jewellery that is the key.