Central Bank Demand to Constrain Gold Supply

China's mining sector is currently producing 340 tons a year and rising. No doubt, there is every encouragement from the state for this figure to rise. We believe that no matter how high it rises, little if any of that supply will reach the world's 'open' market in London. Even global gold production is not likely to rise significantly from the current level of around 2,500 tons. Therein lies a development that, in itself, will change global gold market dynamics.

Newly Mined Gold Supplies
The easily mined gold of the past has been thoroughly exploited, although there may well be the occasional discovery of massive deposits in places like Mongolia or other distant regions of the world. The usual future picture will be of discoveries in politically explosive or hostile nations that contain less than 5 million ounces. Deposits of 1 million ounces will be developed, whereas before they were thought of as far too small and like their larger brothers, development will take 5 years or so still, before they come into production. Infrastructure development will be an integral part of the picture. With rising prices almost matched by rising costs, there is little incentive to mine gold in nations that will add heavy royalty taxes to these costs or even to nationalize them. The prospect of much higher prices has not led to feverish mining developments, nor will it.

What is even better for the gold price is the reality that new discoveries are unlikely to be made in the developed world, except for Canada. The discoveries that will be made will be in places like Russia or China or Mongolia or Eritrea, where governments have every interest in developing them. In short, gold mining companies may well be able to replace depleted reserves but are unlikely to be able to make global gold production rise to any significant extent.

Not for Public Distribution!
We are of the opinion that newly mined supplies in countries such as Russia or China will be bought into that government's reserves and not find their way into the global market centered in London. Even mines in Mongolia or Africa, owned by Chinese companies will divert their supply to the government of the company that owns them.

Supplies into London will come from countries other than those buying their own production into their reserves. We do expect that more and more nations (such as in South America), will buy their own production in the future, further depleting supplies to the 'open market'.

This complicates matters because it will lead to virtually no rise in supplies to the main physical markets of the developed world or even to a fall in 'open' market supplies. With London as the foremost of these markets, we can expect the gold price to reflect the falling supply from countries not buying their own production (like South Africa). For instance, if global supply, overall stands at 2,500 tons and China and Russia take off all their local production, supply to the 'open' market will fall to (340 + 210) 1,950. The net result will be that the gold price will be based on a supply 22% lower than total global supply. This present day reality defines the power of central bank buying over the gold market and the gold price. There is no fighting over price, no competition between government and the 'open' market. Central banks will simply instruct local producers to sell their gold to them at market related prices.

How Important Is Gold to Central Banks?
As the value of currencies drop, gold will rise in importance in national gold and foreign exchange reserves and become not just an important reserve asset but a vital reserve asset. It is becoming the one national asset that rises above any other foreign paper asset in terms of reliability of value. Central banks, in turning either holders or buyers of gold, have become an active encouragement to other central banks with small gold reserves to acquire more. In fact, as government sales of gold have ceased and central banks are, at worst, only holders of gold, central bank gold buying has spread to the four corners of the globe already. The surplus earning nations are leading the way in buying gold as they find that the growing surpluses they acquire must be held in assets that can ride out the developed world debt crises that are worsening at the moment. We expect the number of central banks that buy gold will increase whether they are in gold producing nations or not.

Better than Partial Confiscation
By diverting gold into reserves from local production, a central bank achieves the same result as a partial gold confiscation would have done. The difference is that there is a willing seller in the gold miners. The advantage over an act of the direct confiscation of citizen's gold is that it allows citizens to continue to acquire gold in the open market while the central banks remain unseen buyers. Central banks are showing that they want the total national stock of gold (official plus private) to rise as high as markets will allow. Following this route, any price rises are then not seen as caused by central banks, but by an unfettered market where higher prices are accepted across the world. The ongoing buying by the global retail sector adds to the 'national' quantity of gold owned. In the event of a dire currency crisis or danger to the global markets such a gold buying structure still leaves the option of confiscation of its citizen's gold in hand. This adds a new dimension to the concept of gold confiscation and puts it firmly on the map.

Central Bank Buying in the 'Open' Market
The difficulty for a central bank, in a nation that does not produce gold, is that it will have to go into the 'open market' and compete with retail buyers for the gold it wants, that still does find its way to market. This must be done carefully, because any sign of central bank buying gold in the market and the price of gold runs ahead. However, the central banks have learned this is so and are far wiser buyers now. For instance, Russia has announced that it will acquire at least 100 tons a year of gold for its reserves in the future. The market knows this and has accepted it. The next stage is to be an effective buyer of gold. At the end of the day price is irrelevant. So Russia need only inform its dealer that it would like to see the offer of gold above certain quantities.

Being price-unrelated, such a position cannot be activated unless there is a showing of gold by the dealer in good quantities. Often this happens as the gold price is driven down by selling in the States by an ETF. Then the central bank's dealer takes the offer to the bank and an instant deal is struck, and then the gold leaves the market without prices rising. Only when other, usually retail buyers, trying to produce gold in quantity, drive prices higher in the hope that there are sellers out there waiting for higher prices, will prices jump. The central bank is unlikely to make prices move either way. When looking at the monthly amounts Russia has bought, it shows a considerable variation as it follows this way of dealing.

What Will This Do to Gold Prices in the Future and How High Will They Rise?
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