Investors Going for the Gold in China May Want to Reconsider

JUNE 14, 2011   THE WALL STREET JOURNAL

By TOM ORLIK

China is now hard-wired into the investment case of virtually every commodity. Does that apply to gold?

With restrictions on the market having been progressively stripped away, rising incomes, and limited alternative investment options, demand has risen by an average of 14% a year since 2001. In the first quarter of 2011, inflationary expectations added to the appeal of the yellow metal, and consumer demand climbed to 233 tons, up 47% year-on-year, according to data from the World Gold Council.

Most of that demand has typically come from jewelry, which accounted for 64% of purchases in 2010. But the share of investment is rising, and options are broadening. China was the largest physical-bar and coin market in the world in the first quarter. In March this year, Lion Fund, the first Chinese fund to offer overseas exchange-traded products backed by gold, hit its $500 million subscription quota and then asked for more.

Bloomberg News

Demand for gold as a hedge against inflation may be corroded.

But China's gold hunger may not be as lasting as bulls hope. Demand per capita in 2010 was just more than 0.5 grams—less than half the level of Taiwan or the U.S. In theory, rising incomes should push that up toward developed-world levels.

Per-capita figures, however, should be treated with caution. Gold is expensive, and China's 674 million rural population has limited resources. If the majority of China's demand is coming from its 665 million urban residents, then consumption per capita is already close to levels in comparable countries, reducing space for a catchup.

Inflation is high, at 5.3% year-on-year. But if the rise in consumer prices starts to taper off, demand for gold as a hedge against inflation may also be corroded. The explosion in wealth-management products provided by the banks, offering higher interest rates, means zero-yielding gold faces increased competition as the preferred preserver of value.

In the U.S., gold is also used as protection against a depreciating the dollar. But with a steadily appreciating yuan—arguably the best hedge against the greenback—there is less need for Chinese investors to venture further afield.

The wild card is demand for gold as a reserve asset. A decision by the People's Bank of China to shift even a small portion of its $3 trillion in foreign-exchange reserves into gold would certainly push prices higher. But given the central bank's reputation for caution and penchant for secrecy, it is difficult to imagine a market-moving shift into gold, and it is impossible to know if there are continued small purchases.

China is already the second-biggest consumer of the yellow metal, after India, according to the World Gold Council. Given its sheer size, it will remain a key market for gold. But investors hoping it will do what it has for other commodities and drive the next leg of gold's surge may find themselves disappointed.

Write to Tom Orlik at Thomas.orlik@wsj.com