Published in 2015

We often hear some suggestions that Shanghai Gold Exchange's (SGE) withdrawal number = total demand of the country. In this article we summarise withdrawal activities that do not relate to real physical demand but have made a substantial impact on SGE’s withdrawal volumes.


1) Tax Avoidance

The first and foremost factor behind why we believe the SGE’s withdrawal number differs from the country’s total gold demand estimate, is related to China’s current tax system, with some people exploiting this grey area.

While purchasing (and withdrawing) gold from the SGE is exempted from 17% Value Added Tax (VAT), those buyers would still receive a tax receipt. This is because any financial gain from selling that gold is still taxable. For example if a buyer purchases a gramme of gold from the SGE at 100 RMB, and sell this same gramme for 101 RMB, that 1 RMB profit is still VAT taxable.

We initially became aware of the scheme in 2013 when it first emerged but based on information gathered from our contacts, the number of industry participants mushroomed in 2014 as other traders became aware of the potential loop hole. Basically these traders allegedly purchase gold from the SGE (take the gold out from the vault, and hence it will be counted into withdrawal volume statistics), and then sell the gold in the secondary market (or black market), but at a 1-1.5 RMB per gramme (equivalent to $0.16 - $0.24 per gramme) discount to the quoted SGE spot price. Buyers who purchase this gold at a discount do not receive any tax receipts from the sellers, unlike any normal business activity.

Hence these traders now have cash (received from the proceeds of selling the gold in the secondary market) AND tax receipts originally given by the SGE.

One may question why these traders might be willing to sell gold purchased from the SGE at a discount. First of all, selling gold at a discount to the SGE spot price does not necessarily mean they are losing money. If the gold price is trending upwards, they still make profits even when they are selling at discount to spot. However, making profits through trading physical gold is just the icing on the cake. The main intention has always been the tax receipts, which also have financial benefits.

Tax receipts can always be used to file for a tax refund, as China’s VAT system is designed to target the end user (usually consumers), with upstream participants generally able to recoup most, if not all, of the VAT they have paid. One way those aforementioned traders can use the tax receipts they retained is to sell them to other companies at a discount.

While those tax receipts would be stated as for ‘gold purchasing’ activities, some of those traders alter the nature of the activities listed on the tax receipts, and sell them onto the other industries, including catering and other non-metals industries.

Those tax receipts buyers can sometimes pay 3-4% for those receipts, saving 13-14% (17% minus 3-4%) on tax payments.

Meanwhile, selling those tax receipts at 3-4% of the nominal amount is already more profitable than fabricating jewellery on their own, which the fabrication fee charged by the industry average currently is approximately 2.50 yuan per gram.

Thus, at the end, by conducting such trading activities, the traders can still have money realised from selling gold (the amount could be more or less than the original ‘investment’), plus any monetary value received from on selling those tax receipts.

The other purpose in which traders can put these tax receipts to good use is in the case of silver (and other metals as well). As China’s silver trading price is VAT inclusive, the domestic silver price is thus at a premium compared to its international benchmark, but at a discount if excluding the VAT. Hence, it creates an arbitrage trading opportunity for the sharp minded.

People can first smuggle silver in the country from overseas (where the price is usually lower when compared to China’s silver trading price). The business category of the tax receipts received after purchasing gold from the SGE is then amended from gold into ‘silver purchasing’ on the tax receipt. These people can then allocate these amended tax receipts onto the smuggled silver, and can sell the silver at China’s prevailing price (which is usually higher when including VAT ), pretending the metals are from official channels.

Of course, all of these activities are considered illegal by the Chinese government. How much of these activities would be detected by the authorities eventually, is another question.

One of our contacts with some understanding of this activity estimated that just from Shenzhen alone, such trading activities could have possibly impacted SGE’s withdrawal volumes by a few tonnes per day. While it is very difficult to quantify just how much of the SGE’s withdrawal volume is being influenced by such trading activities, some industry participants have boldly estimated that at least 20% of SGE’s withdrawal volume is being inflated by such activities.


2) Gold leasing activities and arbitrage opportunities (In China, gold is money, at lower costs)

Gold leasing activities are normal practices between banks and companies in the gold industry, such as miners and jewellery fabricators. However, it is well known that as liquidity in the banking sector has dried up since 2014 in China, companies from other industries have been scrambling for finance to fund projects, and gold leasing activities have become the safety net for many financial troubled companies across all industries. As the interest rate for a normal gold loan varies from 2-4% per annum, which is lower than a monetary loan, it has created various opportunities for those involved, including companies borrowing gold and then selling it in the market for liquidity (but taking on a lower burden compared to a monetary loan), and gold companies who can borrow gold under normal industry practice effectively becoming financiers and pocketed the difference in the interest rates. While the SGE can trace all the gold leasing activities taking place on its board, any related data is not disclosed to the public. However, when leasing activity is tied in with immediate selling (borrowers looking for liquidity), it would generate and inflate higher withdrawal volumes.

It is important to note that in China the tighter the credit line (due to a softer economy and higher risks of bad debt), the higher demand for gold loans. For illustration purposes, assume a Chinese company used to have a $30 million credit line with a domestic bank, but as credit tightens, the company now only has a $20 million credit line. So how does the company fill the $10 million gap? The bank lends the company physical gold to fill the void. From the perspective of the bank, lending physical gold is an off-balance sheet item, which in the worst case scenario, even if the company fails to repay the physical gold, would not affect the bank’s liquidity ratio, bad debt ratio, or any other metrics. From the perspective of the borrower, the capital cost of a gold loan is lower than a monetary loan. Thus a win-win situation for both parties.

Of course, there are more benefits and arbitrage opportunities existing within the gold leasing activities. As mentioned above, the interest rate on gold loans is usually a very low 2-4% per annum. Various Chinese companies and funds have taken advantage of the low cost of capital, by first borrowing physical gold, selling into the market for cash, then investing the proceeds into other investments, usually wealth management products promoted by the banks at a guaranteed return of maybe 6% per annum. The company can then use the wealth management product they purchased from banks as collateral to then take on more physical gold, then liquidate the gold again to buy more wealth management products…the cycle repeats again and again. From the perspective of the banks, not only have gold leasing activities brought monetary return on their gold holdings, it has also created substantial synergies to its other businesses, thus creating more revenue streams. Meanwhile, companies and funds can also earn the return differential by taking advantage of these arbitrage opportunities. Another win-win situation for both parties. This is also a major reason why many Chinese gold miners are so eagerly expanding into the domestic financial industry, as their cost of capital is low and thus gives them a competitive edge.

China’s gold financing activities grew by a large margin in 2014, and have continued to increase in 2015. In 2014, total gold holdings held by the four largest banks in China (ICBC, CCB, BOC and ABC) rose only 15%, to slightly more than 1,500 tonnes based on our analysis, while the major growth (in high multiples) was largely seen in the medium to smaller sized banks. By the end of September 2015, total gold holdings under the four largest banks increased by approximately 425 tonnes, or 28%, to approximately 1,900 tonnes, from the end of 2014.

On the other hand, our industry contacts indicate that a series of bankruptcies in the domestic jewellery fabrication industry in 2014 and 2015 has seriously hurt the banks’ loan portfolio, and the whole jewellery industry is now being classified as high credit risk by the banking sector. It has become more difficult for jewellery fabricators to obtain loans from banks, even in the form of physical gold.

We believe the expansion of the domestic gold leasing market is one of the primary reasons for the strong Chinese gold imports in 2015, despite a weak physical market.


3) Financial statement window dressing

As the Chinese economy softened and liquidity tightened in 2015, companies have been scrambling for cash to pay and to generate cash flow. Some companies have attempted to build up their revenues by merely trading and withdrawing physical gold from the SGE vault so it would appear they have a high level of business activity, while in reality there is no real genuine demand behind this. By dressing up their financial statements in such a way, it is easier for these companies to obtain a bank loan, and to receive more support (i.e. tax incentives) from the local government authorities.

It is important to point out that the SGE would not ask traders the purposes for trading and withdrawing physical gold from the SGE vault, and hence the above mentioned trading activities is not a violation of the SGE rules and regulations.


4) Retailers selling unsold inventories directly to refiners

Retailers have been unwinding their retail inventories as market demand has waned. Indeed, slow moving jewellery that may have been on the shelf for a long time is often ‘recycled’. Retailers often prefer to sell a portion of their working stock at a discount directly to refiners in order to maintain inventories at a desirable level. As an example, during a field research trip earlier this year, a local refiner indicated that one jewellery retailer has sold approximately 40 tonnes of unsold jewellery pieces to them in a single two month period.

One may question why retailers would choose to sell inventories at a discount rather than re-melting the original piece and fabricating it into another design. By selling to refiners, even if such a transaction may result in a financial loss, it still counts as revenue; but by doing the latter, it will only increase the expense category and provides no benefits to the company’s revenue or asset value. It is a strategy that basically dresses the company’s financial statements to look sexier than it actually is.

It is also worth noting that, if market observers try to estimate China’s total gold jewellery consumption based on data provided by the retailers, it is very likely that they would have overestimated the country’s consumption level, as retail sales would include direct sales to refiners, which should not be counted as genuine consumption- indeed, quite the reverse.

While direct selling to refiners will certainly increase the scrap supply, it is also important to point out the obvious – that such actions would also increase the delivery volume (withdrawals) on the Shanghai Gold Exchange (SGE):

1) Fabricators take delivery from the SGE to make jewellery pieces;

2) Retailers purchase jewellery from fabricators, but any excessive unsold inventories are sold to refiners;

3) Refiners in turn fabricate old scrap jewellery pieces back into investment grade bars, and then return the bars back through the SGE for sale;

4) Back to point 1.



There is no denying that all the trading activities mentioned above would definitely have an impact on SGE’s delivery volume, even though it is almost impossible to identify the absolute volume involved. While delivery volumes published by the SGE are a reflection of daily trades, one has to understand that there are many trading activities and indeed a multitude of factors that contribute to the SGE delivery volumes, and, as such, should be viewed and interpreted as something more than just the country’s wholesale gold demand as some market commentators are prone to do.