China retail speculation adds risks to gold price

By Wei Gu
October 9, 2009

As gold prices surge to a new record, China’s retail investors are trading more of the yellow metal, often using borrowed money. This is further evidence that recent high prices may not be sustained.

Like investors around the world, Chinese individuals are buying gold because they are worried about inflation. After all, Beijing has already pumped an unprecedented amount of money into the system, sending asset prices higher. But Chinese retail investors are also known for their herd behaviour. Despite the recent sharp rise in gold prices, many have decided to jump in.

This is lucrative business for Chinese banks. During the first six months, mid-sized Xingye Bank which offers gold trading business with Shanghai Gold Exchange, traded 20.9 billion yuan ($3 billion) worth of gold for its clients, almost three times as much as they did last year.

Other than earning a commission for buying and selling for their clients, the bank is also making a gamble itself. It traded 15.3 billion yuan ($2 billion) worth of gold on its own account, up 15 percent from last year.

Risks can be big for Chinese investors. Like most retail investors, they are often at a disadvantage to international institutions because they lack up-to-date information. Moreover, big price changes in global markets often happen when China is asleep.

A greater source of concern, however, is that investors are placing leveraged bets. Leverage is not allowed in China’s stock market, that’s why people eager to maximize their returns have flocked to gold trading. At Xinye Bank, customers are allowed to borrow as much as 90 percent of the value of the gold contracts they are buying. Investors are also allowed to sell gold short, though most of them are choosing to place long bets. It is not uncommon for investors to use three to five times of leverage.

The risk does not stop with Chinese individuals, however. What happens in China can have a significant influence on world prices. China, already the world’s biggest gold producer, has also become the precious metal’s biggest consumer, overtaking India in the first half of this year.

Chinese gold purchases for investment reached a record high of 70 tonnes in 2008. That is 6 percent of the global amount which includes the sort of bullion, official coins and metal for investment purposes, according to the World Gold Council. Globally, retail demand for investment purposes increased 72 percent in 2008.

There are plenty of legitimate reasons for investors to buy gold. It is a hedge against inflation, and the ultimate store of value. But gold is just as prone to speculative bubbles as other asset classes — particularly if investors are leveraging their bets. China’s bullish retail investors are another reason investors should be wary about the latest gold price surge.

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