December 2010

Investors looking to cash in on China's burgeoning appetite for gold will have to brave regulatory risk that makes the nation's financial giants reluctant to develop gold investment products, leaving a niche smaller institutions hope to fill.

Imports into the world's second-largest consumer of the precious metal soared six-fold on the year in the first ten months of 2010 from a year earlier, as investors looked for alternatives to the volatile stock market and steered clear of the real estate sector following government measures to curb speculation with inflation on the rise.

Some financial institutions are busy designing new products and pushing for market evolution to satisfy China's newly-minted gold bugs, but their efforts might not be awarded.

"Everyone wants a share of the gold market, but it's very difficult to be innovative in this market, because there are too many regulators," said Hou Xinqiang, an analyst at Jinrui Futures based in China.

A number of banks are offering personal wealth management products based on gold, Hou said, adding that this is the area with the most potential for growth. In August, six central government agencies including the central bank vowed to allow more banks to export and import gold, in what was widely seen as a signal that China planned to gradually free up its gold market.

But the banking regulator was not among the six agencies, even though commercial banks have become key market players. Without the banking regulator on board, big financial institutions would be reluctant to push new gold investment vehicles.

"All these thoughts on new products and new trading schemes are great, but one bank or one exchange can't possibly push them to materialize. It has to be done on the state level," said a senior official at a major commercial bank.

Graphic on gold flow from Hong Kong to the mainland

FEW OUTLETS TO SATISFY GOLD FEVER

Despite potential enthusiasm by buyers for new products, there are still relatively few outlets to satisfy the gold fever. "The retail investors' market is extremely exciting, because we can see huge potential and enormous opportunities there," said Lila Lu, head of precious metals at mid-sized lender China Minsheng Banking Corp.

"China's market can't provide retail clients satisfactory products. Part of the reason is that our regulation is too strict." To smooth introduction of new products for gold investment, China needs to push for some changes in the gold market, such as adding a principal-to-principal trading platform, Lu and other industry officials said.

Such a platform would supplement the existing bidding system, in which trading parties submit ask and bid prices into central trading systems at exchanges which make matches.

An OTC market would make trading directly with other parties possible, which would make it easier for banks to deal with large quantities of trades. "Without an over-the-counter market, it is simply impossible to do a lot of products, such as leasing, due to the large size of such trades," said Shen Xiangrong, head of the Shanghai Gold Exchange, which expects to launch an OTC market next year.

The number of retail trading accounts on the Shanghai Gold Exchange reached 1.7 million by the end of October, compared to 918,500 by the end of 2009. These accounts traded 973.84 tonnes of gold in the first 10 months of 2010, up 247 percent on the year, according to exchange data.

While retail investors in the West can get access to gold through a host of products, including physically-backed gold exchange trade funds such as the SPDR Gold Trust, investors in China are mostly limited to physical gold bars, coins and jewellery, as well as paper gold products offered by commercial banks.

Investors could also trade futures on the Shanghai Futures Exchange, or spot and forwards on the Shanghai Gold Exchange, but both require hefty capital to cover margins.

FIGHT WITH BLACK MARKET

Development of a more diverse and flexible gold market could help rein in a rampant underground market, say industry officials. Estimates of the size of the black market vary, but some industry officials said it could equal or even exceed the combined trading volumes on both exchanges, or about 12,000 tonnes a year.

Investors could open accounts with firms to trade on derivatives markets overseas. "Trading on the black market offers low margin requirements, low commission, and high leverage, which is attractive to some investors," said Shen of the Shanghai Gold Exchange.

The margin requirement on trading Shanghai gold futures is 10 percent, while trading on the black market might require a margin of as little as one percent, making speculation much easier, industry officials said. Fund houses are also turning to explore opportunities in gold's appeal to investors.

China's Lion Fund Management Co. launched the country's first gold fund last week, aiming at raising up to $500 million, to invest in gold-backed exchange-traded funds on the global market. Rival E Fund Management Co is planning a similar fund.

"Existing gold investment products are based in different markets -- paper gold is sold by banks to their clients, forwards and futures are mainly for institutional investors. Our product is for investors in the equity market, which is bigger, wider and more liquid," said Song Qing, director of the fund house's international business.

Song said a product with simple and transparent structure, as well as costing less, would meet investors' demands. The fund raised nearly 800 million yuan on the first day of its launch, about a quarter of its total quota, the fund house said in a statement.

But a domestic gold ETF is nowhere on the horizon, mostly due to regulatory hurdles, industry officials said. "An ETF would be a cross-market product. It would need market makers. And cross-border clearance would be necessary -- these problems need to be solved before we can have a domestic ETF," said Song of Lion Fund.

Ends --

By Rujun Shen, Reuters - for Commodities Now.