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Synthetic Gold Leasing: More Details Regarding The “Precious Metals” On Chinese Commercial Bank Balance Sheets.

by Koos Jansen, Gold Seek:

More proof the “precious metals assets” on Chinese commercial bank balance sheets have little to do with the “surplus” gold in China’s domestic market.

One of the topics about the Chinese gold market that has not been fully illuminated is the “gold” on the 16 Chinese commercial banks’ balance sheets. At the end of 2015 the aggregated “precious metals assets” on the bank balance sheets accounted for 598 billion yuan (RMB), which translates into approximately 2,682 tonnes of gold – if all the precious metals were gold related, which is very likely.

In my previous post on this subject we learned from examining the banks’ annual reports from 2015, that there are at least five gold assets that can appear in the “precious metals” line item on the balance sheets. Namely:

Gold savings that belong to the banks’ customers (Gold Accumulation Plans, GAP)
Gold inventory for the banks’ retail gold bar business
Gold leasing business
Gold held for hedging purposes
Gold held outside China

In this post we’ll examine more thoroughly the (Chinese and English) annual reports from 2007 until 2014 of the 16 banks, to learn more on what these huge tonnages represent. The most significant new finding is that Chinese banks conduct synthetic leases – in other words: swaps. By performing synthetic leases, Chinese banks can show “precious metals assets” but no “precious metals liabilities” on their balance sheets. Then, at the very surface it appears these banks own gold, in reality they own zero gold.

Also note, swaps can be executed with foreign banks, through which gold is subsequently imported into the domestic market. And because the Chinese banks have been importing thousands of tonnes in recent years, it should come as no surprise these trades have influenced the “precious metals” line item on their balance sheets.

More findings that will be addressed in this post are:

Chinese reported lease volume reflects yearly turnover.
Gold stored in Shanghai Gold Exchange (SGE) designated vaults owned by commercial banks does not to appear on the custodial bank’s balance sheet.
More confirmation some gold on the balance sheets is stored outside China.
My conclusion is that the “precious metals” on the Chinese commercial bank balance sheets do not account for the “surplus” gold in the Chinese domestic market Western consultancy firms pretend to be ignorant about. The Chinese banks do not own much gold of themselves, as some analysts have speculated, nor are these banks preparing for a new gold standard designed by the PBOC, according to my sources and analysis.

This post is divided in three segments. The first segment is about accounting, which supports the second segment about swaps and other gold related line items on the Chinese bank balance sheets. The first segment can be skipped if you already posses thorough knowledge on accounting. The third segment displays all the “precious metals” related data of the 16 bank balance sheets from 2007 until 2015.

I Accounting Background

Before we can discuss the details of the “precious metals” mentioned in the financial statements of the annual reports of the 16 banks, we need to do some studying on accounting structures (study the definitions of a financial statement, balance sheet, an income statement, assets/liabilities, financial assets/liabilities and derivative financial assets/liabilities). This study will prove valuable for future posts as well. The bank balance sheets are an important topic in the Chinese gold market; understanding accounting helps us to illuminate the Chinese gold market.

Financial Statement

Financial statements of banks are divided in three main segments: a balance sheet, an income statement and a cash flow statement.

Balance Sheet

On Investopedia we can read the definition of a balance sheet:

Balance Sheet

A balance sheet is a financial statement that summarizes a company’s assets, liabilities and shareholders’ equity at a specific point in time. These three balance sheet segments give investors an idea as to what the company owns and owes, as well as the amount invested by shareholders.

The balance sheet adheres to the following formula:

Assets = Liabilities + Shareholders’ Equity

A number of ratios can be derived from the balance sheet, helping investors get a sense of how healthy a company is. These include the debt-to-equity ratio and the acid-test ratio, along with many others. The income statement and statement of cash flows also provide valuable context for assessing a company’s finances, as do any notes or addenda in an earnings report that might refer back to the balance sheet.

An example would be, ICBC holding 1 tonne of gold in small ICBC brand bars as inventory for retail sales. This gold is an asset of ICBC.

Income Statement

Next to a balance sheet, banks disclose an income statement in their annual reports. From Investopedia we read:

Income Statement

An income statement is a financial statement that reports a company’s financial performance over a specific accounting period. Financial performance is assessed by giving a summary of how the business incurs its revenues and expenses …. It also shows the net profit or loss incurred over a specific accounting period.

Unlike the balance sheet, which covers one moment in time, the income statement provides performance information about a time period.

In example, ICBC buys gold at the SGE worth 1,000,000 RMB and has the metal recast in small 200 gram ICBC brand bars. If ICBC subsequently sells the newly casted bars for in total 1,100,000 RMB, then 100,000 RMB is profit and will be included in the income statement.

Cash Flow Statement

Next are the cash flows, from Investopedia:

Cash flow is the net amount of cash … moving into and out of a business.

Total aggregated cash flows are measured over the course of a period, for example one year, as with the income statement. But unlike the income statement, it records all things related to cash flows. For example, if ICBC buys a new building worth 10,000,000 RMB, this will affect the balance sheet (cash decrease, asset increase) and the cash flow statement, but not the income statement.

An Asset

From China’s Accounting Standard for Business Enterprises: Basic Standard we can read how an asset is defined:

Article 20 An asset is a resource that is owned or controlled by an enterprise as a result of past transactions or events and is expected to generate economic benefits to the enterprise.

“Past transactions or events” mentioned in preceding paragraph include acquisition, production, construction or other transactions or events. Transactions or events expected to occur in the future do not give rise to assets.

“Owned or controlled by an enterprise” is the right to enjoy the ownership of a particular resource or, although the enterprise may not have the ownership of a particular resource, it can control the resource.

“Expected to generate economic benefits to the enterprise” is the potential to bring inflows of cash and cash equivalents, directly or indirectly, to the enterprise.

Article 21 A resource that satisfies the definition of an asset set out in Article 20 in this standard shall be recognized as an asset when both of the following conditions are met:

(a) it is probable that the economic benefits associated with that resource will flow to the

enterprise; and

(b) the cost or value of that resource can be measured reliably.

Article 22 An item that satisfies the definition and recognition criteria of an asset shall be included in the balance sheet. An item that satisfies the definition of an asset but fails to meet the recognition criteria shall not be included in the balance sheet.

Financial assets/liabilities

Financial assets/liabilities can be subdivided in several categories, such as financial assets/liabilities designated at fair value through profit and loss, financial assets/liabilities held for trading and derivative financial assets/liabilities. Financial assets/liabilities are included on the balance sheet and the change in fair value of most financial asset/liabilities will appear in the income statement. Not all banks subdivide financial assets/liabilities in the same manner. For example, ICBC lists “financial assets/liabilities held for trading” parallel to “financial assets/liabilities designated at fair value through profit and loss”. Other banks only disclose “financial assets/liabilities designated at fair value through profit and loss” as a total. The details on accounting are beyond the scope of this post.

Let’s have a look at an example of a financial liability. We’ll use plain gold leasing. Suppose ICBC borrows 1 Kg of gold for 1 year and instantly sells the gold at 280 RMB/gram. ICBC will then record a cash asset of 280,000 RMB and a financial liability held for trading of 280,000 RMB on its balance sheet. Say, after one month the gold price surges to 380 RMB/gram. For ICBC the cash asset remains at 280,000 RMB, but the bank will increase the carrying amount of the financial liability held for trading to 380,000 RMB. The 100,000 RMB, which is a loss, will go into the income statement. In the income statement there is a separate line for this called net profit or loss on financial assets or liabilities designated at fair value through profit and loss.

Below is part of the income statement from ICBC’s 2015 annual report.

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