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By Luke Burgess | Tuesday, June 14th, 2011

As the world's top gold producer and second largest consumer, China is the single most important player in the global gold arena.

Last year, Chinese gold demand grew by 32% — reaching nearly 25,000,000 ounces for the first time in history. Yet despite the country's seemingly insatiable appetite for the yellow metal today, world leaders are concerned the demand for gold could get out of hand...

More than doubling again in less than ten years!

The demand for gold in China has swelled intensely since deregulation of the market in 2001, growing by an average 14% per year.

China Gold Demand Per Capita

Jewelry is the principal sector of the Chinese gold market, accounting for almost 64% of all gold domestic demand in 2010. As rapid economic expansion recently boosted domestic disposable income, the demand for gold jewelry in China has more than doubled in the last seven years.

Meanwhile, the demand for gold as an investment has increased exponentially over the past 10 years, with the new era of the Shanghai Gold Exchange.

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In 2010, gold demand for investment in China increased 71% over the previous year. This growth continued in the first quarter of this year.

China was the largest physical bar and coin investment market during 1Q 2011.

Quarterly China Gold Jewelry and Investment Demand

With ongoing global economic and financial uncertainty, gold’s roles as monetary asset, universal currency, and risk diversifier make it an extremely attractive asset class for all investors.

But I believe the following four factors will be particular drivers in the development of the Chinese gold market over the next ten years...

#1 The Rise of the Middle Class and Disposable Incomes

Two decades of economic expansion has created a new market and birthed a rapidly growing domestic middle class, which continues to expand today.

According to China Consumer Daily, it is estimated there will be 75 million households with annual income of more than US$4,300 by 2015, compared to just 15 million in 2005. Similarly, household savings are also expected to triple during the same period.

The Chinese are natural savers. Economists estimate China's savings rates (the percentage of savings in a person's disposable income) is nearly 40%. In the United States, we have a negative savings rate of 0.5%.

The combination of the burgeoning middle class and high savings rate could easily translate into a massive demand for gold in the near future.

The Chinese have been using gold as a monetary asset and wealth preserver for centuries. Excluding the last few decades, gold was really the only form of savings that was practical for Chinese citizens. Bullion is acquired continuously over the years as money is saved and available, often over generations.

The potential increase in gold demand from a the growing Chinese middle class is substantial and should not be overlooked.

#2 Hedging Against Rising and Uncontrollable Inflation

Over the past several years, there has been a rush of capital investment into emerging markets, particularly in China. These inflows have contributed widely to inflation.

The inflation rate in China was last reported at 5.4% in May. From 1994 until 2010, the average inflation rate in China was 4.3%.

China's government has said that taming inflation to a rate around 4% is one of its key economic goals for the next five years.

As part of those efforts, the People's Bank of China has raised interest rates four times since October and hiked the amount of reserves it requires banks to hold. However, efforts to stem rising inflation have not been largely successful.

Fears of continued rising domestic inflation will likely be one of the key drivers in Chinese gold demand in the near term.

#3 The People's Bank of China Needs Gold

Despite being the sixth-largest official holder of bullion, the gold held by the People’s Bank of China (PBOC) accounts for only 1.6% of the nation's total foreign reserves — low by international standards.

By comparison, the U.S. Federal Reserve reports America's gold holdings represent 73.9% of the national forex reserves.

In its latest report entitled “2010 International Financial Market Report”, the PBOC expressed interest in expanding the country's gold reserves. Leading financial and economic experts including Li Yining, one of China’s most prominent architects of reform, and Xia Bin, an advisor to the PBOC, have recently called for an increase in China’s gold reserves to hedge depreciation of foreign exchange reserves.

#4 Increased Interest in Gold from Chinese Financial Institutions

There is a growing appetite among large Chinese financial institutions to increase their asset allocation to gold investment.

Since February 2010, China Investment Corp. — a sovereign wealth fund incorporated in Hong Kong — has acquired a $157 million stake in SPDR Gold Shares (NYSE: GLD), the world’s largest gold ETF.

On January 13, 2011, China's Lion Fund launched a new gold ETF aimed directly at Chinese consumers. As of March 2011, the fund has accumulated assets of nearly $400 million.

Evidence suggests institutions are buying gold for its ability to outperform other domestic financial asset classes during crises, and for its effectiveness as a hedge against macro economic factors and currency fluctuations.

These institutions, along with the People's Bank of China, have very deep pockets. They could be extremely large purchasers of gold bullion for wealth preservation in the near future.

Conclusion

In March 2010, the World Gold Council (WGC) reported Chinese gold demand could double within the next decade.

But given the recent momentum in Chinese gold demand, the WGC revised this, saying in its global gold market review of the first quarter of 2011: “We would not be surprised to see this result achieved in a shorter time frame.”

Inflationary concerns and rising income levels are likely to be the main drivers of China's gold demand in the near term, especially given the fact that Chinese consumers are high savers, and are looking to gold to protect their wealth.

The long-term story for Chinese gold demand is also quite compelling.

Given the increasing prosperity in the world’s most populous country, all signs point to increasing gold demand in China.

Good investing,

Luke Burgess