Prices expected to increase as investors look for safe haven

Strong demand from China has been one of the principal reasons why gold prices have surged to new highs in 2011.

Demand for the yellow metal rose nearly 71.1 percent year-on-year during the first quarter of this year to 187.4 tons in China, and accounted for nearly 20 percent of the global gold demand, says a report by the World Gold Council (WGC) earlier this year.

The figures were more or less within my expectations as I had predicted a gold boom in China way back in 2005. In my book Gold Defends China, published in August 2009, I had suggested China should consider building up gold reserves as a national strategy.

At that time I had based my thinking on the logic that inflation spikes were round the corner as there was far too many banknotes in circulation globally. I had suggested then that buying gold would be the best option for Chinese to hedge against inflation and future currency devaluations.

As the main driver of the global economy, China is facing the same problems that other emerging markets are grappling with - high inflation and diminishing wealth. Most of these problems have been present since 2007 when the domestic stock market started to turn into a bear market from the bull-run.

The benchmark Shanghai Composite Index has fallen to a record low of 2307 points on Oct 21 this year from a peak of 6124 points on Oct 16, 2007. Shrinking housing transaction volumes this year have also indicated that the property market is cooling after a 10-year boom.

With the two main investment avenues - real estate and stock markets - starting to lose their sheen, investors will look for an investment option that is standardized, not too complicated or technical, but has the ability to generate wealth and hedge currency risk. Gold seems to be the best bet under these circumstances.

In addition, factors such as the debt crisis in Europe, the third round of quantitative easing in the US, the yuan appreciation and the consequent influx of hot money, rising global food prices, and the 4 trillion yuan ($630 billion, 455 billion euros) bailout plan have spurred inflation and demand for gold in China.

The China influence on the global gold market, however, has more factors to it than just demand. After six Chinese government departments issued the "Opinions on Promoting the Development of the Gold Market" in July 2010, commercial banks started to actively participate in the gold market and also became major trading members of the Shanghai Gold Exchange.

Last year, gold transactions at the Shanghai Gold Exchange reached 6,051.5 tons, a year-on-year increase of 28.46 percent, with a total value of more than 1.6 trillion yuan.

An interesting facet of the gold demand potential in China is that the appetite is not just from the investors, but may be also from the government.

After the US subprime crisis, it was reported that China incurred losses of over $450 billion from worthless Fannie Mae and Freddie Mac securities. At the same time debt risks are increasing in Europe. The 600 billion euros worth of debt purchased by China in Europe has started to lose its shine, while in the Greek debt restructuring the losses were around 30 billion euros.

Against these backdrops there is a compelling reason for China to increase its gold investments. Gold will be a perfect option to hedge sovereign debt crisis. If the nation's foreign exchange reserves are made available for gold investment, then China's influence in the global gold market will grow by leaps and bounds.

Multi-polarization, the strategic alliance between China and Russia, a weak dollar as well as the widening debt crisis have further increased the global investment appetite for gold. In my opinion, international gold prices may peak sharply in the next six months and reach $2,500-$3,000 per ounce in 2012. That may just be the beginning of "Gold defending China".

The author is the founder of CNYUAN Think Tank, a leading financial consultancy.