China stock rout: Boon or bane for gold?

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With China's stock market meltdown now into its fourth week, what does this mean for gold demand out of the world's second largest consumer of the precious metal?

"Given that one of the reasons for gold's tepid demand in China is due to the strong equity bull market, questions are now raised if the current bearish 'A' share market could spark Chinese interest in gold once more," Howie Lee, investment analyst at Philip Futures, wrote in a note on Wednesday.

Chinese equities plunged to a four-month low on Wednesday, as panic selling gripped markets despite fresh measures by the government to shore up confidence, including easing rules for insurers to invest in blue-chips stocks, raising margin requirements for short positions against small-cap stocks and warning against "irrational selling."

Investors so far have taken little comfort from these steps, with the benchmark Shanghai Composite down over 32 percent since hitting a seven-year peak of 5,166.35 on June 12.

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Lee says while a rotation of funds into precious metals is possible, many Chinese retail players have had their hands burnt by the recent share market pain .

"There are simply not enough funds to put into rotation; if anything these losses may mean even lesser demand for gold jewellery and bullion demand," he said.

China lost its position as the world's top gold consumer to Indiain 2014. Indian demand totaled 842.7 tonnes last year, compared with 813.6 tonnes in China, according to data from the World Gold Council.

Demand fell in both markets in 2014 from record levels a year earlier, but Indian demand slumped only 14 percent, compared with a far sharper 38 percent plunge in China. The mainland's appetite for gold has cooled notably after the 2013 buying spree that was spurred by a steep drop in prices.

"With pent-up demand satisfied (overloading of gold has since been an issue) and most markets looking bearishly on gold, there is little reason for the Chinese to hoard gold now," Lee said.

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Gold has performed poorly so far this year due to a stronger dollar that has damped the appeal of the yellow metal. It is down 2 percent year-to-date, currently trading around the $1,156 per ounce level.

Victor Thianpiriya, commodities strategist at ANZ, on the other hand, views the rout in Chinese shares as a positive for gold demand.

While Chinese investors may have gotten burnt by the market turn, Thianpiriya notes: "Equity investments as a portion of total wealth in China is quite low."

Chinese households still park most of their wealth in cash and deposits, with less than 15 percent of their financial assets are invested in stocks, according to HSBC.

"Anecdotally, speaking to Chinese jewelers over past few months, one of the big reason that jewelry demand has been weak us because of the rising equity market," he said.

"So if we remove that – we could see demand pick up into precious metal and more diversification of assets," he added.

Having said that, Thianpiriya doesn't think pickup in demand will be a big enough catalyst to boost underlying prices.

"There's no real shortage of gold out there. Plus if you look at the price action in markets – everything is getting hammered. It's a big risk-off that we're experiencing at the moment," he said.

Adding to that, the precious metal still looks to be moved by the strength of the dollar, Lee of Philip Futures noted.A stronger greenback makes dollar-traded commodities more expensive to holders of other currencies, thereby dampening demand.

"Things are not looking bright for the precious metal and it appears that prices are running lower ahead of the expected September rate hike [by the Federal Reserve]," Lee said.