January 7, 2006

The Gathering Storm and Gold
by Michael J. Kosares (1/7/06; 17:04:12MT - usagold.com msg#: 140233)
Centennial Precious Metals, Denver
http://www.abcs-of-gold-investing.com/
The following extracts from a Financial Times article headlined "Questions grow over China's forex strategy" with my comments appended. The China strategy no doubt figured largely in yesterday's gold market run-up.
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Financial Times: "The spectre of Asia's central banks deciding to diversify away from their dollar holdings has long threatened a sharp drop in the value of the U.S. currency."

MK: A quote from The ABCs of Gold Investing: How to Protect and Build Your Wealth with Gold:

"Nowhere are the dangers to the world economy more implicit than in the United States' economic relationship with the two Asian exporting giants, China and Japan. It is estimated that east Asia holds approximately two-thirds of the world's foreign currency reserves. Japan and China alone hold an estimated $800 billion and $400 billion, respectively, in U.S. dollar reserves, about 17 percent of the total U.S. federal debt.

[Addition 1/7/06: China is likely to catch Japan in terms of dollar reserves soon, so the emphasis at the moment is quite naturally on China. At the same time we would be remiss to discount the dollar holdings of Japan and the oil exporting nations -- particularly the Gulf States and Russia.

U.S. economic policy in the past could focus principally on Japan (with respect to the dollar overhang. Now American policy-makers have a half dozen nations with which to contend. The United States is quite literally flooding the world with dollars. Needless to say this complicates matters significantly making it difficult for a coherent policy to emerge.

Discipline in the dollar-holding ranks could suddenly break setting off a deluge of bond redemptions which in turn could ignite a full blown financial crisis. In other words, we might be a gun shot away from a full stampede.

The implied threat imposes itself directly on the private investor who has no resources but his or her own were such a panic to unfold. If you haven't diversified into gold, now is the time. If you have diversified but still need to add more gold to your holdings, it is better to get the job done now than wait for a price correction. As the past week exemplified, the downturns are shallow with a quick bounce back to the upside. Don't play games with your future as this dangerous situation gathers momentum.]

The ABCs: "Recently the Sydney Morning Herald openly questioned dollar policy and its potential impact on the Pacific region.

'Around Asian financial circles, there is growing, if still muted, talk of a looming 'dollar crisis' equivalent to the sterling crises of the 1960s - when London could no longer support the reserve role of the British pound - unless Washington mends its profligate ways and accepts higher interest rate and taxes. A default by the U.S. government is still unthinkable, but not so a unilateral change in the rules of international finance-akin to Richard Nixon's halt to the convertibility of dollars into gold in 1971, or Franklin D. Roosevelt's devaluation and repudiation of gold-denominated contracts.'

Under the circumstances, it is not difficult to understand why Japan and China might be interested in increasing their gold reserves. Even a small shift in the Japanese and/or Chinese reserve position toward gold would have major implications for both gold and the dollar.

[Addition 1/7/06: It is not just China and Japan that might be interested in increasing their gold reserves. Russia has announced a similar interest and so have several other nation states. It is a long-held belief in the gold market that wealthy Arab oil producers have been quietly building their gold reserves as oil revenues have poured in. I would contend at this juncture, that private attempts to acquire gold will be more successful than the public, official sector type, though the official sector endeavors will have an important psychological effect on the market even if they meet with only limited success. I would not be surprised to find out down the road that in this period wealthy oil money was quietly going about the business of physical gold acquisition, and that this was the underlying current in the gold market that took it to 25 year highs.]

Richard Duncan, former International Monetary Fund economist, speaks to what this might mean to the world economy of the future:

"By accident or by design, Japan is carrying out the most audacious endeavour to conjure wealth out of nothing since John Law sold shares in the Mississippi Company in 1720. So far, the results have been impressive. Japan's monetary alchemy has been the most important factor in allowing the U.S. government to finance a $700 billion deterioration in its budget over the past three years without pushing up U.S. interest rates to levels that would pop the wealth-creating property bubble there. These developments highlight a fundamental question that has been debated repeatedly over centuries: Can governments create money and make the population richer without setting in motion a chain of events that ultimately ends in monetary chaos?

"We may be about to find out, as Japan tests the hypothesis on an unprecedented and global scale. If this experiment in unorthodox monetary policy succeeds, then we have arrived at a new international monetary paradigm. Governments will have discovered how to finance limitless deficits through the creation of paper money, and we all can look forward to an age of great prosperity. If it fails -- as have all past attempts to create wealth from thin air -- then the world may not be able to avoid a severe and protracted economic slump as the extraordinary imbalances in the global economy, caused by the explosion of fiat money in recent years, begin to unwind.

"In mid-2003, economists at the U.S. Federal Reserve published a paper explaining why the Fed was not "out of bullets" despite having cut short-term interest rates to one percent. That paper stated that "the Fed could even implement what is essentially the classic textbook policy of dropping freshly printed money from a helicopter," if necessary, to stimulate the economy. Today, that helicopter is in the air. But, strangely, it is not the Stars and Stripes that is painted on its side, but rather the Rising Sun. That much is clear. What still is not quite discernible, however, is who is actually in the pilot's seat."

One of the unhappy consequences of the structural trade deficit is that the Greenback is being held hostage by foreign financial interests. Any of these interests can move against the Greenback at any time by simply selling off their bond holdings. Foreign-held dollar debt has become a weapon in the equivalent of an economic Cold War. Just as nuclear weapons were held for most of the twentieth century like a sword of Damocles over the nations of the world, so now are dollar reserves held over the head of U.S. financial markets. To say the least, this puts U.S. stock and bond investors in a precarious position, and makes gold, the stand-alone asset, a critical holding or those who understand the dangers this tenuous synergy implies."

-End ABCs quote-

Then,

Financial Times: ". . .market reaction yesterday to the announcement was limited. China watchers pointed out that the statement on Thursday evening did not come out of the blue, but followed comments by government officials and academics questioning the wisdom of China's reserves management strategy."

MK: The reaction in the gold market was not limited by any stretch. In my forecast for 2006, I commented on the dominant role central bank gold demand could play in the gold market. Beyond the immediate psychological effects, the real world implications will be felt for a long time in the physical market itself. The enormity of the implied central bank demand is likely to further upset the gold market's already delicate and tenuous balance.

Most mainstream commentators -- even those with some understanding of the gold market -- have yet to fully comprehend what is really going on in the gold market. Those who come to this website, however, are well aware of the breach between supply and demand already in place due to a combination of short covering and declining mine production. Now we must factor-in that central banks as a group could become net gold buyers instead of sellers -- altogether a potent brew that could catapult gold into the investment limelight and keep it there for a long time to come. Some of the early reports on Chinese interest in gold suggested a 1500 tonne addition to its reserves. What about Russia? South Africa? The Gulf? India? And don't forget -- European and American investors (perhaps as big a market if not bigger than the others mentioned). The gold market may not be ready for what is about to happen to it.

Financial Times: "Last month Yu Yongding, a prominent academic who sits on the central bank's monetary policy committee, warned that China's reserves could be seriously eroded if the US dollar weakened further, a comment interpreted in some circles as a warning against excessive investment in dollar assets. However, Thursday's statement did break new ground: it was a public statement by Safe, rather than comments by individuals."

MK: In China policy is often foreshadowed by articles written by key policy makers. China will likely act in its own best interest despite the ramifications to the world economy. Though China's approach is likely to be measured and the policy applied over a protracted period of time, the effects on the market will be immediate. We are talking about quantum changes in the way the world does business -- a shattering of the paradigm. All markets will be affected inlcuding gold. Please see more on this below.

Financial Times: "Foreign investors have continued to be willing to finance the US current account deficit at very low interest rates in spite of the foreign exchange losses they suffered during the dollar's decline from 2002-04. This has made it easy for the US to finance its current account deficit, which has risen above 6 per cent of gross domestic product and requires the US to import more than $2bn of capital from abroad every day.

"But it would not need China to start dumping dollar assets for there to be pressure on the dollar. If China became less willing to continue adding to its holdings of US Treasuries, that itself could put downward pressure on the dollar and upward pressure on US interest rates ­ particularly if it encouraged other countries to follow suit.

"Oil-exporting countries have become increasingly important sources of foreign capital, owing to the high oil price, becoming as important as developing Asian countries in financing the US deficit. "

MK: The implications to the American economy of those four small paragraphs are alarming. This past summer the world's financial pages were filled with discussion about Alan Greenspan's conundrum -- the fact that interest rates were dropping in the real economy even as the Fed attempted to drive them higher. When Ben Bernanke takes the reins of the Federal Reserve he might very well be confronted with a conundrum of his own.

If China indeed begins to diversify out of the dollar (by reducing its purchases of U.S. Treasuries) in any meaningful fashion, the dollar will be the victim and so will easy money in the United States. The Greenspan conundrum came from China and Japan undermining Fed policy by flooding the American economy with dollars from their reserve hoards. A Bernanke conundrum -- as described above (the opposite of the Greenspan conundrum) may cause an early launch of those money-dropping helicopters we have all read so much about.

China, possibly without realizing it, could precipitate a stagflationary crisis every bit as dangerous as the one that tsunamied the Asia economies in the late 1990s (Bernanke's worst nightmare if you've had the occasion to study his speeches and academic papers) -- only this time it will occur in the economy upon which all other economies depend. It is a dangerous business and dangerous times for the world's investors.
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The ABCs of Gold Investing: How to Protect and Build Your Wealth with Gold by Michael J. Kosares can be ordered at the link above.

Here is the link to the Financial Times article featured above:

http://news.ft.com/cms/s/5413c5d6-7ee7-11da-a6a2-0000779e2340.html