September 29, 2006

China digs in its heels; What it means for gold.

by Michael J. Kosares (9/29/06; 12:22MT - usagold.com msg#: 147929)
Centennial Precious Metals, Denver

Now that we've safely ensconced the FT Comment & Analysis piece on Chinese reserves at the NewsGroup archive where it can be easily accessed, I would like to make some additional comments on the subject. At present, I think that the magnitude of what is being presented in this article has yet to hit the markets. When it does there could be some substantial adjustments. Right now the financial world is dealing with minor atmospheric disturbances (recession worries, interest rate concerns, the housing bubble, the elections, etc) compared to what might happen once it sinks-in just what China is actually up to.

In the USAGOLD Comment attached to the NewsGroup listing, I stated the following:

"China knows that the Financial Times is a primary conduit to policy makers and major market participants in the west, so these comments by officials at the very top of its government were not placed casually or accidentally. Gold is now definitely on the policy agenda for China. This revelation of Chinese establishment thinking, I believe, marks a watershed for the gold market, and something that will have to be factored into decision-making in London and New York's gold trading rooms from now going forward."

Here is the key references to gold (and oil), so that you can interpret China's meaning and intentions yourself:

"At the top of the semi-public shopping list funded out of existing reserves are raw materials, something confirmed by both Mr Wen and Mr Zeng. The reserves could, for example, pay for importing the oil to fill a long-planned strategic reserve, the tanks for which are near completion. The government is also considering whether to buy gold, considered a hedge against the potential of a falling US dollar."

--End quote--

Observations:

1. In previous public disclosures on China's gold policy, remarks came from functionaries at the central bank, various ministries, academia and the press. These were policy "hints" though; not policy "statements", and although they showed direction they didn't show "intent." The comments in the Financial Times came from China's prime minister and a vice president -- a clear indicator that the many hints out of China about gold now need to be upgraded to "intent." I also found it interesting that Wen and Zeng coupled oil and gold for acquisition. The fact that "oil tanks" for a strategic reserve are now "near completion" indicate just how serious China's intentions really are.

2. One of the most far-reaching and potentially destabilizing revelations in the FT article is a "blunt statement" (as characterized by FT) made by Zhou Xiaochuan, governor of the Peoples' Bank of China that China has "enough reserves." Further on in the article, Xia Bin, an economist at the Development Research Council which advises the State Council, states that China needs about $700 billion (of its $1000 billion) "set aside in reserves in the traditional sense, as a national insurance fund, against financial risk." That infers that $300 billion will be directed to other uses presumably including as outlined above in gold and oil.

Keep in mind that China is netting about $20 to $25 billion monthly in new dollar reserves -- an amount that will also be looking for a home should this plan move forward. To give you an approximation of what this might mean, $300 billion would purchase 15,500 tonnes of gold -- the equivalent of almost twice the U.S. Treasury's hoard of roughly 8000 tonnes. It goes without saying that China will not use the full $300 billion to purchase gold, but that gives you a very clear picture of the scope of China's new found wealth. Needless to say, in the face of China's potential requirements, the paltry tonnages being offered through the Central Bank Gold Agreement would become inconsequential.

3. It is interesting to note that this article appeared in the Financial Times only a few days after Hank Paulson returned from his trip to China. There is little doubt that the Treasury Secretary attempted to exact some sort of currency understanding while he was there. Instead, he got this article. Here's another extraordinary statement from a member of China's policy elite: "Japan's 15-year recession was very much related to their failure of management of the exchange rate. We will not allow this to be repeated in China." In other words, China blames Japan's caving-in to the United States during the 1980s for its economic woes thereafter. It's digging in its heels. What this means in terms of economic results is very simple. The favorable exchange rate mechanism which insures China's export position will continue. The trade deficits with the United States will continue. The buildup of Chinese currency reserves will continue. Where this all balances out is anyone's guess, but those who believe that the bull market in commodities is about to end because somehow China's demand will abate had better reconsider.

4. The threat to the dollar under these circumstances is palpable. The very fact that China might set loose $300 billion in reserves for starters, plus something on the order of $20 to $25 billion per month, presents a problem which will call upon all the skills Hank Paulson and Ben Bernanke can muster. I can't begin to offer the sort of analysis required to enumerate just what this amount of cash rolling around the world's capital markets will stimulate, but we will all have to consider just how much control the Fed can exert over the money supply and monetary policy under such circumstances. Here's another interesting comment made this time by economist Zhong Wei of China's Foreign Exchange magazine. "We cannot blame the U.S. Treasury," he says. "No one forced us to buy dollars." Perhaps not. The real question though is not who to blame, but how the international economy is going to deal with all those free-floating dollars and the ramifications of China's now stated policy.

5. All in all, it would hard for me overemphasize the importance of the revelations in this article for gold owners. Suddenly, many of the questions that have been bandied back and forth for months and even years as to what China might do with its growing dollar reserves are now in the first stages of resolution. I won't deal here with the subject of gold availability because for the gold owner that is a side issue. The real impact will be the counterweight China is about to impose both on the gold market psychology and in reality. Indirectly, gold will benefit as investors internationally take a second look at the dollar. Gold will benefit directly from an ever-present demand source acting as a counterweight to supply. Gold's opponents will no longer be able to wave the red flag of central bank sales without someone else raising the specter of central bank gold purchases. And, it is unlikely that the move to gold will stop with China. It will become exemplary -- with the oil-rich Gulf States immediately coming to mind.

I am attempting to recall when a set of circumstances lined-up in the past more bullish for gold than these (even if China is unable to purchase gold in the quantities it desires). The Central Bank Gold Agreement comes to mind, but, in my view, that pales to the news coming out of China. This development makes acquisitions in this price range a good bet, in my opinion. It won't be long until others begin to put the China puzzle together.


[SEE ALSO... additional commentary on the mid-December visit to China by Treasury Secretary Hank Paulson and Fed Chairman Ben Bernanke.]


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For a more information on the role gold can play in your portfolio, please visit The ABCs of Gold Investing: How to Protect and Build Your Wealth with Gold by Michael J. Kosares.