Last month gold plunged more than 0 in less than a week and the dollar soared, trumping even gold. The move caused a catfight among letter writers with investors and central bankers questioning gold’s safe haven status. By contrast, the US Treasury sold more debt despite growing concern about the US economy and politically dysfunctional Washington. In the seventies, gold corrected more than 50 percent, dropping 0 before heading higher. In the eighties, gold pulled back 0 after reaching 0 per ounce before reaching new highs. So, why the disconnect?
Start with cash strapped Europe where concerns about the euro crisis have sent investors into dollars instead of gold in a “dash for cash” because dollars provide liquidity at a time when liquidity is at a premium. Although the one month gold lease rate hit 0.2703 percent, European banks were “swapping” their gold in order to raise cash amidst a shortage of dollars, depressing gold prices. Investors seem to have confidence to hold dollar assets for maybe 30 seconds, 30 days but not 30 weeks.
Gold’s Next Stop
However, gold has reversed course, resuming its uptrend on growing concerns over the lack of confidence in paper assets and the prospect of another round of quantitative easing. Central banks remain firmly on the path of printing money to pay off public debts and to keep their banking systems solvent. As bankers print ever more currency, they reduce the buying power of money in circulation. It is this dependency on the printing presses to liquefy the entire western banking system that has caused the central banks’ balance sheets to be bloated with sovereign debts and the toxic paper of yesteryear. History shows that inflation always follows monetary expansion. Even with the correction, gold has done better than every other asset, including the dollar, up more than 10 percent last year making its eleventh consecutive annual gain. Having achieved ninety percent of our forecast of 11 in 2011, we expect gold to reach ,000 an ounce and end up for an even dozen years in 2012. There’s just a lack of compelling investment alternatives.
Never-ending European Collapse
Markets are hoping for yet another quick fix so the Euro leaders could just kick the can down the road, one more time. Europe’s underlying problem and left unsaid is just who is to buy the billions of debt needed to rescue its weakest Eurozone members. The solution du jour is to have the European Central Bank (ECB) disgorge a fresh €2 trillion to purchase the weak sovereign debt similar to the Federal Reserve’s trillion money printing exercise that bailed out Wall Street only two years ago. To date the ECB has recycled 0 billion in cheap funding to the overleveraged banks. Standard & Poors has already opined, downgrading the credit ratings of nine European countries, including France and Italy leading to sell offs in their sovereign bonds. Portugal was slashed to “junk” status. Money is still cheap, governments overprint and two months after the October debt and loan accord, Greece is found waiting, again. A Greek default still looms. The IMF’s new Managing Director, Christine Lagarde warns of the risk of “economic contraction, rising protectionism, isolation similar to what happened in the 30s”. The IMF itself only has 0 billion left to save the world, raising the inevitable question – who backstops the backstop?
The breakup of Europe would no doubt cause a global recession, worse than the 2008-2009 period and precipitate a combination of messy sovereign defaults, currency barriers and massive unemployment. This very possibility prompted the European leaders to do whatever it takes to avoid catastrophe, yet to date they failed to control the spreading debt crisis. To be sure, past financial crises have shown that bold leadership and a dramatic reduction in debt are needed. Still despite an EU summit a month, Europe’s policymakers appear unable to ring-fence their problems. Instead their dithering and politicking is all too reminiscent of the policy parallels in 2008 when the bankruptcy of Lehman spread through markets, triggering the worst downturn since the Great Depression. Even worse, European leaders have not prepared their own people for the harsh medicine to come. The markets are not as patient and the rash of downgrades with negative interest rates does not bode well for Italy and Spain who must rollover some 0 billion of bonds. That two or three leaders have been replaced so far appears to be only the beginning, but replacing them with unelected refugees from Goldman Sachs is not the answer.
Of course, the inability of European leaders to kick the can down the road has prompted the obvious solution. Force the so-called independent European Central Bank (ECB) to loosen by printing buckets of money in a Euro-style quantitative easing program. The ECB itself owns about 18 percent of Greek debt. The ECB so far has temporarily boosted liquidity through a swap program designed more to shore up their broken banks than the sovereign states of southern Europe. The much ballyhooed European rescue facility (EFSF) triple A rating was downgraded, after only one payment. However the monetization of debt is exactly what caused Germany to slide into hyperinflation. This is not the panacea. Is forcing the ECB to print money part of the solution or another problem?
Stop Wall Street From Occupying Washington
Everywhere from the Occupy Wall Street movements to Washington to Omaha, the top one percent has been vilified and there is a sense that capitalism and even democracy has fallen short. Part of the reason is that taxpayers were on the hook for the billions of bailouts for the supposed “too big to fail” institutions losing confidence in the free market system. Fiscal gridlock has frustrated everybody. There was even an insider trading scandal at the Swiss National Bank. The anger is understandable. Part of the blame is the financialization of the global economy where Wall Street today represents almost a third of America’s corporate profits. The other is that the world’s largest economy’s finances are caught in gridlock and the promise of pensions and ruinously expensive medical care to America’s retiring generation are not even talked about because those obligations dwarf the country’s debt obligations. Taxpayers are rightly frustrated, losing trust in the system.
The Financialization of The Global Economy
The financialization of the global economy once a blessing is the darkest shadow due to derivatives. Debt has become synonymous with money. Debt is no longer amoral. Debt on debt has become the solution du jour and derivatives the enabler. Too much debt caused the 2008-2009 financial crisis. Too much debt caused Europe’s problems and too much debt will sink the US economy. Countries around the world are hopelessly in the red with debt rising every day. Derivatives a product of Wall Street’s financial engineering or alchemy has been the enabler that allowed the big investment banks to make big money at the expense of the system, escaping the bounds of physical assets, the real economy, debt and regulatory purview. The size of the derivative market has been allowed to grow and prosper to over 0 trillion and is largely run by the world’s banking giants. Indeed, it is the failure of some of those derivatives like credit default swaps (CDSs) that is at the heart of Europe’s problems, a replay behind the failure of Lehman and “too big to fail” AIG.
The proposed 50 percent Greek haircut looks like a default, is structured like a default and is a default. The problem is that no one wants to pay out the CDS bets. The Bank for International Settlements (BIS) reported that hedge funds sold three times or 1 billion of protection on sovereign risk. And America’s big banks in aggregate have “guaranteed” more than 0 billion of debts to Greece, Italy, Portugal and Ireland or three time their exposure. Déjà vu – again it is the banking system that is overexposed which will lead to insolvencies in the event of a default.
Exchanges and brokers too jumped on the bandwagon, changing the rules to attract trading in more derivatives. And existing rules have been relaxed further to enable trading in dark pools, automated trading with computer algorithms and high frequency trading. The biggest concern, however, remains the counterparty risk credit leverage and cross border risks. The strength and credibility of all contracts is the “weakest” counterparty, not so insignificant given the demise of MF Global and AIG. Drachmas anyone?
And then there is America, the world’s largest derivative player and biggest debtor. The poor performance of the world’s largest economy in the wake of the collapse of the sub-prime mortgages and credit bubble burst together with Washington’s debt growth, raises disturbing parallels with Japan’s lost decade. America still has a mortgage problem despite two doses of quantitative easing, closing the year with $15.2 trillion of debt and needing almost $3 trillion of the $7.6 trillion dollars of debt that must be rolled over by the G-7 countries this year. That is a lot of Treasury bills to sell. Spending reached a post war high at 25 percent of GDP, while taxes has fallen to 14.5% of GDP. Like Mr. Ponzi, America has been adept at issuing new debt to pay for old debt.
America is in the midst of a balance sheet recession relying on debt to pay its bills. And as the supply of debt increases, investors will demand a higher yield pushing interest rates up leading to higher inflation in the future. Foreigners already own 50 percent of US debt following a 100 percent increase during Mr. Obama’s term. Indeed in only one term Mr. Obama has piled up more debt than all 43 Presidents combined. The worst is yet to come. The average yield on US debt is a contrived 1 percent. Today, the weaker European players are paying 6 percent plus. America’s debt to GDP surpasses some of Europe’s weaker members. America then must eventually pay the piper and if they have to pay 6 percent on the $3 trillion plus of debt that must be rolled over, someone will have to write a big check. And with the US entering a period of protracted gridlock to be solved hopefully by the election this November, nothing has been done to address America’s problems.
So far America has been successful in inflating their debt away, debasing the dollar through artificially low interest rates, quantitative easing and bailouts. The cost is normally a weaker currency as the Fed’s balance sheet expands. Recently the dollar has rallied, primarily because other currencies are in worse shape. Until now. Any refinancing is dependent upon the Chinese who ironically are being asked to financially support the very economy that is expanding its military in Asia to counter China’s so-called rise to power. Chinese holdings of US debt has fallen 2.4 percent to $1.13 trillion, down from $1.5 trillion in October. Is America’s debt worth this risk? Dollars anyone?
Internationalization of the Reminibi
Since 2005, the reminibi has gained 30 percent against the dollar and still the reminibi is a source of complaint to the United States. Though shrill, the China bashing has declined as the US slides from global leadership. China has created another $300 billion sovereign wealth fund to be funded from the $3.12 trillion of foreign currency reserves. The internationalization of the reminibi is the best argument against a revaluation of the reminibi. To be sure, Beijing has taken additional steps to liberalize the reminibi in a move to convertibility setting up currency swap agreements with more than 10 countries. The key is the settlement of China’s trade with others and resultant liquidity. Already there is more trade using the reminibi as a medium of exchange between China’s major cities in the immediate area of Hong Kong like Shanghai, Dongguan, Shenzen and Macau. More and more, neighbours like Singapore and Korea are using the reminibi. It won’t happen overnight but the dollar days are ending. History shows that great power shifts are accompanied by changes in the world’s reserve currency – the last time was the demise of sterling replaced of course by the dollar. Reminibi anyone?
With record amounts of liquidity sloshing around from taxpayer financed bailouts, quantitative easing programs and deficit spending, investors are nervous about holding fiat currencies. Needed is a new Bretton Woods with a currency based on gold, instead of the so called faith-based currencies of countries that cannot live within their means or honour their debts. China and other creditors have rightly diversified away from the dollar and euro, searching for other options because of diminished confidence in the western financial system. China is in an excellent position and lately encouraged other countries to use its currency as a medium for trading and importantly investments. China has become the first port of call as countries seek funding in a capital short economy, promoting direct trade of the yen and reminibi without the usage of dollars with its biggest trading partner Japan. By its very size, China’s reminibi is destined to become a reserve currency like the euro and the dollar.
The Rise of China
Sinophiles are difficult to read. Everybody it seems is an expert, and many believe China is to be blamed for America’s problems. Yet few have travelled to China and many are prescribing what China needs is a US-type solution of revaluation and consumerism. While consumer spending is only half that of the United States, the Chinese are buying their first car, not their second SUV. China’s government too has been in a catch-up phase, spending on infrastructure like airports, roads, trains and yes housing. While the so-called real estate bubble has burst, no Chinese banks have been brought down. Chinese banks are backed by the state, America’s banks had to be backed by the state when Fannie Mae and Freddie Mac become wards of the state. However, unlike the demise of MF Global, a card carrying member of America’s shadow banking system, China has not had similar failures. No depositor can claim a loss of savings, something MF Global shareholders cannot claim.
Despite the turbulence overseas, there is tremendous confidence led by China in the huge consumer spending power in Asia. Although, consumer spending is half of the United States, the world’s second largest economy’s per capital output is only one fifth of most developed countries. After three decades of robust growth due to ever-increasing exports, China is the world’s most prolific exporter and has significantly raised the living standards for its billion plus population. Domestic pressures remain. The need to maintain growth and peace within its borders is a dominant issue for China’s new generation of leaders to be selected this year. While infrastructure spending has slowed down, there are signs that the young population is just discovering fashion, the internet and spending as a past time. However, unlike the west, China’s savings rate is quite high. Its hotel market is also booming and expected to overtake the US in the next decade. Tourism is considered a major part of the current five year plan, and thus there has been a big increase in hotels to accommodate the increase in tourism. Hilton for example plans 100 hotels by 2014 or four times the number of properties it currently manages. And, gambling revenues in Macau were up 26 percent in December or five times that of Las Vegas.
And Enter The Dragon
And in a sign that the consumer is following a western style consumption, it was noteworthy that red wine has grown at a compound annual growth rate of 12 percent with wine being bought not only for consumption but for investment. In fact the Shanghai Wine Exchange Center was established only in September has 2,000 investors already. Although possessing a largely unsophisticated palate, Chinese investors and consumers are collecting the big brands, big years and big wines such as a Chateau Lafite which sold for 2,550 yuan in 2008, now sells at 12,620 yuan or an increase of 500 percent in only three years. A case of 1985 DRC Romanee Conti recently sold for $1.46 million HK or $230,000.
The government has tightened monetary policy for about a year now. The planned slowdown in the real estate sector was the major casualty. Average new home prices in 52 of 70 major cities fell in December, but the decline was due more to the government’s dictate that curbed loans to the real estate market. Also in evidence, in a conversation with the Shanghai International Mining Commodity Exchange some of its newest members have switched from real estate into mining in search of the next big profit opportunity. Inflation is a major government concern. Since 2007 housing prices were up 140 percent nationwide, and Beijing alone had an eight fold increase in the past eight years. But the bigger story than the housing slowdown is that inflation has fallen for the fifth month in a row to a 15 month low.
We believe, China’s economy will grow at 9 percent in this year of the Dragon and next. Dragon years are often periods of prosperity but also brings periods of unpredictability and turning points (eg: Dragon year 1928). Although, the government reduced subsidies for fuel efficient models which caused a 4.2 percent decline in vehicle sales in October, 1.1 million units were sold. Hyundai reported a 13 percent increase, selling 100,000 units in the month. Since its entry into the WTO in 2001, annual automotive sales grew from 2 million units a year to over 18 million units. In another move to consumerism, the Chinese only worked 17 days in January thanks to the New Year three day holiday and the seven day Spring Festival or Chinese New Year holiday. The holidays caused the world’s largest seasonal migration of free spending people that China’s three biggest airlines even increased the baggage allowance over the festive season. China is still in the early stages of urbanisation. Rather than a migration from farms to choke the big cities, China’s policy is to build up the second or third tier cities. Each year, 17 million people move from rural to urban areas, equivalent to half the population of Canada. As a result China plans to build 97 airports, linking these urban centres.
Later this year, China will introduce a new set of leaders with a new President and Premier and seven of nine Politburo Standing Committee members to be replaced. The new generation of leaders have a vested interest in ensuring the next five years of growth continues at the same pace of the previous 38 years. While the world is obsessed with real estate, China is expected to encourage investment in energy, environmental, agriculture as well as infrastructure investment. In December, the writer took a high speed train from Beijing to Tianjian which is a normal 3 ½ hour car ride. The trip was completed in 30 minutes with speeds of up to 300 km/hr. Yet like all things in China, there are contradictions because when I arrived at the Beijing station, the queue for a taxi was at least the distance of a football field and it took another 30 minutes to get a taxi. Traffic remains horrendous in Beijing and while there were fewer cranes, signs of a slowdown were not evident. Chinese hard landing forecasts appear to be a western obsession and ill-founded.
China is the largest gold producer in the world and soon, the largest consumer of gold. Although China holds the fifth largest gold reserve, China has less than 2 percent of its reserves or 1,054 tonnes in gold. We expect China to boost its gold reserves in line with other industrialised countries’ average at 10 percent. Such purchases would take up to two years’ of world output. In November gold imports in Hong Kong grew 20 percent and almost 500 percent year over year reflecting retail demand for mainland purchases and Hong Kong’s lower tax rate on gold purchases. China’s appetite is expected to grow.
Are Regulators, Politicians too?
Much is made of the string of scandals caused by Chinese companies listed on the North American markets. The value of Chinese delistings on US exchanges exceeded the value for China IPOs. That firms such as Muddy Waters could publish unsubstantiated accusations without the regulatory oversight of the Street is just another regulatory loophole. The irony is that companies are considered guilty until proven innocent, and like many victims of violent crimes today must resort to the courts for the arduous process of seeking remedy. Rui Feng’s Silvercorp Metals is accomplishing more than the regulators.
Blaming China and its regulatory framework for loose standards is equally unrealistic as many of those Chinese companies retained America’s top rated accounting firms such as KPMG and Ernst & Young for their audits. Similarly it was a rash of American dealers who specialized in reverse takeovers (RTOs) that not only made the rounds in China but used a network of hedge funds to finance the plethora of reverse mergers. Of course, many RTOs should not have been allowed, but then the cheque writers were equally guilty in the pursuit of quick profits among these thinly traded RTO. But should listing standards be tightened? The reverse takeovers have been part of listing standards since day one. The standards are high in every regulatory environment from London to Toronto and to the United States and are even higher in Hong Kong and Shanghai whose market caps surpass that of North America. The failure then is not standards, but in the due diligence by investors and the so-called dealing community whose quest for quick profits created the very loopholes that caused the rash of listings and governance problems.
Capital markets are like highways, creating barriers might keep some bad drivers away, but it is a two way street. There are an equally large number of American companies seeking listings and funding from the important capital pools in Asia. Putting up false barriers could boomerang on those who need capital most in a capital-short environment.