I’m talking about China.

As you may know, I’d been pretty bullish on the China story for several years, going back to my days as editor of the Australian version of The Daily Reckoning.

But that view started to change late last year.

I’ll be honest, your editor didn’t turn from a raging bull to a grizzly bear overnight. The change has been gradual.

We started off by pulling back on the number of stocks we tipped that were dependent on a booming Chinese economy. Then we started to look at ways of hedging portfolios against a Chinese economic crash.

Now we suggest only buying into the China story if you’re into high-risk, high-stakes punting. Otherwise, stay clear and hedge your portfolio against the inevitable bust.

That’s something Dan Denning is showing his readers in Australian Wealth Gameplan. If you haven’t seen his ‘Exit the Dragon‘ strategy yet, take a moment to read about it here…

Because believe me, a crashing Chinese economy could be much closer than the mainstream press could ever dare dream.

Just remember, the mainstream press arrived late on the scene with the China story. And they’re destined to exit the scene even later – probably just after the dust has settled is our guess.

So, what is it that’s caught your editor’s eye? What is it that has caused us to shift into an even higher state of alert on the Chinese economy?

Well, it was the news last week as reported by Businessweek that, “China Cuts Rare Earth Export Quota, May Cause Dispute.“

Diggers & Drillers editor Dr. Alex Cowie gave you the rundown on rare earths last week in this article, so I won’t go over all the details again.

But as a summary, simply put, without rare earths you wouldn’t be able to read today’s issue of Money Morning.

You probably wouldn’t be able to drive the car you drive, and you wouldn’t be able to watch the latest episode of Australia’s Next Top Super Master Chef Idol… or whatever the show’s called.

Because without rare earths, LCD and plasma screens aren’t possible. Mobile phones would be a distant dream or very weird looking, and even some of the new technology used in the automobile industry such as in hybrid cars couldn’t happen.

All of those things, plus many others – the Defence industry for example – rely on this bizarre group of elements called rare earths.

Incidentally, before I go on, I’ll openly state that rare earths is a pet topic. We’ve followed the industry for some time in Australian Small-Cap Investigator and wrote extensively on the subject in the April 2010 issue which we titled “The Coming Plasma Wars…“

In that issue we painted a grim picture of how China’s stranglehold on the rare earths industry – about 95% of global production – could ultimately lead to economic disaster for the rest of the world.

Unless that is, non-Chinese production ramps up to pick up more than just a 5% market share.

Again I won’t go into the full story as that’s for Australian Small-Cap Investigator subscribers only, but the gist of it is for how much longer can the Chinese authorities prop up their economy and prevent civil unrest?

Our guess is that like every other violent and oppressive regime in history it will ultimately meet an end. When that happens, the odds of the Chinese manufacturing industry continuing to run are minimal. And equally minimal are the chances of Chinese rare earths producers being able to export the minerals.

Remember, this is a situation where the Chinese control the export of a crucial resource. It’s not like the iron ore or copper industry where China is the buyer. For those industries, if China stops buying there are others that could eventually pick up the slack.

I’m not saying it would be seamless, but other buyers would gradually emerge.

But for rare earths it’s the Chinese, not the Australians or Brazilians or Canadians that is in control of the resource.

And that’s why the Businessweek article caught our eye. The story claims:

“China, the world’s largest rare- earths producer, cut export quotas for the minerals needed to make hybrid cars and televisions by 72 percent for the second half, raising the possibility of a trade dispute with the U.S.

“Shipments will be capped at 7,976 metric tons, down from 28,417 tons for the same period a year ago, according to data from the Ministry of Commerce yesterday.”

To show you exactly what this means, the company that I’ve tipped in Australian Small-Cap Investigator has produced the following table:

Click here to enlarge

I’ve circled the two key numbers. Total exports for 2009 were 50,145 tonnes. In 2010, the total exports are predicted to be just 30,259 tonnes.

Make no mistake, that’s a massive difference. But why would the Chinese do such a thing?

According to Businessweek it’s because:

“Rising production of hybrid cars and music players such as Toyota Motor Corp.’s Prius and Apple Inc.’s iPod have driven up demand for rare earths even as China cut the quotas to shore up prices and ensure domestic supplies.”

In other words, because there’s such a demand for rare earths from overseas manufacturers such as Toyota and Apple, the Chinese apparently want to “shore up prices and ensure domestic supplies.”

Right. The second part of that we can accept. Even though in a moment we’ll argue it’s not the real reason for the cut to the export quota. Even so, the argument is that due to the demand from overseas, Chinese manufacturers are having to compete for rare earths and are perhaps having their supply of rare earths impacted.

But the first part of the argument, about shoring up prices, doesn’t make any sense at all. If there truly is such a huge demand from overseas and domestically, then that alone should shore the price up without the need for a cut to the quota.

So, could there be more to the story than meets the eye?

We think so. Not that the mainstream press has bothered to pay much attention to it. The best the Fairfax papers could come up with was a cut and paste job from the Businessweek article.

We’re yet to find any commentary from any of Australia’s mainstream know-it-alls who are usually so keen to jump on to any China related story. If it’s good news then they’ll say “I told you so”, and if it’s bad news they’ll say, “Fuhgeddaboutit, China’s gonna grow for thirty years, Ken Henry said so…”

You see, the real reason for the quota cut is likely to be much more sinister than the boys and girls at Businessweek would have you believe.

It’s not so much the price of rare earths, or even the concern about maintaining domestic supplies that the Chinese are worried about. What’s more likely to be their real concern is the demand for Chinese finished products.

What this decision tells you is that the bureaucrats are seeing a slowing demand for Chinese produced goods. Remember, for all the mainstream guff about China having a market-based economy, the fact is that China has a command economy.

It’s industries produce goods based on what it’s told to produce, not on what the market demands. And as anyone will tell you about command economies, the bureaucrats dishing out the orders aren’t usually the quickest to recognise a glut in production.

Why do you think you hear the stories about Chinese companies dumping products in foreign markets for below cost? They don’t do it in order to win market share, that’s just a furphy the vested interests like to claim.

The real reason is because the bureaucrats have set production levels too high and then they’ve been too slow to cut back.

Odds are that this is what’s happening across the board in Chinese industries. Manufacturers are producing goods under orders from centralised bureaucrats, goods for which there isn’t the demand.

What can the government do about that? Well, if you rule by fear the last thing you’ll want to do is order businesses to slash production and slash jobs. Not when millions of rural workers have been moving to the big new cities to work for these manufacturers.

Can it really be expected that these people would just say, “Ho hum, back to the country then.”

Of course not. Cutting production to real levels of demand would mean millions – and I mean millions – thrown out of work and literally onto the streets. No oppressive and violent regime wants to risk having millions of angry people on the streets with pitchforks and torches.

So the only other option is for the Chinese authorities to try and attract more demand. What better way of doing that than cutting the supply of perhaps the world’s most strategic resource – rare earths.

And if you think that’s drawing a long bow, think again. We’re talking about a resource that’s required for the production of items most people use every day. For instance flat screen televisions and mobile phones.

To prove the point, take this article from yesterday’s Sydney Morning Herald:

“Televisions will soon start to outnumber the number of people in the average Australian household as the cost of flat-screens declines and viewing habits change, experts say.

“Sales of televisions larger than 40 inches recorded 75 per cent growth in the past year, with 140,000 sold in the six weeks before the Socceroos’ opening round World Cup match against Germany on June 13, according to analysis by the industry research group, GfK.”

The article goes on:

“Last year Australians bought 2.7 million televisions…”

Now multiply that number globally. Now consider the number of mobile phone handsets that are bought every year here and overseas.

We’re talking huge numbers.

And it’s a huge number the Chinese want to gain an even bigger control over. That along with every other industry that uses rare earths.

Think about the numbers in the chart I pointed out above. The Chinese export quota is forecast to be nearly 40% lower in 2010 than in 2009.

It’s not as though non-Chinese manufacturers can simply sign a deal with non-Chinese rare earths producers to fill the gap. Well they can – such as the stock we’ve tipped in Australian Small-Cap Investigator – but it will be nowhere near enough to meet what global industry requires.

And as we pointed out in the April issue of Australian Small-Cap Investigator, “industry insiders believe it will take Mountain Pass fifteen years to get the full supply chain going.”

By the way, Mountain Pass is the large US rare earths deposit that used to be the largest source of rare earths until the 1970s. That was before the Chinese took over the industry. Production was finally halted at Mountain Pass in 2002!

So mark my words, this announcement by the Chinese authorities on rare earth production should be much bigger news than it has been so far. Largely because it tells you more about the real state of the Chinese economy than any government manipulated statistic will ever tell you.

The headlines in the mainstream press tell you about the booming Chinese economy, about the insatiable appetite for Australia’s resources and how the Chinese are creating a new breed of middle class citizens.

What the headlines don’t tell you is what the rare earth quota cut implies – that China is desperate to do anything to prop up a manufacturing sector that is producing more goods than it can sell.

And the only solution it has to prevent – or at least postpone – a catastrophic economic meltdown and civil unrest is to manipulate the market to try and gain control of more manufacturing from overseas.

One way of doing this is to slash exports for the one natural resource that China has supreme control over – rare earths.

So far the mainstream media has let this one slip through to the keeper. In our opinion that’s criminal considering the potentially huge impact this measure could have.

However, because we believe this event is so important, it’s one that we’ll follow very closely over the coming months.

The first cracks in the Chinese economy are starting to appear, but so far, very few people seem to have noticed.

Cheers,
Kris Sayce
For Money Morning Australia

There is a big upset in the Rare Earths market right now, and with good reason.

China has steadily positioned itself as the world’s biggest producer of rare earths in recent years. Even though it is sitting roughly a third of the world’s deposits, it is now controlling 95% of global supply. It has squeezed other producers out of the market by undercutting their prices, and now has a monopoly on the market.

Last week China cut exports quotas by 72%. This brings down shipments from roughly 28,000 tonnes to a measly 8,000 tonnes. The Chinese Society for Rare Earths said that its producers weren’t making enough profit. Well, this move should drive rare earth prices through the roof, and give the producers all the profits they could imagine.

So, what are rare earths, and why should you care as an investor?

Well rare earths are as the name suggests, relatively rare. Only 75,000 tonnes are produced each year worldwide. Industries use their unique properties for technological applications like computer hard drives, cell phones, as well as green uses such as wind turbines and hybrid vehicle technology. The rare earths are needed badly for green technology in a modernising economy. Demand is rising and Chinese supply (effectively most of global supply) has just been deliberately bottle-necked.

The names of rare earth elements are not easily dropped into conversation, and are even harder to spell. Let’s just say there are 17 of them and they have names like ytterbium, erbium, and praseodymium. I’m not sure the chemists that discovered and then named the elements back in the day were thinking long-term!

So where do you find this stuff?

The chart below shows how the known resources are distributed globally. It is predominantly found in just five countries: China, where most of it is produced, and Australia, Malawi, USA and Greenland.

The first thing to notice is that Greenland is sitting on 36% of known deposits. This is not often talked about but could be a very important part of the story in the future.

Greenland is home to a population of just 50,000 people. This is about the same number of people as there are in that Country Music capital of Australia, Tamworth. Yet this Scandinavian country is about the same size as Western Australia. Aussie listed Greenland Minerals (ASX:GGG) is sitting on an enormous JORC resource of over 4.5 million tonnes, but the government is currently opposed to developing it as it contains uranium as well.

The mind boggles when you consider the wealth that the Greenland government could generate from its deposit, and then consider how far this could go across the tiny population. You wonder how long the government can sit on their hands for as the non-China world starts screaming out for their minerals.

The Australian rare earths industry is sitting on 18% of global deposits and is far more advanced. Companies with deposits includes Alkane Resources (ASX:ALK), Navigator Resources (ASX:NAV), Lynas Corporation (ASX:LYC) and Arafura Resources (ASX:ARU). These companies are up by an average of 11% in the few days since the announcement of China’s export cut.

Kris Sayce is in the UK this week in the middle of a ‘heatwave’. This quote from UK paper confirms that: ‘Temperatures soared to 31.7C (89.1F) in Gravesend, Kent, yesterday – the highest in the UK this year.’

But before he went over to the sweat it out in the UK, he saw the potential for the Rare earths market to be pressured by the Chinese and made a recommendation for a Rare Earths company in Australian Small Cap Investigator. It is already sitting on 28% gain.

It is certainly a story to follow. Even if China relaxes its export restrictions in the future as some analysts expect, the country has confirmed that stable supply from China can’t be assumed in the future.

This is going to give other more reliable producers as great opportunity to supply the market, giving investors opportunities for gains.

Watch this space.

Dr Alex Cowie
For Money Morning Australia

Right now, the international risk system is dominated by three main companies: Moody’s, Standard & Poors and Fitch.

All three of these companies, didn’t see the global financial crisis coming, or the European debt crisis coming. And it’s precisely these events that Dagong International is using to its advantage.

But you can’t help but feel that this company has its own agenda.
Firstly, this Beijing based company claims to be completely independent of government interference as it’s privately owned. However the company made its most recent announcement at the Communists Party’s favourite propaganda machine, the head office of Xinhua News Agency.

And before we even get to the comments Dagong has made regarding the status of American debt, let’s not forget that China has recently invested more than USD$900 billion (AUD $1.02 trillion) in US Treasury debt.

So at the very least, you can say this company has a vested interest in promoting China.
This is where it gets interesting.

You see, Dagong has said that because of the strong hold that the three credit rating agencies have over the international market, China has been rated unfairly. In fact the company feels that they isn’t being given due credit for the strength of the economy and relatively low level of debt.

Some experts have agreed that the Western nations tend to judge developing nations unfairly.

And for the moment, we won’t even suggest that China is cooking their books, because this new agency does have a couple of valid points.

Shockingly, this new ratings agency has said that American debt deserves to be rated worse than Chinese debt. Which is at odds with the three major rating companies because they all believe that American debt is perfectly safe.

Actually, all three of the ratings power houses call it the ‘world’s safest’ debt.

Yep, this is the exact same three companies that gave mortgage-backed investments a high rating. And yes, the exact same mortgage-backed investments that have the States in the sticky debt-laden bed they now lay in.

It’s refreshing to another point of view on the matter. Something the rating’s industry desperately needs.

Yet, Dagong is only pointing out the obvious when it comes to the current financial problems in the US. The main reason the company rates America lower than China is because of the slow growth and high debt. As Dagong explains it, increasing borrowing costs and the risk of default for America is extremely high.

But here’s thing. We are really only just beginning to understand the debt problems unfolding in America. The all important ‘economic indicators’ are suggesting that a double-dip recession is looming.

This information isn’t new, but for months now everyone has chosen to believe that the recovery will happen. Because let’s be honest, who wants to think that things could get any worse for America?

So whose advice do we trust more? The powerful agencies that ‘own’ the ratings space and ‘missed’ all of the events that lead up to the GFC? Or a company that clearly has its own interests to look after?

Right now, we’d be suggesting neither. But it’s refreshing to finally have another opinion in the international credit ratings business, even if the company will have to hide their communist leanings.

Shae Smith
Assistant Editor
For Money Morning Australia

It's no secret that China's phenomenal growth has been driving the global recovery. China's first-quarter GDP grew at an 11.9% annual pace despite three significant increases to reserve requirements that were designed to cool lending and growth. That's why in much of 2009 and early 2010 I was bullish on China and overweighted my global portfolios in favor of this country.

But all good things must come to an end and right now it's time to get selective about which China stocks you buy. That's why I recommend investors cut back their China holdings and look for new opportunities in emerging markets.

Continue reading It's Time to Sell China -- and Buy These Emerging Markets

It's Time to Sell China -- and Buy These Emerging Markets originally appeared on BloggingStocks on Thu, 06 May 2010 13:15:00 EST. Please see our terms for use of feeds.

But there is something I wanted to mention today…

It’s been a while since we caught up with any of our old broker pals – probably because we’re a bit of a pariah these days.

But when we do meet up over the $13 all-you-can-eat buffet at the RACV Club in the next couple of weeks we’ll try and eke out of them what kind of message is going around Australia’s broking rooms.

Our guess – and it’s only a guess – is that it will be similar to the message written by Michael Pascoe in The Age yesterday. It was under the headline, “Why a China slowdown will be good news.”

The whole article has a similar ring to the “house prices will plateeeeeeaaaaauuuuu” argument.

You’ve got to give it to the mainstream, apparently nothing ever goes down. Except when it’s already gone down of course. But don’t mention that because everything’s going back up again.

But a pretty good sign of the market getting near the top is when brokers and commentators start cheering 5% and 10% falls in the stockmarket, or when growth in the economy slows, “Oh, it’s OK, the market needed to take a break, it’s a good buying opportunity.”

Or, the economy “needs to pause, it should plateeeeeeeaaaaauuuu from here for a few quarters…”

Sometimes that’s true, but when the mainstream is singing it in unison, it’s time to be on guard.

But all that aside, there’s more to worry about that just whether Pascoe thinks a slowing China will be good news.

It’s the whole attitude towards China that’s even more worrying. The general idea that the Chinese are privy to a miracle formula that enables them to conduct not only the Chinese economy but the global economy in the same way that Andre Previn conducts an orchestra.

Take this quote from Pascoe:

“China knows the switch must be thrown to greater domestic consumption and less reliance on export growth. The comrades are taking steps in that direction. It would be nice if they took more of them and did so faster, but they are wary of rocking their bus – there are an awful lot of people jammed into it.”

Again, the assumption is that China can throw a “switch” and miraculously everyone in China will perform exactly as directed. That everyone will buy and sell in exactly the correct quantity and at exactly the right time.

Not only that but they’ll also pay exactly the pre-set price when they buy something and receive precisely the right pre-set money when they sell something. And when they’ve got that money they’ll hold it for just the right time before spending it on something else as directed by central planners.

Make no mistake, that’s what central planning requires. Heaven forbid if someone should buy two pairs of shoes rather than one pair, or a jar of jam rather than marmalade. Doing so would send the whole plan out of kilter.

And even worse, should a black market develop where goods and services are provided at a different price or quantity than the central planners decree, then there’s another spanner thrown in the works.

Not that the mainstream commentators consider any of that. According to them, central planners such as the Chinese or the Reserve Bank of Australia can just throw a switch and individuals and businesses just eagerly follow the determined path like brainless automatons.

To be honest, we’re not sure why the Chinese government have been placed on this pedestal. We can only think that the mainstream believes because China operates a fully coercive economy, that it can order people about at its whim and therefore economic success is assured.

The reality is far from that.

No economy can be centrally planned continuously without it leading to an eventual total collapse. That the Chinese economy has managed to go on for so long is what’s really amazing.

But get something straight. I’m sure you’ve seen the impressive photos of the Shanghai skyline and the vibrant and bustling downtown areas. But just because yuppies in Shanghai are buying Rolex’s and Louis Vuitton bags doesn’t signify wealth any more than Australians buying a 150 inch plasma television or a seven-bedroom house signifies wealth.

Wealth and spending aren’t the same thing. You can have wealth without spending, spending without wealth and spending with wealth. Oh, and no wealth and no spending of course.

But to simply come to the conclusion that because some Chinese are spending on fancy watches and fancy cars that those individuals or the whole economy is wealthy is misleading to say the least.

The important thing to remember is that the Chinese economy has taken off, largely thanks to being able to provide western businesses with cheap labour and cheap production. But it has done so coercively.

For every fancy watch buying person in Shanghai, there’s thousands of others who haven’t curried favour with the government and are therefore left to suffer the consequences of a repressive society. A government created oppressive society.

And like any other coercive and violent government it has rewarded those it favours and hurt or destroyed those it dislikes.

But that doesn’t mean Western governments are no less discriminatory, just because Western governments have adopted minimum wage legislation. All that’s done is to push employment offshore into the lap of coercive governments. Where they own the means of production and force individuals to accept labour terms or… well, you get the picture.

Those left in the West unable to find work because they’ve been priced out of the market may not be forced to work in oppressive conditions, instead they become part of a permanent underclass relying on favours from their own coercive government.

A government that can turn the welfare tap on and off as it sees fit.

Without minimum wage legislation in Western economies, there would be less demand for cheaper overseas labour and less ability for socialist governments to control those individuals.

Besides, Western governments are no less guilty of giving favours to certain people and industries while simultaneously penalising those it considers to be less desirable.

So while Pascoe and the other mainstream cronies talk about the heroic Chinese government and its ability to flick a switch to point the economy in the right direction, they should remember that the switch flicking is not the result of free markets and free will.

It’s the result of coercion and violence.

I’ll make the point again, there’s much, much more to fear from putting more power into the hands of governments than there is from putting power into the hands of individuals. Yet people in the West have somehow become dependent and reliant and over-trusting of government authority.

The result is less freedom – as Shae will explain in Money Weekend tomorrow.

But to sum up, the idea that Australia can ride on the coattails of a booming Chinese economy forever is mistaken. Sure, take advantage of it while you can from an investment perspective – as we have in Australian Small-Cap Investigator and Alex has in Diggers & Drillers – but if you think it will last forever as the mainstream commentators seem to believe then I’m afraid you’re going to be sorely disappointed.

Cheers,
Kris.

Your editor is taking a long weekend. However, we’ve lined up a couple of guest essays to give you something to read while you’re tucking into your Easter eggs.

Tomorrow, BullionVault’s Adrian Ash will give you more info on China’s gold buying spree. And on Monday, Diggers & Drillers editor Alex Cowie will give you the lowdown on Australia’s second largest export commodity – coal.

In between, assistant editor Shae Smith will have the usual weekly round-up of events for you in Money Weekend on Saturday morning.

But until then, this…

If you want to get a good picture about how much money you can make as an investment banker, look no further than the latest press release from the Federal Reserve Bank of New York.

The press release states:

“The Federal Reserve Bank of New York today announced that it has expanded the information that it makes available to the public related to the Maiden Lane portfolios.”

So what? Well, the Maiden Lane portfolios are the quaint and innocuous sounding names given to the government owned holding of former Wall Street heavyweights Bear Stearns and American International Group (AIG).

For your pleasure, Maiden Lane holds USD$74.9 billion, Maiden Lane II USD$34.8 billion and Maiden Lane III USD$56 billion.

But funnily enough, that’s not even the full picture. Because as the Fed points out:

“The new information includes nearly all of the holdings of Maiden Lane LLC (ML)-with the exception of residential whole loans as that would violate individual borrowers’ privacy…”

In other words, it doesn’t contain all the crappy subprime mortgage loans that are rotting away on the balance sheet.

But it’s not the dollar number that amazes us so much – we expected that – rather it’s the number of ‘assets’ in the portfolios.

Each asset represents a deal that has been lovingly crafted and nurtured by a caring and responsible parent – or, investment banker.

Take this one from the Maiden Lane portfolio:

IVYL_06-1A A1 144A (cusip: 46601QAC2) – USD$102,286,000

Or this valuable asset from the Maiden Lane III portfolio:

ALTS_05-1A ALTB 144A (cusip: 02149RAC2) – USD$1,102,582,000

Beautiful aren’t they!

Unfortunately your editor doesn’t have access to the wildly expensive Bloomberg Professional service which would reveal exactly what these investment gems are. So we’re somewhat in the dark.

[Ed note: If you do use the Bloomberg Professional service, feel free to send a screen grab of the description page of these assets to moneymorning@moneymorning.com.au, we'd greatly appreciate it].

The first one we’ve got no idea what it could be. The second we’ll take a wild guess. It could be a coincidence, but we do recall the bank examiner to the Lehman Brothers collapse referring to ‘Alt-B’ residential mortgage backed securities.

Without going through the 2,000+ page report again, our addled brain tells us Alt-B mortgages were almost as risky as Alt-A loans, which themselves were only slightly less risky than Subprime loans.

But, as we say, it could be a coincidence. Whatever they are, USD$1.1 billion is a heck of a lot of money. And remember, that’s just one deal. And it’s also just the amount held by Maiden Lane III. Consider how much of this stuff is being held by the banks and funds that haven’t gone bust.

We haven’t counted all the individual ‘assets’ in these portfolios, but looking at the number of pages they run to, you’re looking at thousands of them. And as we say, these are just the ones revealed by these bust companies.

And each asset represents part of a deal crafted by the bankers to rip money from investors. Investors who for the most part have absolutely no idea they’ve bought any of this stuff.

It helps to give you an insight into how investment banks like Macquarie Group became known as the ‘millionaires factory.’

Quite frankly, it all backs up our ages-long skepticism towards any investment that’s ‘packaged’ for retail customers. It doesn’t matter whether it’s a packaged property investment, a packaged share investment or a packaged bond investment, I just don’t like them.

The trouble is, part of the reason these types of investment are so popular is due to compulsory retirement savings schemes both here and overseas.

When individuals don’t have direct personal control over their savings, it ends up in the hands of investment managers or advisers who prefer to take the easy route. And what could be easier than chucking millions of dollars at an investment banker who tells you that investment ‘ALTS_05-1A ALTB 144A’ is the best thing since Google went public.

Compulsory savings schemes are just like any other compulsory scheme. Because you’ve got no choice but to do it, you see it as an impost or a burden, and therefore you take less care and less interest in it.

If there was no compulsory savings then investment managers would have to try and attract your savings. And chances are you’d want to know exactly where that money was going.

If your monthly retirement contribution came out of your pocket rather than being paid for before it gets to your pocket, don’t you think you’d want to know where it’s going?

Can you imagine any investment manager saying this to you:

“Oh, I thought we’d buy you $10,000 worth of ALTS_05-1A ALTB 144A. It’s a lovely little investment. It’s got an exposure to over-leveraged, marginal home owners in Michigan, Alabama and Wisconsin. The clever thing is, we’ve managed to engineer the investment so that all these crappy borrowers with low credit scores are classified as a triple-A credit rating. It’s clever because it means I get to make the sale and earn a million bucks by making you think it’s low risk, but you still lose all your money when investors figure out how rubbish it is. Everyone’s a winner – except you! Sign here…”

Would you buy? Thought not.

Of course, when investments are pooled, you’ve got no idea, and very little say in the matter. When the individual has control, then it’s a different story.

Don’t get me wrong, individuals make investing mistakes too when they’re left in charge of their own money. People who fell in with Opes Prime and Storm Financial are a classic example.

But the point is, when individuals have control over their investments they should have a better understanding over where that money is invested.

And even the Storm and Opes Prime examples – as we understand it – are more of a case of investors being told what to do rather than the whole process being explained to them properly.

But the way we see it, much of the cause of the excesses in financial markets is due to financial engineers having too much access to investor’s cash, too much access to bank-created credit, and too much of an incentive to get create new products and investments for the sake of earning a fee rather than because it’s a good investment for the punters.

Our fear is things will only get worse if trade unions and property spruikers have their way and convince politicians that retirement money should be compulsorily invested in pointless infrastructure projects, residential mortgage backed securities or government backed annuities.

What’s the solution? Well, that’s something Dan Denning and I are working on in Australian Wealth Gameplan. But I’ll also fill you in with some ideas in the next few weeks in Money Morning.

Cheers,
Kris.

“CHINA BUYS GOLD” is the story that all commodity journalists want to break, and the headline that gold bugs the world over most want to read.

Because if (or when) the People’s Bank of China shifts from quietly adding domestic mine output to its reserves…and starts buying gold bullion in the international market instead…the rapture of $5000 gold will be upon us.

It’s unlikely to play out like that, however – not until 2016 at least. First because Beijing’s policy wonks aren’t so stupid. And second, because “China buys gold” is already old news.

Mistaking a part for the whole – and assuming that China means the People’s Bank alone – means missing the huge growth in private Chinese household demand of the last 5 years.

Rising 85% by weight since 2004, China’s private gold demand has more than quadrupled in Dollars. It pretty much doubled by value in terms of both Dollars and the Renminbi in the last two years alone, rising to $13.6 billion in 2009.

Overall, China accounted for more than 14% of global gold investment and jewelry demand last year on the World Gold Council/GFMS data – a close second to the 16% of private world hoarding swallowed by India.

Now the World Gold Council forecasts that China’s annual gold consumption has the potential to double in the next 10 years. Its new report notes the link between China’s gold demand, runaway GDP growth, and phenomenal household savings rate. But it doesn’t put a figure on that relationship – itself a blunt rebuke of the idea that modernization and consumer capitalism would see gold cast off as a barbaric relic…

Based on World Bank estimates of China’s household savings rate – probably worth some $660bn last year – the proportion of private savings spent on gold investment and jewelry each year has almost doubled to 2.1% since the market was deregulated in 2001.

Yi Gang, deputy governor of the People’s Bank of China and administrator of the State Administration of Foreign Exchange (SAFE), recently estimated that private households own some 3000 tonnes of gold. Two-thirds of that has been accumulated in the last 5 years alone. Those 1890 tonnes outweigh by four times the gold bought by SAFE and then transferred to the People’s Bank between 2002 and 2009.

Perhaps that’s been just as Beijing intended. Gold Mining output is a strategic target in the regime’s current 5-year plan. Sending money offshore to plug the widening gap between local supply and demand, private citizens help reduce China’s side of the global trade imbalance. They’ve also, all told, drained some $44bn from the banking system by swapping cash and bank-deposits for metal since the start of 2004. They’d clearly like to buy more, too.

“The size of the gold market is limited,” Yi went on. “So China’s [official] purchases of gold in the global market would push up global prices…China’s domestic Gold Prices are related to global prices, so Chinese consumers will face higher prices and they won’t like it.”

The People’s Bank, in other words, is sticking with its policy of buying domestic mine production for its own reserves – rather than open market supplies – because it’s worried about upsetting China’s voracious gold-buying public. Which is awfully sweet of the Communist dictators.

Trouble is, based on below-ground reserve estimates and the surge in China’s mine output, China’s gold mines could be all gone within six year says data from the US Geological Survey. So if the People’s Bank finds good cause to keep buying gold in 2016, it will have to turn either to the global market…or pick up non-mine supplies closer-to-home…where it will just happen to find an extra 6,000 tonnes, according to the World Gold Council’s projections, added to today’s privately-held jewelry, coins and bars.

Handy!

Nationalizing private gold was what the US government did, under F.D.Roosevelt, when it banned private gold-bar and coin ownership in 1933. Which was a pity. Because that post-inflationary slump known as the Great Depression – which merely paused, and didn’t halt, the United States’ progress as world No.1 economy – would have proved a great time to preserve wealth with gold.

The Treasury confiscated gold – on pain of a $10,000 fine or imprisonment – at the price of $20.67 an ounce. Then raising the value of its hoard to $35 an ounce, Washington banned private dealing in non-adornment metal, leaving anyone who neglected to turn in their US-held gold a fugitive the moment they tried to sell it. Clinging onto gold outside the domestic US, on the other, and remaining free to realize its value, meant enjoying a 90% drop in the price of listed US equities, plus a halving in the cost of living.

That’s something China’s private gold-buyers might want to bear in mind today…if only they can get money offshore to buy gold and keep it there.

Adrian Ash
for Money Morning Australia

Adrian Ash is head of research at www.BullionVault.com

“Tanner takes razor to red tape”

Apparently, “The Rudd government will increase the powers of its red-tape regulator in a bid to prevent any unnecessary rules from stifling economic growth…”

Red-tape regulator!

Anyway, it goes on, “Finance Minister Lindsay Tanner will subject new legislation and regulation to greater scrutiny while also forcing the heads of government departments to take greater personal responsibility for finding ways to cut regulatory costs.”

Sounds good doesn’t it? Heads of government departments cutting regulatory costs. Hmm, how will they do that we wonder?

But that’s the trouble, they can’t. It’s impossible. There’s no market mechanism for them to benchmark against. It’s not as though federal government departments can send spies out to see what that other Australian federal government is doing, because there isn’t one.

And even the idea that it can benchmark against other departments’ costs is false. Without a motivation to make a profit, and fully knowing that any shortfall can be covered by increased taxes or public borrowing, governments can’t know whether it is saving money.

Besides, hapless public servants will inevitably fall for the old, “costs have increased due to inflation” trick.

They’ll see any cost increase in-line with price inflation or just below price inflation as a ’saving.’ Their other trick will be to claim the rate of cost increases is lower than in previous years.

Either way, there won’t be any savings.

But back to the AFR. The bit that really tickled us was this:

“Mr Tanner has finalized orders that would empower an independent agency to decide whether a department needed to report on the economic cost of a new regulation, taking the decision out of the hands of the department itself. The change gives the Office of Best Practice Regulation (OBPR) greater authority to scrutinize laws and rules proposed by departments…”

Ah, only in government. You can imagine the conversation when this OBPR department was set up:

Pen-pusher 1: I’ve had a great idea of how we can cut red tape.

Pen-pusher 1: I know.

Only a chump would think that creating a whole new government bureaucracy in some way reduces bureaucracy. One step forward, two steps back.

However, that wasn’t the most ridiculous thing we read yesterday. That honour goes to Nobel prize winning economist Paul Krugman for his column in the New York Times.

As we’ve written before, not only is it sad that a supposedly well educated man like Krugman could get so much wrong, but it’s even sadder that so many people read and truly believe what he has to say.

And even sadderer is that the chumps in government largely follow his advice.

Take this bit of babble:

“Most of the world’s large economies are stuck in a liquidity trap – deeply depressed, but unable to generate a recovery by cutting interest rates because the relevant rates are already near zero.”

Doesn’t something seem terribly wrong with that argument? If low interest rates was the solution to excessive debt then surely interest rates near zero would already have solved the problem.

Wouldn’t the fact that it hasn’t solved the problem not make you think that perhaps, just perhaps, low interest rates aren’t the solution at all?

Perhaps when you keep doing the same thing – cutting rates – and it keeps causing the same problems – excessive credit – the answer is to do something else. Such as not letting the ‘excessive credit genie’ out of the bottle in the first place.

Not according to Krugman. With interest rates near zero, he and his Keynesian mates are in a bind. They’ve got no more ideas apart from closing their eyes and wishing really hard that it will all go away.

Actually, that’s not strictly true because – wait for it – Krugman does have a cunning plan.

But before I reveal his dastardly deed to solve the world’s woes, there is a point he makes about what would happen if China started to dump US dollars. Something we covered in yesterday’s Money Morning.

Krugman asks:

“What you have to ask is, What would happen if China tried to sell a large share of its US assets? Would interest rates soar?”

No need to bother yourself by thinking of an answer, Krugman’s got that sorted:

“Short-term US interest rates wouldn’t change: they’re being kept near zero by the Fed, which won’t raise rates until the unemployment rate comes down.”

Is that possible? Let’s think about it. Let’s look at the transaction from the both sides.

If the Chinese did dump US dollars then they’re doing so because they believe something else represents better value. Either they’re selling US dollars to buy another currency to hold, or they’re selling US dollars to buy a physical commodity or some other asset.

Either way, the seller is selling because it values the US dollar less than the currency or item it’s buying.

But what about the buyer of the US dollars? If the buyer is a firm that’s sold a commodity or other good to the Chinese then the buyer of the US dollars will either keep the dollars to invest or it too will trade them in for something else – another currency maybe, or more supplies for the business.

Again, the business makes a decision about which is more valuable or useful to it – the US dollars or what can be bought using US dollars.

So, to avoid lengthening this example, let’s assume the firm intends on saving whatever proceeds it has. Its first choice is to keep the money in US dollars and earn only a fraction of a percent in interest.

That’s not much of a return. But the firm must really believe that’s the best investment for them when all things are considered. If it wasn’t it wouldn’t make the investment.

But that’s a firm buying and selling stuff. Let’s also consider a big global investing firm. In both instances the investors that need to get a return for their clients. Is holding US dollars such a great idea?

It certainly isn’t a good idea if you’re concerned that a big holder of US dollars – China – plans on selling lots and lots of the little Greenbacks.

The reason it’s not a good idea for the investor is this, when any asset is sold down, the price tends to fall. It’s the same for shares, property, bonds, and even currencies.

If that happens, then relative to other currencies, those investors that continue to hold US dollars would see the value of their US dollar assets fall. The knock-on effect is that investors would anticipate a further sell-off and therefore look to sell their US dollar positions first. It would be the proverbial rush for the exit. Unless…

What’s the one thing that could discourage an investor from selling a depreciating asset? One thing would be an increase in the income flow from retaining the currency. In other words, a higher rate of interest.

If as an investor you’re offered a higher rate of interest, you may view this as an acceptable trade-off to counteract the falling value of the dollar. This could make you less likely to sell your US dollars.

But if there is no interest rate incentive it’s only natural an investor would look to sell out before other sellers pushed the price down.

With no comparable increase in the interest rate, the investor isn’t getting paid for holding on to the currency.

And furthermore, if the investors knew in advance that interest rates would not rise then why hang around waiting for something that’s not going to happen. And investors must be pretty certain interest rates won’t go up because the US Federal Reserve tells them so:

“…warrant exceptionally low levels of the federal funds rate for an extended period.”

OK, “low” doesn’t necessarily mean zero, but it clearly doesn’t mean 2% or 3%.

But the typical response to that is, won’t the ‘free market’ automatically adjust interest rates higher? Correct, a ‘free market’ would do that. But don’t forget, whenever there is a central bank a free market in the truest form doesn’t exist.

Besides, as Krugman ingeniously points out:

“Long-term rates might rise slightly, but they’re mainly determined by market expectations of future short-term rates. Also, the Fed could offset any interest-rate impact of a Chinese pullback by expanding its own purchases of long-term bonds.”

That’s right, the Fed will keep interest rates low by just buying up all the bonds. Bond sellers will get a bail-out and receive top dollar rather than suffer losses from falling bond prices. And buyers who may have bought bonds at a lower price (when bond prices fall interest rates rise) won’t get a chance to benefit from a lower bond price and higher interest rate because the Fed will just print money to try and support the bond price at a higher level and therefore maintain low interest rates.

That means investors who may have been tempted to keep hold of their US dollars in order to invest in lower priced bonds with a higher yielding interest rate will now have no incentive to do so.

I mean, seriously, can it really be true that a Nobel Prize winning economist thinks it’s a good idea for the Fed to create money from thin air to pay off debts? It’s just not logical.

Think about it, if it was such a good idea why don’t all governments do it? Then there would be no government debt at all and we could all start from scratch. Better still, why not let all private individuals do the same thing?

Krugman and the dopes at the Fed must surely know that monetizing debt by just creating more money to pay it off is a bad idea.

But just in case you need confirmation of why it’s a bad idea, it’s simply this. It’s an appalling inflationary tactic that harms everyone. The only short-term beneficiaries are the government as it doesn’t need to suffer the wrath of the electorate by either cutting services, raising taxes, or defaulting on debt.

Everyone else is a loser.

Naturally Krugman wraps up his sorry tale with another fallacy:

“It’s true that if China dumped its U.S. assets the value of the dollar would fall against other major currencies, such as the euro. But that would be a good thing for the United States, since it would make our goods more competitive and reduce our trade deficit. On the other hand, it would be a bad thing for China, which would suffer large losses on its dollar holdings. In short, right now America has China over a barrel, not the other way around.”

We can only think he’s got in mind that old saying: “If you’re in debt to the bank for a million dollars and you can’t pay it back, you’re in big trouble. But if you’re in debt to the bank for a billion dollars and you can’t pay it back, the bank is in big trouble.”

It’s a nice saying. Very twee. Trouble is, it’s not true in the case of the individual, and it’s not true in the case of China. Although granted, for different reasons.

Although it’s true that the obligations the US has to China is little more than the ‘promise to pay the bearer’ a gazillion dollars, the reality is that the US doesn’t have China over a barrel at all, far from it.

As we pointed out yesterday, China is probably already resigned to losing a big chunk of its US dollars. That’s why it’s building skyscrapers instead of building piles of Greenbacks.

According to Krugman, China has around the equivalent of USD$2.4 trillion of reserves. Of which, according to the US Treasury, USD$889 billion is held in US treasury securities.

In other words, about 37% of China’s reserves are in US dollar bonds.

So, if China did dump all of its bonds and US dollars, what would the impact be? Well, we’ll assume the bonds and dollar isn’t going to fall to zero – we’ll assume that because Krugman seems confident the Fed would backstop it by buying up these securities!

Therefore, the Chinese may take something of a hit, but unless we’re talking hyper-inflationary money printing by the Fed – which is possible – then the Chinese will still get something out of it.

But even if we are talking hyper-inflation, so what. China has 63% of its reserves that aren’t denominated in US dollars. That’s 63% of its reserves which would increase in value relative to US dollars. What it loses in US dollar terms it gains in all other terms – China has a hedged exposure.

The losers would be America not China. A terminally weakened currency and massive debt which no one would want to buy. Not until hyper-inflation had run its course anyway.

A nation that would be unable to afford to import goods and services. The only possible savior for the US is its massive holding of gold – providing it’s all accounted for! But even so, that doesn’t necessarily give it a get-out-of-jail-free card. Having a store of gold is fine, but unless the US could do a quick about-turn and reinvigorate its formerly productive economy, then the gold would slowly but surely be exported in exchange for consumer goods.

Let me put it this way. The picture Krugman paints is a world where everyone pays off their own debt by creating money out of thin air, and where the economically successful economies play second fiddle to the weak and desperate.

It’s a world that doesn’t and cannot exist. It only exists in the child-like minds of mainstream economists who fail to understand the real consequences of harmful government and central bank policies.

Don’t get us wrong, we think the whole China story is a bubble waiting to pop. But the idea that the US is playing this perfectly and holds the upper hand is completely and utterly false.

Cheers.
Kris.

Greece on the verge of default – [whistle].

China trying to engineer a soft economic landing – [whistle].

US Federal Reserve increasing interest rates – [whistle].

Australian property bubble bubbling – [whistle].

Millions of your taxpayer dollars wasted on home insulation stimulus – [whistle].

But funnily enough, it’s the mainstream response to the last one that baffles us the most.

After four insulation installers have been killed – and doubtless tens or hundreds of others have been injured – and at least 87 fires have resulted from the installations, Environment Minister Peter Garrett has abandoned the scheme.

Of course, already, billions of taxpayer dollars have been spent on this monumental waste of money.

But here’s the thing we don’t get. At the time all these whacky schemes were announced, the mainstream told you that it was necessary to spend money because spending money was good for the economy.

You remember that don’t you?

Well, if spending money is good for the economy, then surely the disastrous outcome of the housing insulation scheme is an unexpected boost for the economy.

Because if simply spending money is good, then surely spending more money is even better.

The government now has to fork out hundreds of millions of dollars more to arrange for inspectors to make sure the work on at least 48,000 properties has been done properly.

Doubtless it hasn’t – hence the four deaths – so those inspectors will need to arrange for the work to be fixed up. That will cost more money.

Then we’re sure that just to be on the safe side, the government will send inspectors out again to make sure the fix-ups are safe – there’s even more taxpayer dollars spent.

According to the lame thinking of the mainstream that should all equal a boost to the economy, as more taxpayers dollars are spent.

Not surprisingly, the mainstream press haven’t mentioned any of this. Either because they’re too thick to work it out, or because they realise how illogical the idea of stimulus spending is, but they don’t want to admit it. After all, spending other people’s money is fun!

Aside from the wasteful spending, the 6,000 job losses suffered in the home insulation sector is another perfect example of how the misallocation of resources can permanently damage the economy.

As Paul Howes, national secretary of the Australian Workers Union points out, “77,000 jobs went in manufacturing, and the knock-on of that will be felt for years and decades ahead as factories were shut that will never re-open.”

Of course, what Mr. Howes fails to point out is that it’s the unions that help to ensure there are job losses. Their push for higher minimum wages guarantees that Australian businesses will either go bust or have to ship the work offshore.

And he doesn’t mention the millions of other manufacturing jobs that have vanished over the years thanks to the trade union movement.

But here’s the bigger problem. All the excitement about the stimulus programmes ‘creating’ new jobs masks the fact that those jobs which didn’t benefit from direct stimulus spending – such as manufacturing – lost jobs.

Not only that, but once a factory has closed down, as Mr. Howes correctly points out, they “will never re-open.”

If it was uneconomical to maintain a manufacturing business, it will be ten-times more uneconomical to try and re-start one from scratch.

Yet, all those jobs that were ‘created’ by the government to install insulation, what’s happened to them? Oh, that’s right, the programme has been cancelled. So the billions of dollars spent on ‘creating’ jobs have not only destroyed 77,000 manufacturing jobs, but it’s not even benefited the industries that were supposed to gain.

As we wrote a year ago on 4th February 2009:

“The government economic stimulus package will have no positive impact on the broader economy whatsoever. None.”

Yet again we’ve been proved right, and the mainstream press proved wrong.

At the time we also quoted some of the shrill headlines from the mainstream press:

“Rudd throws $42bn at economy” – Australian Financial Review

“Schoolyard blitz to avoid recession” – AFR

“We’re all in this together: except Turnbull” – AFR

“Rudd and the Reserve free up billions to beat recession” – The Age

“Rudd splashes the cash” – The Age

Every last one of them cheering for the government to spend your money to save the economy. Not a single journo was capable of expending one brain cell to figure out what the terrible consequences for the Australian economy would be.

An economy that believes the best solution to national wealth is to build, and then buy and sell houses between each other.

But there’s the consequence for you. One industry gets a bunch of stolen taxpayer money to keep prices sky-high and the credit bubble growing. The other industry gets swamped and ravaged by trade unions and minimum wage legislation which forces it to close down forever.

The upshot is the Australian economy hasn’t benefited one jot from the billions spent in the stimulus programme. All it’s done is allocated resources to prevent a bubble from popping – for now – and ensure thousands of people have received training for an industry that can’t possibly sustain them without the presence of taxpayer money.

Because if it could, then they wouldn’t need the stimulus to begin with – it’s not rocket science.

Despite the complete failure of stimulus spending we’ve little doubt the spin doctors will continue to call for more taxpayer dollars to be thrown at the economy – especially the housing sector.

And as long as that happens then we’ll continue to see headlines such as this:

“Housing debt in overdrive” – News Ltd

According to journalist Anthony Keane, “Total housing debt is set to reach $1 trillion within a year. The figure itself is not a worry, but there is concern the pace of borrowing is exceeding household income growth.”

“Not a worry”! Is he mad?

Nearly $1 trillion isn’t a worry? Oh Lordy. We’ve heard it all now.

But anyway, we’ll end today on that note. As we’ll get stuck into housing again tomorrow.

Cheers.
Kris.

CHINA’S LATEST SLEW of positive data “raises the prospect” of Beijing tightening its easy money and fiscal policies, or so the newswires claim. Currency strategist Steven Barrow at Standard Bank adds that China could be more significant for global liquidity than the United States, too.

Because the Fed’s asset pile is nothing next to the People’s Bank’s hoard of cash, he says. So “the Fed’s grip on the [easy-money] punchbowl is not as firm as the market might think,” as shown by Barrow’s chart below.

The upshot for gold investors? Given that China’s foreign reserves are at least 50% held in US Treasuries, dollars and government-backed agency bonds…and given that gold has risen four-fold vs. the greenback inside 10 years…and seeing how the gold market is currently spooked by a whiff of improving US data, and the tang of non-zero Dollar rates it might imply…it might be worth a look.

So let’s squint through our telescope…10,000 miles distant.

Since the start of 2000, China’s official gold reserves have grown by 167% to 1,054 tonnes, now the world’s fifth largest central-bank hoard. That contrasts with the US Treasury sitting pat at 8,133 tonnes (the world’s largest single hoard) and Western European banks selling around one-fifth of their “legacy” holdings so far this decade, (now down below 12,016 tonnes).

Beijing’s style of reporting on gold also contrasts with Western announcements, made over the last 10 years within the precepts of the Central Bank Gold Agreement first signed in Sept. 1999 and renewed again this autumn. The CBGA sets a pre-declared sales ceiling of 400 tonnes per year, and also includes the International Monetary Fund’s 403-tonne divestment (now half done thanks to the Reserve Bank of India buying 200 tonnes of IMF in October). Whereas the word “secretive” doesn’t begin to describe China’s official gold dealings.

The People’s Bank only reports changes to its gold holdings occasionally and erratically. Pace the World Gold Council’s numbers:

• In 1981 China had 395 tonnes;
• End-2001 that moved to 500.8 tonnes;
• End-2002 it rose to 600 tonnes;
• April 2009 saw China announce it held 1054 tonnes.

This spring’s announcement from Hu Xiaolian of the State Administration of Foreign Exchange referred to buying since 2003, she said. The actual news apparently came due to an accounting shift, out of SAFE and into People’s Bank reserves. That was significant in itself, perhaps, because it moved the 75% increase in gold bullion holdings from sovereign wealth management to central-bank ballast.

So on hearing the news, “China’s announcement signals a broader shift in central banks’ attitude towards gold,” said Philip Klapwijk, chairman of the world-leading GFMS precious metals consultancy. “[This is] reigniting gold’s relevance as a monetary asset,” agreed Suki Cooper, gold analyst at Barclays Capital.

But was it really the big story? April’s announcement took gold to around 1.6% of China’s foreign currency reserves. Which was in fact lower than the 2003 level of 2%, courtesy of the 7-fold growth in China’s foreign currency hoard…now around $2 trillion, up from $159bn at start-2000.

Bear that slippage in mind below…and bear in mind that the real Chinese demand story, both comparatively and across the global gold market, continues to be private consumption.

Basis the GFMS consultancy’s data, Chinese households spent more on gold jewelry and physical investment during the third quarter of ‘09 than during all of full-year 2005. Spending a total of US$3.7 billion on the metal, Chinese consumers confirmed their world-beating demand for 2009-to-date, overtaking Indian households as the world’s No.1 buyers.

Considering that jewelry taxes were only relaxed in 2002, and investment was allowed only from 2005, that’s some move to now top the table, even for the world’s most populous nation. And on our analysis here at BullionVault – based on World Bank estimates and GFMS figures – private mainland gold demand now equals some 2.0% of China’s famously massive household savings, up from 1.0% ten years ago…and even as annual household savings have more than trebled.

Most critically, private mainland demand over the last five years has been almost four times what the People’s Bank acquired from 2003-2009, piling up a massive 1775 tonnes in private hands. Cumulative buying rose 16% by value in the first 9 months of this year versus the same period in ‘08. But how much Beijing’s easy-money and fiscal stimulus is to thank – rather than cultural trust in gold and quasi-religious auspicion, both polished by private wealth accumulation – who can say…?

(Adornment and investment motives, as an aside, are more difficult to separate in the East than here in the West. Hence the catch-all “investment jewelry” referred to by Wall Street and City analysts looking at Indian and Asian gold.)

Back at the People’s Bank – which employs fewer staff per 100,000 of population than anyone else by the way, down at 0.19 compared to the Fed’s 19.9 and Russia’s staggering 71.2 according to the Economist this week – official opinion on gold is divided. What the European and North American financial pages typically see as a communist monolith in fact contains (and gives voice to) a diverse and often controversial set of views. But three aims seem clear:

1. Diversification: Beijing’s wonks don’t need to read the Journal of Portfolio Management to know gold’s quadrupled vs. USD, Yen, Sterling, CHF (and Yuan) and trebled vs. Euro since 2000;
2. Domestic crowd-pleasing: See household demand above, and set next to the Reserve Bank of India buying 200 tonnes from the IMF…just as private Indian households slow their gold hoarding in the face of relentlessly higher prices;
3. Economic prestige: The golden rule (He who has the gold etc) will suit even Beijing’s longest long-term thinkers. The United States ended WWII with more than 21,000 tonnes of gold, some 70% of total monetary metal. Dollar rule came as a direct result. So if the Dollar’s now toast, and power is truly shifting across the Pacific, the big picture would demand a big pile of bullion.

That’s why (or so we guess) State Council advisor Ji Xiaonan believes Beijing should start investing in at least 1,000 tonnes of gold per year for its official reserves. Claiming to have led an expert ‘task force’ on the matter last year, “We suggested that China’s gold reserves should reach 6,000 tons in the next 3-5 years and perhaps 10,000 tons in 8-10 years,” the China Youth Daily quoted Ji in late November. Yet the Western media, typically, misread that quote, saying “That is in line with many officials’ view that China should decrease the proportion of its $2 trillion foreign exchange reserves held in Dollar-linked investments and raise its gold holdings to diversify its portfolio.”

Not quite. Because for central banks, gold is a politically-charged asset, not simply a portfolio hedge. “Germany in 1944 could buy materials during the war only with gold,” as Alan Greenspan noted in 1999. “Fiat money in extremis is accepted by nobody.” And look at the numbers Ji quoted – 6,000 tonnes would take China way above Germany. 10,000 would trump Washington.

Gold is a safe haven for all investors because there is “no violation of contract” noted Zhang Bingnan, a senior member of the China Gold Association, to Reuters at the Shanghai Gold Conference last week. “Gold is the only non-credit product in the financial market.” These attributes only stand out more clearly for central bank policy wonks and long-term planners hoping to keep control of the fastest-growing economy on earth.

Still, the People’s Bank can’t avoid T-bonds entirely, of course, even if it is cutting its agency holdings. There’s simply not enough gold in the world, and too many Dollars, for that. That’s why “We hate you guys,” as Luo Ping, a director-general at the China Banking Regulatory Commission (CBRC) complained on a visit to New York in February.

“Once you start issuing $1-$2 trillion…we know the Dollar is going to depreciate, so we hate you guys, but there is nothing much we can do.”

One thing Chinese officials can do – if they’re to try and keep pace with private gold demand, and anchor the nation’s money reserves with gold – is to buy directly from the minehead. That was how South Africa built its forex reserves during apartheid sanctions in the late 20th century. Back then, South Africa was the world’s No.1 mining producer. It just so happens that China is today.

“It’s cheaper for us to buy gold from the Chinese market,” said an un-named People’s Bank official to Western journalists last month, “but it doesn’t help diversify our huge foreign exchange reserves. Even if China bought half the world’s annual gold supply, it would only cost a few tens of billions of dollars, which is tiny compared to China’s huge reserves.”

“Even if it’s sold at a market price, we should still buy,” counters Xia Bin, head of a key Beijing think tank advising the State Council cabinet (and also making plain that this is his personal view).

“India’s okay with it, why shouldn’t we be? What’s the use for so many dollars, whose purchasing power is weakening anyway? With so many foreign reserves in hand, I think China should buy, without doubt.”

Either way, “China has the scope to step up gold purchases but should take a long-term approach, avoiding the open market,” says Zhang of the China Gold Association. “If we adopt a too aggressive and rash manner, it is not practical.” Because China-inspired surges in the gold price would only work to make buying gold more expensive, as the recent case of India’s 200-tonne purchase makes plain.

India’s move was “probably the most remarkable event in the gold market since the Central Bank Gold Agreement (CBGA) was announced in late September 1999,” according to Matt Turner at the VM Group. Glance at November’s price chart and you’ve got to agree, at least short term. Gold cut a straight line from $1045 to $1226 an ounce.

Yes, it’s come down sharply from there. But that’s perfect for price-conscious consumers getting set for January’s New Year celebrations…and it’s just the thing for long-term strategic planners wanting to build their hoard.

Adrian Ash
for Money Morning Australia

Adrian Ash is head of research at www.BullionVault.com