Friday, December 4, 2009

Is the Chinese Fox Out to Get the Golden Hens, as they Rush Out of Their "Bubble" Coop?

The Chinese are crying bloody murder. Yesterday the Telegraph reported a senior Chinese central bank official as saying that the gold market is a bubble. The paper quotes Hu Xiaolian, a vice-governor at the People's Bank of China, as saying that Bejing will not buy gold indiscriminately.
“We must keep in mind the long-term effects when considering what to use as our reserves,” she said. “We must watch out for bubbles forming on certain assets and be careful in those areas.”
To us the statement reeks of self-interest. It is akin to the fox telling the farmer to leave the hen house unguarded.
Is the gold market in a bubble?
We don't think so. Admittedly most of the bubble talk has come because of the sharp parabolic increase in gold prices over November. But just because a spike is parabolic does not necessarily imply we are in bubble territory. Consider this: the average price of gold in 2008 was $871 (with a peak of $1030). Thus far at the end of 2009 gold is trading at ~$1200 which amounts to a 37% increase. Is that bubble territory? Clearly not.
Tim Iacono recently published an excellent analysis on gold's bubble-talk on The Big Picture. We highly recommend a full read of his article, where he points out that since gold began its ascent in 2000 there have been at least 2 periods where gold has surged by 50-70%. And despite these significant surges the market has kept trending up. This he says, is clearly counter intutive to a bubble formation because:
"If this is a gold bubble, it’s unlike any other bubble that I’ve ever come across because it keeps happening over and over. Normally, after a bubble reaches its maximum point of inflation and pops, it stays popped and doesn’t begin to inflate again for many years or even decades – think Nikkei stocks in 1989, Nasdaq stocks in 2000, and housing in 2005. If the current move up in gold is a bubble it has to be some kind of new “recurring” bubble. Of course, governments around the world could probably put an end to these recurring gold bubbles if they took Paul Volcker-like tough-love measures to restore confidence in paper money once and for all. But, realistically, given today’s decision makers, there are probably only two chances of that happening – slim and none, slim reportedly having just left town".
Now we do not dismiss that the gold market could undergo severe corrections from time to time. In fact we fully expect it. One must also remember that there is some amount of carry trade going on in gold, which could get unwound. In addition we do not dismiss covert Fed intervention in the gold market to try to suppress its rapid ascent from time to time. However we firmly believe that as long as governments keep printing paper (think Japanese and U.S. quantitative easing), the upward trend in gold is intact and will be awfully hard to suppress.
So why the bubble talk from China on gold? Is China talking gold down in order to buy the remainder of IMF gold for cheap?
This thesis has been postulated by some folks who reason that China is trying to talk gold down in order to buy IMF gold for cheap, say ~$800/oz. While this scenario is possible, it is not very likely in our opinion. The reason being, that even if China were to save $2.6 billion, purchasing 200 tons of IMF gold @ $800/oz (instead of $1,200/oz), its purchase would immediately put its remaining ~$2.3 trillion of dollar holdings in jeopardy. A Chinese purchase of an enormous 200 tons of IMF gold would almost surely be seen as a strong signal of its lack of confidence in the dollar. Therefore such an overt purchase from China is unlikely in our opinion.
In addition, unlike India which has no significant gold mining assets and therefore has to import gold from other nations, China is a huge producer of gold. Any Chinese diversification out of the dollar will most likely be met by its own domestic production and via covert purchases from other nations/central banks.
It is important to note that China itself has been busy accumulating gold at break-neck speed
In April of this year China disclosed that it had quietly doubled its gold reserves to 1,054 tonnes, from 600 tonnes in 2003. Although this amounts to less that 2% of China's foreign exchange reserves, it represents the world’s fifth largest gold holding. In addition a recent Reuters report reveals that last year a team of experts from Beijing and Shanghai set up a task force to study the issue of gold reserves. The report quotes Ji Xiaonan, chairman of a supervisory board for big state-owned companies under China's state assets commission, as saying, "We suggested that China's gold reserves should reach 6,000 tonnes in the next 3 to 5 years and perhaps 10,000 tonnes in 8 to 10 years."
While a weak dollar benefits Chinese exports it comes at a huge price
China pegs its currency to the dollar. So while a declining dollar is boosting Chinese exports, this boost comes at the cost of its enormous dollar holdings losing purchasing power. China's $2.3 trillion foreign reserves pile (most of which is in U.S. Treasuries) is fast losing purchasing power over other currencies such as the Euro and the Yen. This rapid purchasing power decline would make diversification out of dollars even more costly for China. In addition sustained dollar's weakness over commodity exporting currencies such as the Australian dollar, makes importing iron ore, coal and other commodities very expensive for a huge commodity importer nation like China.
So the ideal scenario for China would be a gradual decline in the dollar, giving it time to diversify out of the dollar into other assets. A runaway gold price would be a significant threat to this scenario, as it signals rapid deterioration of global confidence in the dollar, and could lead to a disorderly liquidation in the dollar. This scenario is not far-fetched as the U.S. dollar index has broken its critical 76 support level and is trending towards its all time low of ~72. Below 72 there is no technical support and the dollar could descend into a free-fall. Which is why in recent days China is busy trying to talking gold down.

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