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Thursday, April 23, 2009

Is China Trying to Back its Currency With Metal?

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There's talk of a recession from the Reserve Bank, down yonder way. And the Prime Minister has again promised the government is going to spend its way out this slump, or at least go broke trying. But we begin today's Reckoning with the idea that Australia is a massive treasure trove of mineral wealth, which is the next best thing to money in an age of paper paupers.

A smattering of articles in recent weeks has highlighted the stockpiling of metals by the China State Reserves Bureau. The Bureau scarfed up 329,000 tonnes of copper in February and 375,000 tonnes in March. This buying has partly fuelled copper's 47% rise year-to-date (it's tied with lead for the biggest gain so far) and its 70% rise from a low of around $2,800 in December of 2008.

Couple this with additional stockpiling of metals like aluminium, nickel, zinc, and tin, and you could make a case that China is trying to back its currency with metal. After all, that would be consistent with the call in March by People's Bank of China Governor Zhou Xiaochuan for a global reserve currency that was not the U.S. dollar. Also, a currency backed by a basket of commodities would certainly have more tangible value than a currency backed by a basket case of basket case currencies (yen, dollar, euro, Yuan).

But the story is probably simpler that a great global currency end game. Copper prices fell by 70% from their July 2008 high to their December lows. Trading depreciating U.S. dollars for copper at rock-bottom prices is a great trade. It's especially great for a nation that plans to electrify itself (which takes a lot of copper) and be a world-leading producer in hybrid cars (which also takes a lot of copper...and a lot of rare earth metals, by the way).

So is China laying the foundation for a commodity currency backed by stockpiled metals and minerals? Probably not. It's just stockpiling minerals and metals while prices are low. And to the extent that the move has anything to do with a currency, it's not China's currency. It's the U.S. dollar.

The Chinese economic planners realise they have made themselves strategically vulnerable to dollar devaluation by owning so much long-term U.S. Treasury debt. The U.S. government is loading up on debt. It intends to pay it back with printed money. This classic devaluation punishes long-term bond holders whose principal is thrashed by inflation.

Besides, since Chinese companies (State-owned and otherwise) keep getting rebuffed trying to take equity stakes in foreign resource producers, it's better to take the Jim Rogers approach and just by the stuff directly and not bother with Wayne Swan and FIRB.

Does any of this benefit Aussie resource producers? Well, yes. Chinese stockpiling of metals has lead to a seven percent rise in aluminium prices in the last month and a nearly twenty percent gain in much maligned zinc prices. As we showed in a Diggers and Drillers e-mail update two weeks ago, Aussie base metals producers have surfed the Chinese liquidity surge into commodities to double digit share-price gains.

Liquidity surfers beware!

The trade only makes sense for would-be stockpilers if prices on the Comex and the London Metals Exchange remain attractive (rock bottom). If speculators try to climb on board the stockpiling bandwagon, it's going to make for a really volatile trading market. Copper for three-month delivery lost 3.6% in London trading on the LME. And on the Shanghai futures exchange it fell even further, down 5% in yesterday's session.

My my my. Let's think about this, shall we?

This situation isn't exactly the same as the across-the-board rally in all asset classes that began in 2003 after Alan Greenspan cut U.S. short-term rates to 1% and left them there for awhile. But it is absolutely the same in one particular aspect: U.S. monetary and fiscal policy is fuelling inflation in certain asset classes, and probably not the asset classed policy makers intended.

In this case, the Fed's quantitative easing policy is designed to drive-down borrowing costs and free up credit. What's happening, though, is that U.S. creditors are abandoning the long-end of the yield curve of the bond market and flooding the short-end (when they aren't bidding up commodities). Fewer creditors want to lend the U.S. government money for 30-years. More are willing to do it for 90 days, even if yields are low, just for the sake of having a liquid, near-cash investment in a still dodgy financial landscape.

You can see this vividly by looking at two-year charts showing the yields on 90-day T-Bills and 30-year Treasury bonds. Check them out below. Bloomberg reports that according to data from the U.S. Treasury Department, China bought $5.6 billion in bills in February and sold $964 million in longer-term notes. Its preferences are clearly changing. You'd expect the 90-day T-bill to again approach zero, and 30-year yields to rise. And in fact, that's exactly what the chart shows.

90-Day T-Bill Rates Again Approach Zero

30-Year Rates Bounce as U.S. Creditors Factor in Inflation

These two charts are bad news for Uncle Sam and probably good news for Uncle Kevin. For the U.S., the shift in borrowing to shorter-term notes and bills makes future borrowing needs extremely interest rate sensitive. Every try rolling over a $1 trillion in debt when interest rates have doubled? And remember, future borrowing needs are massive, with the Congressional Budget Office predicting a deficit of $1.4 trillion next year and nearly $10 trillion by 2019.

If creditors aren't willing to fund U.S. deficits, then the Fed will. And that means printing money. This has two effects. One, it drives up interest rates on longer-term bonds even more (making long-term financing expensive) and it accelerates the flight out of U.S. debt into tangible assets.

Either way, funding U.S. deficits with borrowing-whether its long- or short-term-is the prelude to dollar devaluation. The only way that money gets paid back is through money printing. There is a remote possibility that new taxes could cover the interest expense on U.S. debt. And in case you missed it last Friday, the U.S. Environmental Protection Agency officially classified carbon-dioxide and several other so-called greenhouse gasses as threats to public health.

This reclassification gives the EPA authority to regulate threats to public health under the U.S. Clean Air Act. More likely is the passage of a bill in the U.S. Congress to institute a "cap-and-trade" system on carbon dioxide in which carbon dioxide "polluters" could bid for permits that allow them to emit a certain amount of CO2.

The folks in the Obama administration reckon a "cap-and-trade" regime on CO2 could generate anywhere from $500 billion to $1 trillion in new government "revenues." And the best thing of all is that it won't look like a tax increase. It's a new regulation that imposes upon business the real cost of producing CO2 emissions.

If you think for a minute that those costs won't be passed on to consumers, though, you are obviously brain dead and not reading this at the moment (RIP). Consumers will bear the brunt of a cap-and-trade system with higher energy costs. And that's if the higher costs don't put energy producers out of business altogether. After all, it's not hard to imagine the government imposing a "cap-and-trade" system that raises production costs, but simultaneously capping retail electricity rates (howling voters freezing in their sub-prime prisons).

Do these people really hate coal that much?

You can see that all across the world, the effort to prop up asset values with more inflation is having a widening circle of negative unintended consequences. To keep all that borrowing from being immediately inflationary, governments are grubbing like addicts for new sources of "revenue" that don't arouse the ire of the population. And they don't seem to care if they wreck the economy in the process.

Which brings us to Uncle Kev. Australia's future borrowing needs look small compared to Team America's. Right now, the Aussie government reckons that the deficits as a percentage of GDP will be around 2% in the upcoming budget year and 3% in the year following. That doesn't sound so bad, does it?

In the U.S., the CBO projects the 2009 Obama budget will produce a deficit 13.1% of U.S. GDP. Even under an optimistic scenario, the ratio only declines to 9.6% by 2010. The trouble with deficits is that they become part of the public debt. And the public debt as a percentage of GDP is already at 74% in the U.S. and climbing.

Granted, it's been much higher in other countries (like Japan) and not led to a collapse deficit financing. But each country's case is particular. And what we'd say here is that the long road to national debtor status begins with running annual deficits out of "necessity." The real trouble with short-term deficits is that they add up, year after year, into long term debts.

Speaking just before Reserve Bank Governor Glenn Stevens confessed that Australia was in a recession, Kevin Rudd-in that tortured parlance that he has mastered-said, "The truth is this - the global economic recession makes it inevitable that we'll have a recession in Australia which means that, as we frame the budget, we're going to have to make even stronger our economic stimulus strategy because unemployment will rise even further."

What on earth does that mean? go here.

We think it means that Rudd is already laying the ground work for further transfer payments to Australians which he is going to call "stimulus" and which he is going to claim will help the country avoid recession. But that was the goal the first time around in December, and it didn't seem to work then. So why try again?

Undoubtedly, the people in Canberra who are eager to borrow on your behalf and funnel the money to favoured constituencies will say that the "stimulus" made things less worse (as if a $900 cash payout makes up for the risk of losing your job). They will keep on stimulating until the Prime Minister's poll numbers fall, at which point China will probably be blamed for something to distract the public's attention. Or perhaps the issue will be immigration. Who knows?

Mind you, we're not saying the Liberals look any better on this issue. Across the world, moron politicians on the Right and the Left are trying to spend their way out of a recession that was caused by too much spending. Only an idiot could embrace and defend that strategy. But then, we are talking about politicians here.

The danger here for Aussie investors is that increased government borrowing to finance transfer payments and backstop the commercial property sector will force up interest rates. Higher interest rates are bad for household borrowing, corporate borrowing, and anyone who has a lot of debt to service (which includes a lot of Aussie households).

The secret to any good lie, we remember reading somewhere, is that the number of people who find out the truth is smaller than the number of people who heard the lie once and believed it. Most people are lazy. We hear a good lie once and even if we don't believe it, it sticks in our head. Say it enough and it begins to pass for truth, even if it's absurd.

Australians keep getting told that government stimulus is the way to soften the effects of recession until the recovery takes hold (an event which keeps getting further and further away on the horizon). But this is a lie. The stimulus doesn't solve any of the problems that face the economy. It just keeps people busy and distracted for awhile, while annual deficits and a rising debt (which must be financed by foreigners) become a fact of life in Australia.

The only upside to continued world-wide government ham-fistedness is that the monetary and fiscal insanity heighten the appeal of real assets. This represents tangible wealth for which there is a world-wide market. That's why in the April edition of Diggers and Drillers we resume our look for smashed-down base metals stocks that have exposure to commodity price gains by way of proven reserves of various base and precious metals. It's the best trade of the year so far. Just ask the Chinese.

Dan Denning
for The Daily Reckoning Australia

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