November 14 2007

Long Yuan = Long Gold?

It may sometimes seem that China is somehow both unaffected by and indifferent to the spiraling shifts of the world’s currency and banking sectors we are in. Neither is true.  In spite of strong growth rates, China’s economic re-emergence continues to be pinned to a series of measured shifts by resilient party insiders to continuously refine the “market communism” concept. They appear almost ready to reap the rewards of a trade strengthened currency, and we believe that will signal further strength for gold.     

Without question the huge gains for gold and silver prices over the past several months can be related to thrashing of the greenback. The breakdown of the US$ accelerated by bad housing debt is what we and, in increasing numbers, others have expected for several years.  The inverse relationship that helped push gold higher has been part of a broader relationship - Short Dollar = Long Commodities – in which gold has actually been a laggard. Concern is growing that recent parabolic looking moves for paper currencies and oil could mark the beginning of a global downturn. The concern is understandable, but we view it as unavoidable turbulence in the shift of economic weight across the Pacific.      

Oil price gains chart both geopolitical concerns and the falling Dollar, but are well past any supply fundamentals. There is currently enough oil in the system to match demand, but since its suppliers are unhappy with their US$ contracts they have done little to sway the speculators who have pushed prices higher. We have mused in the past that if the world needs a neutral commodity-based currency, it should be the calorie. Traders are effectively making this happen by parking Dollars in long oil contracts. This is hurting US consumption as much as declining house values do. Further US dollar decline can be expected, but oil can’t continue to rise inversely to that decline without killing other US consumption and greatly denting Asian growth. Despite western consternation about Asian indifference to this, China actually appears ready to deal with the issue.

Several influential Chinese have indicated they favour a rebalancing of its foreign exchange holdings to emphasize “balancing stronger and weaker” currencies. This may in part be aimed at trade sanction proposals in Washington, but also we think at soaring oil prices.  Markets have read this to mean Dollar dumping that will exacerbate the weakening of $/€ rates. We actually think the impact on the Yen will be as large (say sayonara, carry traders) as the push on the Euro, thought that is an aside for now.  These musing bespeak the “controlled flexibility” that is becoming a hallmark of China’s economic management.

China changed its foreign exchange policy several years ago from a hard Dollar peg to a basket of currencies in which the Yuan shifts value in a “managed float” band (“floating peg”) that is 0.3% per day wide.  The basket is “trade weighted”.  An exchange of weaker for stronger currencies within its basket should mean that the Yuan appreciates more quickly. That would make it a more effective part of the floating exchange system, without China’s governors having to give up the “managed” part of the deal. A rising Yuan will also take pressure off the Dollar in due course, by making Dollar priced oil, and given the recent BHP-Rio Tinto merger “letter”, also things like iron ore cheaper per unit in the economy that is their one major growth area.  So, does that mean the gold run is over? 

In the past decade China has made a strong move up the gold producers list and is now generating more of the yellow metal than Canada or Australia and getting set to take over number two spot from the USA. It does hold some gold in its Yuan basket. Adding to this by soaking up its domestic gold supply would allow China’s central bankers to exchange Yuan for an anti-Dollar that has a liquid market, without raining on anyone else’s parade. At $100 billion a year, gold’s market may not easily become a significant part of the currency system, per se. But China’s current US$6+ billion a year of gold production would still help to offset the worrying decline in the Dollar.

Even if China’s currency system is not about to become a significant gold buyer itself, a strengthening of the Yuan would add cost pressure to the yellow metal’s output in the same way that rampaging Rand, Canadian$ and Australian$ rates have. In all cycles metal supply shortages proceed rising metal prices, and these have always been felt last in the gold sector. The only difference in this prolonged secular bull cycle is that significant cost gains have been recognized by the market and become support for higher base metals prices. Gold producers have not really gotten on top of cost gains yet, and fundamentals like this do, eventually, have their day. A rising Yuan and China’s increasing importance to the gold supply should combine underscore the lack of new gold supply, at current prices. Long Yuan will equal Long Gold.             

David Coffin

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David Coffin and Eric Coffin are the editors of the HRA Journal, HRA Dispatch and HRA Special Delivery publications focused on metals exploration, development and production stocks. They were among the first to draw attention to the current commodities super cycle and have generated one of the best track records in the business thanks to decades of experience and contacts throughout the industry that help them get the story to their readers first. Please visit their website at www.hardrockanalyst.com for more information.

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