The China Factor
July 16, 2004
The gold price has been rather volatile in the past
two weeks as sentiment about the state of the US economy keeps changing.
The changing sentiment impacts the dollar, which impacts the gold
price. As I’ve said before, I don’t expect the gold
price will sustain a major rally until we see the dollar weaken
in response to higher interest rates. I know that’s counter-intuitive,
but I also think it’s inevitable. If you’re wondering
why, please read the April 16, 2004 column entitled “The deficit,
the economy and the price of gold.”
The China Factor
Chinese demand for raw materials has no doubt contributed
to the rise in commodity prices over the past few years. The urbanization
of China is consuming vast amounts of copper and steel as an example.
And as more and more Chinese buy cars their demand for oil is increasing.
I think we should put China in perspective though.
China is growing very rapidly and will almost certainly have the
largest economy before the turn of the century. But according to
estimates I have seen it will take more than fifty years for China
to surpass the US. And even though China’s impact on the world
will be felt throughout that time we should not forget that change,
especially a major change such as this, always goes hand-in-hand
with volatility. Markets seldom move straight up or straight down.
We have to ask ourselves first to what extent China
has been responsible for the recent surge in commodity prices and
secondly what is likely to happen in the next five years or so.
I agree that China will dominate the world in a hundred years but
my own investment time horizon doesn’t stretch that far.
The Chinese economy has been growing remarkably fast, yet it is
still very small when compared to the US. The United States accounts
for almost 30% of the world’s gross domestic product while
China accounts for only 4.4%, about as much as Britain. Granted,
China’s economy is growing at a much faster rate than Britain’s,
but if the growth in China is supposed to be the cause of a commodity
price boom, then shouldn’t the lack of similar growth in Great
Britain be the cause of a commodity price slump? And what about
the lack of similar growth in France, Germany and Italy?
If we assume that China’s economy is growing
at about 8% per year and the US economy is growing at 4% per year
then the nominal annual increase in US GDP would be more than three
times as large as the increase in China’s GDP on a US dollar
basis. Or, think of it this way: a 1% change in US GDP equals almost
the entire annual increase in China’s GDP.
What happens to the US economy during the next five
to ten years is far more significant to our investments than what
will happen in China and the two are correlated.
Also, keep in mind that production is shifting to
China from the US and Europe. It means the increase in Chinese demand
for raw materials does not necessarily represent an increase in
absolute demand since some of it is displaced demand. That is demand
for raw materials that has been displaced from the US and Europe
Nonetheless, China’s growth and urbanization
is creating significant demand for raw materials that cannot be
But much of China’s industrial complex is dependent
on US demand for its products. If the US economy stalls and demand
for Chinese goods declines or, at best, the growth in demand slows
down, China’s economy could take a serious knock.
China already has excess production capacity relative
to current demand, so a decline in demand could cause a rapid and
painful contraction that will make the Chinese banks realize the
value of credit quality. Non-performing loans in China’s banking
sector are approximately forty percent of total loans outstanding.
I suspect the government in China will take care of this problem,
but not without cost to the private sector and the economy.
If a good portion of the increase in metal prices
during the past two years has been due to Chinese demand then we
should be very careful of a slump in China’s growth as it
could precipitate a steep decline in prices as well.
Of course, while the world prices gold and other commodities
in US dollars, the dollar’s exchange rate will be the single
most important macro determinant of prices. The dollar has declined
39% against the euro since January 2002. The price of gold is up
43% over the same period confirming the relationship between the
US dollar exchange rate and metal prices. Gold Fields Mineral Services’
Base Metal Index is up 75% during that time though, indicating that
base metals are being driven higher by something more than the dollar.
Chinese demand has certainly contributed but it’s
not all China. The price increases also reflect low inventories
and production shortfalls relative to historical demand, especially
in the nickel market. We should also thank the US government for
creating metal demand. The US sends warplanes to destroy other countries’
infrastructure and then sends them aid to rebuild it again. In addition
to creating demand for raw materials to build more war machinery
such as planes, ships and tanks, the rebuilding of destroyed infrastructure
requires a lot of metal.
However, if China’s economy stalls because of
reduced US demand and tighter credit controls in China (current
policy) then traders’ sentiment could move base metals prices
lower. As the US economy slows down we’ll see a further reduction
in demand for base metals and other raw materials, and lower prices.
This will be offset by a decline in the dollar that will make it
appear as if metal prices are holding up, but metal prices in other
currencies could well decline.
While China will continue to have an impact on metal
markets its biggest influence could be felt in currency markets.
As China grows it will become more and more important to Japan,
Southeast Asia and Russia. By the end of the century China will
be far more important to those countries than the US.
At some point it will be in China’s best interest
to decouple its currency from the US dollar (at the moment the renminbi’s
exchange rate is fixed against the dollar). If China doesn’t
decouple the renminbi, the currency will fall right along with the
dollar, making China’s imports more and more expensive. China’s
growth already requires vast raw materials imports, relative to
its economy, so a stronger currency will benefit China in spite
of losing some competitive advantage in the US. When China releases
the renminbi, the Southeast Asian currencies and the yen will appreciate
against the dollar since their main focus will be competitiveness
in China, not in the US.
Once that happens there will be less strategic advantage
to China and Japan to support the US dollar and we could start to
see the vast hoards of US Treasuries that those two counties hold
come onto the market. This could really depress the dollar and send
metal prices (in dollars) soaring.
The bottom line is that for investors in the
US, the US dollar remains the key. For investors outside the US
the water is murkier and they should be more cautious about betting
on China in the short term.
Paul van Eeden
Paul van Eeden works primarily to find investments for his
own portfolio and shares his investment ideas with subscribers to his weekly
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