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
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
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 to China.
Nonetheless, China’s growth and urbanization is creating
significant demand for raw materials that cannot be ignored.
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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