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 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 investment publication. For more information please visit his website ( or contact his publisher at (800) 528-0559 or (602) 252-4477.


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