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Wednesday, 5 September 2012

Gorillas in the mist

Goldman Sachs Asset Management chairman Jim O'Neill popped up in the news this week, releasing a note to clients with some revised thinking on prospects for China's economy.  With still a favourable overall view, O'Neill considered several likely outcomes for Chinese growth, including a "pessimistic" outlook of 7% GDP growth.  An interesting point in his analysis - that in any worst case growth scenario, the Chinese government is "surely to step in", attracted some comment as many noted that given certain conflicting undercurrents and factional conflicts within the administration and the Chinese Communist Party, the Chinese authorities may not be willing or able to intervene.

Similar to the reaction when various large Chinese cities announced vast new spending programs, some observers were sceptical as to whether bold political action will be as likely be delivered as in 2008.  O'Neill's fund meanwhile has been promoting a new set of fast-growing MIST countries (Mexico, Indonesia, South Korea and Turkey) which have been the star performers in the fund's popular Next 11 fund. And the failure to even consider a less than 7% GDP growth outcome (when some commentators consider that growth may be negative) suggests O'Neill might just be missing a gorilla in the room - Asian (and Chinese) slowdown which others believe may not be priced in by the market.

A very strategic resource
The last couple of weeks saw a renewed debate considering the return of a gold standard as a way to restore stability to the global economy and encourage growth (and end America's money printing), even while the balance of opinion believes such a standard is a false hope or otherwise likely to result in the stagnation currently seen in the Eurozone (which as Peter Coy explained arguably is committed to a new gold standard).

There is an interesting angle for China in this debate, as it has been active in the gold markets.  As you may recall China has been trying a basket of different measures to manage its economy including Keynesian stimulus in 2008, enormous foreign exchange reserves, capital controls and now liberalising exchange rates (which may be countering each other in effectiveness).  In fact reports have emerged which provide detail of China's activities in gold as well.

In addition to outright purchases of the metal, interest was also expressed from Chinese companies in acquiring gold producers.  In its report of China's largest gold producer, China National, considering the acquisition of a majority stake in the African subsidiary of the world's largest gold miner, Barrick, the Beyond Brics blog reported that the company's president, Sun Zhaoxue believes that China should view gold as a "strategic resource as important as petroleum energy".  That might partly explain why there is a gold mining division in the Chinese internal security forces (the People's Armed Police).

As well as its value as a metal, reserves of gold have been argued by some as a better store of value for a national central bank than government bonds, especially in a low inflation environment where the government issuer of the bonds is engaging in monetary easing (which depresses the yield as the price increases from the asset purchases).  In China's case it is looking for an alternative store of value to offset its huge holding of US Treasuries (US government bonds) which earn low rates of interest because the US is engaging in Quantitative Easing (printing money by buying US Treasuries) and which it cannot liqidate easily.  The liberalisation of the Renminbi (i.e. the process of opening the Chinese currency to full convertibility) is seen as one step that can counter-balance China's US dollar holdings (as the greater volumes of Renminbi will be used and deposited internationally).  Sun Zhaoxue alludes to this in his article.

However it is questionable whether holding gold ipso facto will ensure greater security for China.  How so? Well looking into some of the debate around the merits of a gold standard suggested that the credibility of the system might be more important than the physical holding itself.

I hold therefore I am
Outspoken financial journalist Max Keiser, has looked at a number of commodity stories, including possible manipulation of the silver market by JP Morgan and its high frequency trading (HFT) business (background here).  In a recent broadcast Keiser examined some of the justifications given by gold bugs (especially libertarians in the US), who he found often confuse their libertarian values (such as objectivism advocated by Rand) with the behavioural principles of the "Austrian school" (advocates of a gold standard).

A key question in the discussion was the degree to which financial institutions could issue credit secured against their gold reserves - it is only physical gold which is the "ultimate extinguisher of credit", but the use of fiat (paper) money removes the gold from credit making it easier to expand credit (which if prolonged can cause inflation and is exaggerated by quantitative easing).

In his article Peter Coy blames the First World War for causing the inflationary expansion of credit which destabilised the gold standard, however according to the Cato Institute (which is apparently libertarian) in a paper on this topic, von Mises, a key figure in this analysis, believed that instead of the war, it was the attempts by bankers to get around the gold standard and increase credit in the economy, when, from the 1890s the world's central bankers relaxed the standards of inter-central bank credits:
 It was'' not the old classical gold standard, with effective gold circulation,'' that failed after 1929; what failed was'' the gold 'economizing' system and the credit policy of the central banks of issue'' 
What von Mises proposed (to address this inherent conflict) was that the gold standard should be operated completely independently of monetary matters and essentially gold should be valued at production cost.  And this is interesting because it seems to be a call for independence, similar to that underlying the Bitcoin digital currency, which operates free of any government and is instead backed by the power of the computing network of Bitcoin users (with no centralised issuing authority).

All of this would suggest that credibility is important.  As well as the amount of gold which the People's Bank of China (the central bank) or other bank may hold, financial market participants will also assess how credible those banks are in administering and valuing such reserves.  This may not be as simple an assessment as it seems.

In gold (and tungsten) we trust...
Frauds of the week
Mentions must go out to:  the Chinese Art market (worth $13 billion according to Forbes magazine) and  China Sky One Medical and its chief executive (which the SEC charged with securities fraud this week for overstating financial results).

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