Is China at the Point of Overheating?

How to Flush the Hoover Dam Through a Garden Hose

Ivan Martchev, April 16, 2010

Once, I heard a white-haired market commentator say: "If Wall Street ever gets truly interested in gold bullion, the effect on the price will be similar to trying to flush the Hoover Dam through a garden hose." Well, I've visited the Hoover Dam in the not too distant past and can say that the analogy is right on the money.

All the gold that has ever been mined in the history of civilization and that is available as above-ground inventory is worth a little over $1 trillion. And numerous questions have been raised recently about the purchasing power of the currencies of the West which are being used for foreign exchange reserves by our favorite BRIC nations.

With all that economic might, the BRICS have gathered a lot of foreign exchange reserves. China has $2.447 trillion worth of forex reserves as of March, Russia has $420 billion, and India has $279 billion while Brazil has $242 billion. What are the BRICs to do with all this money?

Clearly, forex reserves were a cushion in late 2008 and early 2009, given the flight of capital out of BRICs. This helped stem the run on BRIC currencies and has largely helped them recover in 2009 and 2010. But what happens when those forex reserves get to $4 trillion, then $5 trillion? This is not a sustainable situation and all sides know this very well.

The Chinese have the most at stake given their outsized portion of the BRIC forex reserve pie. They have been spending a lot of dollars on energy and mineral acquisitions outside of China -- $32 billion last year -- but this is a small number compared to the overall climb of forex reserves. In our opinion, China should buy more resource assets in Africa and Latin America and invest heavily in the rest of Asia, including India, in order to diversify its forex risk. Sterilizing forex reserves by buying an endless supply of U.S. Treasuries is no longer a wise course of action.

There is this "joined at the hip" relationship with the U.S. where the Chinese have to keep buying Treasuries since they have bought so much already -- they can't sell because selling would drive prices lower and hurt the rest of their existing portfolio. But the Chinese have been buying shorter maturity Treasuries and are likely to take a hard look at hard assets, pun intended.

Gold is Not Behaving "Normally"

We originally saw the latest surge in the dollar as danger signal for gold bullion based on its prior relationship with the Midas metal. This time it has been different though as gold has remained well supported despite the surging dollar, which is a direct outcome of the relentless climb in BRIC forex reserves. By the time BRIC forex reserves double from here -- which is entirely in the realm of possibility in the next 10 years -- gold bullion should more than double.

It is impossible to put a precise target on the price of gold bullion as it impossible to say how much money central banks will print. But, if we have to judge if the fundamentals for gold bullion have gotten better or worse in past year, the answer is a clear "yes". Forex reserves have risen noticeably, central banks have been super accommodative, and gold bullion has rallied along with a rallying dollar. We foresee a general decline of all western currencies -- not only the dollar -- against most currencies in Asia that are still undervalued. The day will come that no matter which is going lower -- the euro, the pound or the dollar -- gold will be rallying.

Our favorite way to play gold remains via the SPDR Gold Trust (NYSE: GLD), while we have featured other precious metals ETFs that benefit from the same trends. We have to note that many investors mistakenly take the Market Vectors Gold Miners ETF (NYSE: GDX) as a proxy for gold bullion -- it isn't. Gold stocks that are represented in the GDX are leveraged investments -- they are equities. Gold bullion that is represented in the GLD is a hard asset -- it's not an operating company with a profit and loss statement. In times of market uncertainty, gold can go up and gold stocks can go down -- as it happened in 2008.

Since we believe that the world economy is recovering and there is an inflationary threat on the horizon, investors should have exposure to both gold bullion and gold stocks.

To see how we are playing the shifting strategy in managing China's vast forex reserves join China Strategy today!