News

How does China's economy affect the price of gold, and why should we care?

In his latest Buyside: International Commerce column, ‘Why gold is likely heading down: Blame it on the China price,' Avner Mandelman argues that because it's been selling its products below true cost (the China price), the country is “about to meet the fate of all those who sell below true cost: mass layoffs, upheaval and perhaps a change of management.”

“Why should you care?” Avner asks. “Because of gold.”

“Recently gold has been very volatile, and could tack on $50, or even $100, in the short term. But longer term, if inflation – already quashed by Freddie and Fannie's blow-up – is further squashed by China's punctured bubble, gold is likely heading down.

“Why? First, low inflation, even deflation, will lessen the need for inflation hedges. But second, and more crucial, as the West buys less of China's more fully priced products, and as China's cash needs escalate, its government, to feed the peasants and to maintain its power, will sell state assets - including gold. This, plus inflation, could push gold much lower than anyone thinks, perhaps to half its current price. How's that for a real contrary opinion?

In 1999, Avner Mandelman founded Giraffe Capital Corporation, a Toronto money management firm, to take advantage of the pending NASDAQ correction. Subsequently Giraffe was one of only Tech investment funds in North America to have made money through the tech bubble. Giraffe's specialty is “sleuth investing”– physical due diligence of companies.

Avner also writes about stocks and investments, both in Canada and the US, including Barron's. Among his books is The Sleuth Investor, recently published by McGraw Hill.

Avner joined us for a discussion. Thank you to all those who submitted questions, and sorry to those whose questions we didn't have time for.

Editor's Note: globeandmail.com editors will read and allow or reject each question/comment. Comments/questions may be edited for length or clarity. HTML is not allowed. We will not publish questions/comments that include personal attacks on participants in these discussions, that make false or unsubstantiated allegations, that purport to quote people or reports where the purported quote or fact cannot be easily verified, or questions/comments that include vulgar language or libellous statements. Preference will be given to readers who submit questions/comments using their full name and home town, rather than a pseudonym.

Claire Neary, Globeandmail.com: Thanks very much for joining us, Avner. Lots of people sent us questions, so we'll get right to them.

Shay Code from Canada writes: I'm curious about what seems to be a change in opinion regarding gold. In your column on Sept 27, you suggested gold would be a good inflation hedge versus holding cash. Your most recent article (which seems very prescient on the Chinese situation) seems to contradict your previous position. Your thoughts?

Avner Mandelman: Gold seemed fine until the latest data came in regarding China's economic situation -- it was worse than even I had assumed. And even though the Chinese economy is sinking, the Chinese are still supporting the price of some commodities to defend their domestic producers, which costs them hard dollars. For example, the Chinese government is supporting prices of copper, cotton, and some plastics, even as commodity prices have been plunging -- oil (halved), copper (ditto), grains (soybeans, wheat), corn, etc. etc.... everything is coming down. You may not be reading about this as you are reading about oil decline, but it's as important. Furthermore, there are record inventories grains and oil, etc., so when the Chinese sell their own inventories, the price will come down more, even as they sell their gold. Is it reasonable to assume gold will be the only commodity to stay intact?

James McLean from Saskatoon, Canada writes: One of the standard arguments made by gold bulls is that very low interest rates, unprecedented interventions by the US government in US markets, and staggering US debt will significantly devalue the US dollar. This will inevitably result in inflation, perhaps not in the near term as deflation continues its course, but after economies have stabilized. As I understand the gold bulls' argument, gold is the only hedge against fiat currencies that are poised to devalue rapidly. How does this argument square with your vision -- is China's gold hoard so massive that when it starts selling it off, this will counteract the inflationary flight to gold?

Avner Mandelman: I agree that in the longer term inflation will return and the USD will fall, and this will cause gold to rise. But meantime it can be halved -- just as oil, which in the long term will likely rise, has been more than halved in the meantime (from 145 to 60). It's a question of time.

Jimmy L from Sherbrooke, Canada writes: China only has 1 per cent of the world's official gold holdings, approx. $15-billion. They have $2-trillion in foreign reserves, the largest portion of which is held in U.S. Treasury and agency dept. They need to find $600-billion for their stimulus plan. How do you think that they will get it? I bet that they will be selling U.S. Treasuries, so gold will go up (relative to U.S. dollars). I guess that the Canadian dollar should do much better. Analysts rarely comment on our dollar. What do you think?Thanks.

Avner Mandelman: You are right — they will use their US dollar hoard (and they are using some of it even now, for subsidies, and to support some internal commodity prices). As for gold, yes, they have a small portion of the world's gold, but up to now I don't think they have been selling. Also, the main argument for gold's lower price is lower inflation. Inflation is the intersection between supply of money and demand for money. The first is rising, yes, but the second is falling faster. There are tested models that track inflation vs. both these factors (I may write about it in the future), and they show clearly that inflation is falling fast (the Bank of England published one eye-opening chart recently), and may even go to deflation — especially if China sells some of the stored materials it has been buying.

C. M. from London, Ontario Canada writes: You repeat in your article that China is selling everything below cost. Specifically, that they aren't including 'the cost of capital' in their pricing. I thought China was a creditor nation, that it has no debt. I don't quite understand how a country that loans trillions needs to have a cost to it's capital. Can you explain that one to me ? Thanks.

Avner Mandelman: The article didn't say "everything," but rather "most things." And the fact they accumulate cash is no indication they are doing something right. In a glass-making company, for example, the glass-melting kiln lasts 3 years. Therefore every year you must put aside 1/3 the cost of a new kiln. If you don't, during these three years you'll pile up cash in large amounts, especially if you sell below true cost, because everyone will buy; but this would not prove you are pricing the product right.

Similarly with China: They have been selling a lot of cheap stuff, and everyone was buying, so China piles up cash. But now they must use it— and they do, mainly for "subsidies" for the inefficient producers. And the producers are inefficient because they rarely had to compete on true cost.

Terry Lys from Calgary Canada writes: The US Federal Reserve, due to massive Wall Street bailouts, is committed to printing more money than it has since its inception. Everyone knows that inflation will be subdued in the short-term. Given that gold is a hedge against inflation, what effect on inflation do you think the exploding money supply will have in three years?

Avner Mandelman: Inflation is the intersection between supply of money and demand for money. There are tested models that track inflation based on these factors. Supply of money is now rising very fast. But demand for money is being destroyed daily. Indeed, if you look at the price of commodities, they are everywhere coming down, and inventories of them are piling up— there's no demand. The best tested models show that inflation will be close to zip over the next one to two years. (The Bank of England came up with an eye-opening chart just a few days ago — they see close to 0 per cent, and perhaps even less.) So yes, Gold can soar in a few years — just as oil might. But just as oil was more than halved first (145 to 60), so can gold be.

john goldsmith from Canada writes: With the new levels of borrowing going on world wide, with special attention to the US needs, will this lead to a real value problem, and a serious loss of confidence in paper currencies, with no Country having a leadership position, some time in 2009, if this has a chance of happening, where does the price of Gold go?? What is the chance of this happening when compared to the China Price under cutting the World Gold Price in half during the same time frame, eg. 2009??

Avner Mandelman: In times of uncertainly and conflict, the store of value is the US dollar. Take a look at the history of the dollar— in every war, it soared. When the US is strong militarily, its currency does well. The same was true with England after it (+friends) beat Napoleon in Watreloo. The winner gets the best currency, because it usually takes from the losers. So yes, long term the US dollar would weaken, but at present, there is a shortage of dollars. Absolute shortage, because so many have been destroyed.

One example: The contango in oil. You can buy oil today and store it, and sell it in a few months for several dollars more. The few mnonths' return translates to 30 - 40 per cent p.a. IF, that is, you can get banks to lend you money for it, and IF you can get storage. The second may or may not be available. But money is not available. As I said, the theory suggests that the US dollar will be decimated. But go tell it to those who have none now, and need it to buy essential stuff. This situation may last for at least a year, perhaps two. After that we'll see...

terry f from Toronto Canada writes: You had predicted that the market would continue it's downward trend, I believe back in September (i.e.you were right), but more recently you haven't sounded less bearish. Is my assessment accurate, and if so, why the change in your view?

Avner Mandelman: I assume you meant, "you have (not "haven't") sounded less bearish."

When there's panic, my instinct is to go the other way. However, the panic has subsided too fast and what we see is gloom. What else has changed, is that the Chinese are constructing their own Freddie and Fannie, by pushing their own shirtless Joes to buy houses (really apartments). Furthermore, based on reports of friends who do business in China, it seems that the Chinese banking system has about a trillion dollars worth of loans that have little interest payments, and very loose repayment schedule. (I am being charitable here.) If this is correct, what happened in the US may be repeated to some significant degree in China.

David Gunter from Longwood, Fla., United States writes: Great insight on China, but not exactly clear on the inflationary or as you claim deflationary implications. If this bubble has been popped, as you claim, won't the true cost of capital soon be imbedded into products from China as the market will force a reform - leading to higher, not lower prices. Or is this ruinous policy perpetual in China?

Avner Mandelman: China tries to raise prices, but these don't stick. So what they do is increase subsidies to producers, thereby depleting their own store of cash— and still many producers are going broke. They may try to embed cost of capital in products, but with inflation on the wane worldwide, and people out of cash worldwide, who would buy? So the Chinese government has to keep subsidizing, and running down its cash...

It seems that higher export prices from China will contribute to inflation elsewhere and in China.

* See above: The price is made by the one who owns the wallet. There are now ample inventories of almost anything: Oil, gain, soybeans, copper, silver (yes), platinum, cotton... As far as gold goes, it generally responds to inflationary expectations. Surely the monetary stimulus of virtually every major central bank will eventually be realized and that a portion of the trillions of new money created will go to purchase gold, causing an increase in the price.

Inflation is the intersection between supply of money and demand for money. Supply is high. But demand as been destroyed. The Bank of England came with a chart a few days ago showing inflation going down to 1 per cent, and perhaps below 0 per cent. And just wait until the close to (alleged) trillion dollars of bad loans in the Chinese banking system are flushed out. With a trillion dollars more destroyed, it's another mini Freddie and Fannie hitting the fan. With less cash to buy, where would all the inflation pushers come from?

Albin Forone from Canada writes: How do you factor the recently announced large stimulus package into your thesis? I'd have guessed a shift to domestic infrastructure and consumption from export would be helped by a policy of strengthening the RMB, to make imported raw materials and consumer goods cheaper. This would also help Canadian exporters.

Avner Mandelman: I don't believe the Chinese announcement, or their numbers. First, if they are indeed growing at +9 per cent per year, why do they need to boost their economy with 0.6 trillion? Either they panic needlessly, or their numbers are bogus. I think it's the latter, in spades. In fact, I don't believe any dictatorship's numbers. Much of China's growth has been based on selling below cost, in my view. The Chinese workers are terrific — hard working, good family people, by many accounts — but much of their output has been wasted by channelling it into selling stuff below cost, to keep them employed no matter how. Like Nortel selling below true cost, which leads eventually to mass layoffs and restructuring.

tom grand from Burlington, Canada writes: What's your outlook for uranium?

Avner Mandelman: Not sure. All energy prices will eventually rise. But the highlights is on "eventually." At present, with oil prices at 60, and with cash having been burnt on the Freddie and Fannie bonfire, why build more nuclear reactors? And indeed, even if you wanted to, where would you get the money to build them? The banks haven't got it, and the US government already committed itself to buy junk mortgages off the shirtless joes and janes who voted them in. So yes, long term Uranium may prove good, but you'd need to see first money become more plentiful— a few years— and perhaps a war or two, that would spike up the price of oil. (Oil rises almost only in conflicts, not on supply/ demand fears. Fears are usually part of a promotion. Reality is either war, or economic recession. The first boosts oil, the second tanks it. Nearly all others are far less significant.)

Ballin Munson from toronto Canada writes: Avner, With $2 trillion or so in cash, why would China use its gold reserves (and hence drive down the value of its' remaining assets) as opposed to sending all the paper back (through bond purchases, equity stakes, whatever) to the countries it got it from?

Avner Mandelman: The $2-trillion is really $1.5-trillion, and even this is overstated, I think. And, of course, $1.5-trillion is about 1.5k per peasant (about $1- billion in the countryside). Perhaps I didn't make it clear, but gold is not the only thing that China would have to sell. It would probably have to start selling some of the commodities it has been buying into inventory, to support their price, and therefore local producers. If China's banking system is indeed in the parlous state it is reported to me by friends who do business in China, then the recent Chinese announcement of a 0.6 trillion boost is understandable.

As far as selling gold, many other countries would love to sell it. There are about 250 billion of gold held by Central banks. Don't you think they'd live to sell it at today's market price (if they could do this without disrupting the market), to recapitalize their commercial banks? China would, too, imo.

B C from Canada writes: 'As China's cash needs escalate, its government, to feed the peasants and to maintain its power, will sell state assets - including gold.'

I enjoy your comments on this matter. Thanks. What other state assets will China sell? Is US federal debt their biggest available asset? Could it get so bad that they are a large net seller of US federal bonds? I do not see that as a palatable option. Wouldn't that cause a great deal of downward pressure on the US dollar and make it more difficult for the US to fund its various aide and stimulus packages?

Avner Mandelman: This is logical, but cannot be seen yet in the market. At present, the only "safe" asset in the world is also the one in shortest supply — US dollars. The more they make of it, the more the world needs, because so many have been destroyed. In two to three years it will catch up on us and be seen in inflation, but in the short term (one to two years), we are likely to see low inflation. And if the US economy is going into a long, deep freeze, bonds will not weaken much, because the demand for capital will be low. But let's take it one year at a time here...

Tony youssef from Canada writes: Hi Avner, I have traded Opti Canada successfully over the last 3 years and recently the stock has collapsed from over $20.00 to around $2.00. They are very close to producing oil but have disappointed investors with delays over the last few months. How can I do some sleuthing to figure out what is going on with this company? I know oil is going down in price and that credit markets are frozen but the way it is trading investors must believe the company is going bankrupt. Can I have your opinion on the matter? Thanks, Tony.

Avner Mandelman: I have no idea about this company. I can only make two comments: In this environment, the general oil supply/demand is as important as your knowledge of individual companies. You can be right on the company, but if oil goes to $45, your stock will tank.

As for doing due diligence on any company— get my book "The Sleuth Investor" and see the relevant chapters. In essence, you want to know everything you can about the people, the company, and their environment. The kind of details you can't write down, or even tell about. Talk to anyone connected with them— get out of the office or the house, and meet their people, their suppliers, their customers, anyone who can tell you about them. But if you invest only a modest amount, you may find it's too much work for too little reward. So budget your time— unless you do it for fun (as most sleuths do). Good luck!

Claire Neary, Globeandmail.com: Thanks very much for joining us, Avner. We appreciate you taking the time to answer our readers' questions on your always provocative columns.

Avner Mandelman: Thanks for the questions. It's gratifying to see the column is read so closely... It'll keep me on my toes when I write future columns.

Best, Avner