China has become one of the world's locomotives, becoming the world's third biggest exporter. China's boom has sparked an unprecedented expansion in world commodity markets. China produces two-thirds of all DVD players, microwaves, and over half of all digital cameras. It has become the world's largest consumer of aluminum, copper and cement and the world's second largest import of oil.
China is the Saudi Arabia of the Capital Markets
Unlike the Japanese, who bought Van Goghs and golf courses with their surpluses, the Chinese appear to be more sophisticated in spending their almost $500 billion of foreign exchange reserves. In the past, China seemed content to replace Arab investors as purchasers of U.S. treasury bills. Asian central banks were active in the foreign exchange markets by buying up U.S. dollars to deter their currencies from appreciating further. China is to the US financial markets what Saudi Arabia is to the world oil markets - the primary provider of capital. Chinese companies to date have invested about $33 billion throughout more than a 160 countries, but the Noranda purchase is the biggest, so far.
Prompted by this prudent desire to diversify and the recognition that the U.S. dollar is vulnerable, China has also bought euros, Canadian dollars, and even gold last year. But now, instead of settling for more low-yielding dollars, China has bought dollar assets or proxies with their surplus dollars lessening their dependence on the dollar. The Chinese central bank likely lost $10 billion due to the drop in the US dollar, and no central bank can do that for very long. Increased protectionist measures by Americans and the nationalist outcry against Chinese companies exposes America's vulnerability. Americans must realize that the rules of the game have changed. He who owns the gold, makes the rules. Investors should adjust accordingly. The Chinese subsidization of the American economy is over.
China has one of the highest savings rate in the world, and in recognition has liberalized the ownership of gold. China's central bank governor estimated that Chinese citizens currently have 1.2 trillion yuan or $145 billion of savings, which contrasts sharply with the spent savings of the Americans. Historically, the Chinese have an affinity to gold and the government's recent move to allow individual ownership has prompted the World Gold Council to predict "the rise in demand for gold in China from the current 200 tonnes to an annual 600 tonnes over the next few years." We believe Chinese demand will surprise even the World Gold Council. Already five banks jumped the gun and queues were formed, similar to the long lineups outside the Bank of Nova Scotia in the late 1970s. The Chinese have one of the lowest grams per capita usage, at 0.1 grams per capita in contrast to 0.73 in India and 1.41 in the United States. China's official gold reserves are less than 2 percent at only 600 tonnes. The central bank is expected to boost its holdings in line with the more industrialized nations. To achieve a level of the Europeans at 15 percent of reserves, China would need to consume all of the gold produced in the next two years.
The Big Risk
For sometime now, we have warned about America's financial imbalance and vast accumulation of domestic debt, which are the dollar's Achilles heel. To date the dollar has lost over twenty percent of its value and appears poised to slide another 10 percent. Without the largesse of foreign investors, the Americans must somehow attract more than $50 billion of net investment each month. Foreigners bought $39 billion in net purchases of US securities in August, less than the $64 billion bought in July.
The big risk lies on the United States whose debt load threatens to endanger the world's economy. The US has become the world's biggest debtor. Every day, the superpower is looking more like another big Latin American debtor. For the past decade, America has been living beyond its means. The US government has increased spending while cutting taxes, causing a swing of $700 billion of red ink. America's households have also spent more than they earn, subsidizing their lifestyle against the illusory value of their home. We believe a potent cocktail of twin deficits will lead to a collapse of the dollar, exacerbated by $55 oil prices and continued geo-political uncertainties.
America's bubble was spawned by a huge reliance on debt and its way of life is unsustainable. Unlike the Chinese whose boom is built on traditional wealth creation, America's boom is built on debt and the false illusion of "asset wealth". Since 2001, a potent mixture of leveraged assets, deficits at 10 percent of GDP, $7.3 trillion of government debt, negligible savings and the opiate of artificially low interest rates have contributed to a huge U.S. credit binge, which will be passed on to the next generation. The United States today has over $53 trillion in government debts and liabilities that start to mature in four years when the first of the baby boomers begin to retire. The average household's personal debt today is about $85,000, and if you include Medicare and social security, this increases five times to $475,000. A mixture of spent savings and huge fiscal deficits, financed largely by foreigners, has ruined many Latin American economies. The US is poised to follow, but just how big a crash, we don't yet know (almost half of the US government debt is currently held by foreigners). And in this quarter, this appetite for American assets appears to be waning along with interest in the greenback. Gold will be a good thing to have.
Fannie Enron Mae
Falling rates are also a problem for "too big to fall" Fannie Mae. Fannie Mae with $1 trillion of assets is the second largest financial company after Citicorp and among its biggest derivative players. Fannie's accounting practices and misuse of "generally accepted accounting rules" are the focus of an interim scathing 211-page report by The Office of Federal Housing Enterprise Oversight (OFHEO). The regulator of America's giant mortgage company recounts how Fannie Mae improperly expensed half of $400 million so that the company could meet its earnings guidance allowing top management to receive the maximum bonus payouts. Fannie Mae deferred the other $200 million of prepayment losses or expenses following the collapse of interest rates in the third quarter of 1998. Last year, its top executive, Franklin D. Raines was paid $20 million. The report was searing, it stated "the misapplication of GAAP are not limited occurrences, but are pervasive and are reinforced by management" and, "the Enterprise was making preemptive adjustments for the sole purpose of managing prospective earnings".
Indeed the OFHEO report also revealed billion of dollars of derivative losses. Fannie improperly recorded $12.2 billion in deferred losses relating to cash flow hedges that if adjusted, Fannie would be undercapitalized. Just how undercapitalized was Fannie Mae? We don't know. The company subsequently agreed to boost its reserves by 30 percent, as an interim measure but must raise billions of new funds or liquidate assets.
As private companies with a government charter that guarantees its debt, Fannie and its smaller cousin Freddie were able to borrow huge sums of money. Today, Fannie Mae and Freddie Mac owns or guarantees nearly half of the United States $7.9 trillion of residential mortgages outstanding. Like Enron, the roles and responsibilities of the key executives are being questioned as well as executives from the Controller's department. Key management may be replaced, and congressional hearings have begun. The Justice Department has also launched a criminal probe.
Even Alan Greenspan issued warnings that there was a danger in this concentration of mortgage risk and suggested the privatization and removal of the contentious government guarantee. The International Monetary Fund also waged in, warning that both Fannie and Freddie's "bias" concentrated interest-rate risks and the hedging of which would amplify interest-rate movements."
Last year, Fannie Mae's retained earnings only stood at $24.5 billion, against a derivatives book of $1.04 trillion. And the other mortgage company? Freddie Mac recently restated $4.5 billion of earnings, removed key executives and settled with federal regulators. Foreigners today hold more than 12 percent of outstanding US agency securities and nearly half of its debt. The question then to ask, who bails out the bag holder? Gold is a good thing to have.
John R. Ing
Maison Placements Canada
130 Adelaide St. West - Suite 906
Toronto, Ont. M5H 3P5
(416) 947-6040
October 27, 2004
The information contained herein has been obtained from sources which we believe reliable but we cannot guarantee its accuracy or completeness. This report is not and under no circumstances is to be construed as an offer to sell for the solicitation of an offer to buy any securities. This report is furnished on the basis and understanding that Maison Placements Canada Inc. is to be under no responsibility whatsoever in respect thereof. Directors, shareholders or employees of this company may be beneficial owners of the securities referred to herein.