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Gold: A Tale of Two Deficits

July 25, 2002

Gold rallied over $320 an ounce, ending a month long correction as the euro rose above parity against the dollar. We believe the second leg will begin shortly and will see $375 per ounce before the yearend. Since last year, gold has jumped 15 percent as the weaker US dollar made the metal cheaper for foreign money. Gold is emerging as an alternate asset class to the dollar as investors seek refuge from falling stock markets, geopolitical concerns and a lack of confidence in the integrity of those markets.

We believe gold's price rise is a reflection of a looming crisis. The United States has turned from a creditor nation to a debtor nation. Debt must be reduced. That means the dollar will fall further. As such, gold has begun a multi-year bull market that will see $510 an ounce next year.

A more rapid fall in the dollar is likely. After a decade of pumping billions of dollars into the US because it seemed like the "land of milk and honey", investors are seeking a premium to hold US dollar assets. America's status as a safe haven is shaky.

The Return To Red Ink

Today, America again faces twin deficits. Mr. Bush has become the biggest spender in decades, causing a swing from five consecutive years of budget surpluses to an expected budgetary deficit of $200 billion. The White House cites the economic slump, the War on Terrorism and a drop in tax revenues as reasons for the deficit. Little is said of the new Homeland Security Department or the billions of pork barreling that was added to expenditures. It is our belief that there has been a long-term structural change and we are at the start of a multi-year decline in the dollar. In addition, US assets are over-owned and over-valued; money will leave because they no longer promise good returns, particularly with interest rates at forty year lows.

The US Economy Has No Clothes

The long awaited dollar devaluation is due not only to the prospects of twin deficits but also to the erosion of confidence and the demise of that country's icons. The swamp has drained and now heavyweights from Merrill Lynch to WorldCom, Arthur Andersen to Tyco and Enron to Dynergy have exposed the fragility of the bubble. The perception now is that the US economy has no clothes, and the bubble was due more to "funny accounting" and "infectious greed" rather than good management. Less foreign money coming into the US and a bigger government presence in the bond market (to finance the deficit), means funds will be scarce.

The collapse of investor confidence in the integrity of America's capital markets has caused a witch-hunt of its corporations, accountants, regulators and even Martha Stewart. A crisis of confidence has put down roots amid the wave of scandals. The loss of foreign confidence is important because the deficit has been a key factor in that country's prosperity. Foreign money largely financed America's consumption and increasingly a ballooning federal budget deficit. The current account deficit in the first quarter soared to a record US$112.5 billion from a revised US$95.5 billion a year earlier. In April, the deficit was a record US$35.9 billion from $32.5 billion in February. The deficit is of concern because the US must absorb an ever-increasing share of global savings to finance an unsustainable current account deficit of $450 billion or 5% of GDP. The Americans depend upon inflow of $1.7 billion a day to sustain the deficit and keep the dollar and US stock prices from falling. It is estimated that foreigners own about 40% of the US treasury market, 24% of the corporate bond market and 13% of the equity market. But this has changed. According to the Treasury Department, foreign investment in America stocks and bonds totaled $100 billion in the first quarter, which compares unfavourably to $522 billion in all of 2001.

Dollar Collapses Have Been Good For Gold

In the past seven years, the US dollar surged 50% to a peak in February, coinciding with the greatest financial bubble in history as the US stock market soaked up billions of foreign capital attributable to the insatiable appetite of foreign money. America's current account deficit today is far higher than before the sharp dollar falls of the 70s, mid-80s and mid-90s.

So far the dollar's decline has not led to a major exodus of foreign investors. The decline has been benign, although on a trade-weighted basis, it is down 13% from its peak in February. But, history shows that past dollar corrections have been violent. With the collapse of the Bretton Wood's system of fixed exchange rates in 1971, the dollar went through two extended periods of weakness. Between 1971 and 1980, the Americans ran twin deficits (current account and budget) and the US dollar lost 70% of its value against the Swiss Franc, D-Mark and other currencies. Gold went from $50 per ounce to over $800 per ounce. In 1985, the Plaza Accord bailed out the US economy and the dollar fell 35% against a basket of currencies in 12 months. At that time the current account deficit was less than 3% of GDP. Gold in the same period went up 66% from $300 to $500 per ounce.

Debt - Crisis of Confidence

The largest bankruptcy in history looms (at least for now) as WorldCom admitted it pumped up financial results by US$3.8 billion. With an estimated $105 billion in assets, WorldCom's collapse has eclipsed Enron's bankruptcy. What is unfolding is the unraveling of the financial market's excess, bubble by bubble or company by company. Many think or hope that the unraveling is almost over with the WorldCom news but, we've only just begun. While everybody is focusing on the team of accountants and regulators that are scrutinizing corporate America for further transgressions, little is said of the process or the monetary framework that fueled the boom.

The Bubble Will Keep Deflating

Simply, America's bubble was fueled by massive borrowing by both companies and households alike. Although the huge inflow of foreign capital was a major factor in financing that prosperity, the Fed's aggressive monetary stance was the real culprit. With the economy slowing down, bank lending has declined significantly and the capital markets are closed. With much of corporate America's debt just above junk bond status, corporate America's dilemma is how to finance business and service debt payments. The US telecom sector has more debt than the entire Japanese real estate sector.

Too Much Debt Causes A "Death Spiral"

For sometime now, economists were complacent about the increase in debt because balance sheets looked healthy; everyone went on a borrowing binge, as debt was cheaper than equity. Investment grade companies floated a record $582 billion of bonds in 2001. In the first quarter, $184.5 billion of investment grade bonds were issued. Credit quality, of course has deteriorated and the derivative market also provided wholesale money that was often not shown on the balance sheet. Companies that added debt are now caught in a vise of falling revenues and the need to finance interest payments. The series of collapses are causing a "death spiral" as falling stock prices undermine the investment capital of the financial institutions that previously financed the last boom. The full damage has yet to be revealed. Since the start of the year, the amount of US commercial paper outstanding for non-financial companies has dropped to $176.7 billion from $224.8 billion. The derivative market today is believed to total $138 trillion overshadowing the debt market estimated at $38 trillion. In the first quarter, JP Morgan's derivative book is believed to be about $63.4 billion, while Citibank is estimated to have $11.2 billion in derivatives.

One of the biggest risks in derivative contracts is that the counter-party does not or can't pay. This happened in the gold market and the Russian crisis. Of concern is that the amounts involved are now multiples of the capital of the lending institutions- no one is too big to fail.

America Is Following The Japanese - Only Ten Years Later

And that is where America is following the same path taken by Japan ten years ago. Like Bre-X, a burst bubble is followed by years of prolonged recession. Japan is still struggling from its own long-burst bubble. The eerie similarity between the United States of today and Japan of the 90s is that both have excessive debt. Japan's excess was fueled by crazy property prices and a booming stock market. Similarly, a stock buying mania drove the Dow to record highs. When the bubble burst last year, the Americans faced a Japan-style deflation. In late 1998, after the Russian defaults and Asian contagion, the Fed lowered rates. US monetary policy is considered to be the most powerful tool to fight recession. After September 11th, the Federal Reserve moved again aggressively to cut interest rates to forty year lows. And like the Japanese, the Fed has exhausted its rate-cutting options and now has little room to maneuver with rates at nominal levels. And defying conventional wisdom that lower rates are bullish for stock prices, the US economy, like Japan, has not picked up. The dollar must come down further. Worse yet, US foreign exchange reserves stand only at $30.8 billion, less than 10% of $409 billion held by Japan.

The build-up of debt is a legacy of the past that must be dealt with today. Japan is still mired in a decade-long struggle with deflationary forces - a vicious cycle of dropping prices, imploding asset values, rising unemployment and lower stock prices. We have been down this road before. In the 20's and 80's speculative bubbles were followed by years of relearning the fundamentals. The United States will revive from the binge but it will take years to recover from the self-reinforcing implosion of asset prices and demand.

The disillusionment with US markets and the greenback has caused a revival of gold, which touched $330 an ounce. In our view, gold has begun a secular bull market. Dollars are flowing into other currencies and gold. The lower dollar will also revive dormant inflation. Last year we had a flight to quality and safety in Japan and Argentina, with their banking institutions and currencies in crisis. With the drop in the dollar and the stock market, gold has regained its position as a safe haven asset and is a good thing to have.

Hedging- No Longer Acceptable

In the past, gold producers sold unmined reserves in the forward markets through the bullion banks at a pre-agreed price for delivery in the future. The bullion bank borrowed the gold from a central bank at say 1.5%, and would have a short position while it waits for delivery of the mine production. The gold producer would invest the proceeds in interest-bearing investments or the contango to earn 3%-5% for a "carry trade". In an environment of sinking prices, the twenty odd or so banks were happy to make money and generate fees. Eventually, the producer would deliver the gold and that gold was returned to the central bank. For the central bank it was a zero sum game since they lent out their gold at modest interest rates and the gold was eventually returned. However, the decline in interest rates and the rise in gold price has exposed the risks of that trade.

Recent hedge buybacks have seen deliveries into the hedge books and the repayment to the central banks. With, the price of gold raising many gold producers are unwinding their positions. This added demand to the marketplace and removes supply from the market, which caused the price of gold to strengthen further, ironically hurting the position of the counter-party, or bullion bank.

The Higher The Gold Price, The Bigger The Risks

Now in a world where gold has ranged between $250 and $350 per ounce, the positions of the gold producers, central banks and the bullion banks were more or less in equilibrium. However, in a world of $350 plus gold price, there is a problem. First, the mark-to-market position of all gold producers today is underwater. At $350 plus, the balance sheets of many of the producers would be constrained. Of more significance, is the bullion banks' position since they holds the other side of the gold producers' position. There is no question that with abundant reserves, a gold producer can withstand many shocks. However, as we have seen following the Enron and WorldCom debacle, neither bullion banks nor the banking community are immune or too big to be caught in a massive short covering squeeze. And that is the problem with gold hedging, the higher the gold price, the bigger the risk for the gold bullion banks and, of course, the hedging market.

…For The Bullion Banks

But wait, it gets better. You can only buy a maximum four-year contract on the COMEX market. The gold bullion banks created new derivatives to generate more fees, extending this term, utilizing their own balance sheets. Barrick, for example has up to a fifteen-year facility with some twenty banks. Barrick and the bullion banks created "spot deferred contracts", which allowed the gold producer the right to defer its deliveries and corresponding forward price to the bullion bank for up to fifteen years. Therein lies the risk since the bullion bank is exposed. If Barrick decides to defer or if a particular central bank decides to call in its position with that bullion bank, due either to something like the Washington Agreement or as with the Dutch central bank, a desire to lower its risk in a volatile market, the bullion bank is exposed.

…And The Producers

In addition, since the gold industry wanted to take advantage of the time value of money, the bullion banks created even more exotic instruments. These new derivatives didn't require margin or exotic call strategies. After all, since the gold producers held abundant in ground reserves, their balance sheets would be good enough. In our last gold report "Gold: We've Only Just Begun" we showed most hedgers have hedged in excess of two years of production. It is our view that companies with hedges beyond a couple of year's production lose flexibility when the gold prices rises. (Table 1.) Newmont was the only senior gold producer with a hedge position of less than one year. It is our view that within a rising price environment, a "no hedge" position or a hedge position of less than one-year is good.

And it gets even better. Recently, a portfolio manager at a major institution came under criticism because he suggested there was a gold conspiracy by the US Treasury, BIS, IMF, the central banks, JP Morgan and Citibank to suppress the price of gold. Whether or not there is indeed one, a relevant point is that the hedging business is a huge business. There are no definitive numbers as to how much is hedged. That portfolio manager alluded to an official position of perhaps 5,000-10,000 metric tonnes but it may be as high as 15,000 tonnes or 1/3 to ½ of all Central Bank holdings today. We believe at only 5,000 tonnes that in itself would represent more than two years mine supply.

Consequently, the higher the gold price, the bigger the risk, for the gold producers who have hedged, for the bullion banks who have hedges and the Central Banks. Ironically, as Ashanti, Cambior, Long Term Capital Management and Enron have learned, hedges are not so perfect. Gold is a good thing to have.


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