Sunday, May 31, 2009

Seek Refuge in Modern Day Communism

It's not a shock to anyone.

The U.S. economy is in shambles and is spending/creating money in excess daily. Agreed, most of the world is doing the same in an effort to stimulate their economies. However, it is difficult to find a government more willing to inflate its currency more than that of the United States. Luckily, the U.S. dollar has its reserve status to bail it out. Nearly every commodity is priced in U.S. dollars and it is the most accepted currency on the planet... For now.

It is my opinion that most Americans, while growing more skeptical of the smoke and mirrors of the bureaucrats in Washington D.C., cannot fathom a world in which their currency no longer holds its reserve status or realize what that would mean to the United States economy. Most people forget that the U.S. dollar at one time was backed by gold. It was at Bretton Woods in 1944 that the world supported the U.S. dollar as the world's reserve currency, as long as its value was supported by gold. The world understood that inflation was the enemy of any economy, having seen the extraordinary hyperinflation created by the Weimar Republic of Germany, where the money supply grew so rapidly that bills printed just a week prior were deemed worthless.

However, after enduring some of the complexities that maintaining a currency to a fixed price of gold created-- such as other countries' reserves growing more quickly than the United States', and the U.S.'s choice to pay for the Vietnam War and The Great Society programs through inflation and not increased tax revenues-- the gold standard officially ended in 1971, when the U.S. closed the gold window, thus making the dollar and gold nonconvertible. At that time, the U.S. government fixed the price of gold at $35/oz.

As of 1933, the U.S. government under Executive Order 6102 during the Roosevelt administration made it illegal for U.S. citizens to own gold. This order remained intact, even after President Nixon announced in 1971 that U.S. dollars would no longer be convertible into gold. The limitation on gold by U.S. citizens was repealed on December 31, 1974 under the Ford administration.

The massive increase in gold prices that ensued after the U.S. closed the gold window, crippled the ability of U.S. citizens to protect themselves from the U.S.'s inflationary policy. As mentioned, the fixed price of gold in 1971 was $35/oz.

On December 31, 1974, when U.S. citizens were legally allowed to purchase and own gold again, the floating rate was $186.50/oz. on the London exchange.

On January 1, 1975 the price of gold dropped to $175/oz, then spiked in February 1975 to around $185/oz before sinking to $105.70/oz on September 1, 1976. The foreign markets had decided to take advantage of the United States citizen's appetite for gold and sold a substantial amount of it to them for an equally substantial profit.

Undoubtedly, investor confidence in gold as an investment waned after its massive loss in value, keeping many on the sidelines just as gold prices rose again during the inflation of the latter part of the 1970's.

On January 21, 1980 the price of gold rose to an all-high of $850/oz before turning downward again. The Reagan Administration's efforts to revitalize the U.S. economy in the early 1980s through tax cuts, coupled with Paul Volker's war on inflation, were largely responsible for gold's devaluation and investor's desire to hold it as a safe haven.

Looking at our current situation, it is interesting to note that according to Goldprice.com, the inflation-adjusted price of gold in 1980 was around $2,176/oz in today's terms. Also of note, the Dow-to-gold ratio, which is the price of the Dow Jones Industrial Average divided by the spot price of gold, has historically had a median value of around 12. During the turn of the new millennium, however, the ratio reached an all-time high of around 43. Currently, its price is around 9.

While the current Dow-to-gold value suggests that the price of gold is relatively expensive, in comparative terms to its historical median, gold's current spot price of around $950/oz, when compared on a historical level to its inflation-adjusted price, appears to be quite cheap, especially considering that the world has not yet incurred the stresses of the massive inflation that is being created, in particular, in the United States but also across the globe.

It is of particular note that the United States' debt as of the end of fiscal year 2008 was $11.3 trillion or 79% of our 2008 GDP, which does not include the amount of unfunded commitments, such as Social Security and Medicare. The U.S. total debt is on pace to equal 100% by 2013, based on slightly less generous data than what President Obama is currently projecting, which, at this point in time, is suspect, to say the very least.

So am I suggesting that one should buy gold at its current level?

No.

On the contrary, while I believe that gold will make a solid hedge against inflation in the coming periods, which I will tackle in a future article, I believe that a much better investment lies abroad in the least liquid market of all of the emerging nations in Asia. The Renminbi.

"The What?"

The Renminbi is the official currency of the People's Republic of China. The currency is currently pegged to the U.S. dollar and has a current exchange rate of approximately 6.82-to-1 USD. The Renminbi is currently is not a free floating currency on the foreign exchange market (FOREX), however, so it must be purchased in China, through a Chinese bank, or via a local exchange or bank.

"If it's so difficult to get, then why should I go through the trouble to get it?"

Since its economic liberalization in 1978, China's economy has grown more than 70-fold and is among the fastest growing economies in the world, with its GDP having averaged 9.7% growth since 2000. (The United States has averaged about 2.3% annual growth over the same period.) China's GDP currently ranks 3rd in the world, nominally speaking, (behind the U.S. and Japan), although its per capita is approximately $3,300, making China, on a relative basis, one of the poorest countries in the world. While its combination of a low per capita and a world-leading population of 1.3 billion pose a very serious problem for China going-forward, it is very difficult to overlook the growth that this situation possesses as well.

China is currently the 2nd largest exporter in the world behind Germany and has the largest foreign exchange reserves in the world by a wide margin-- it has about 92% more reserves, or nearly $1 trillion dollars, more than the next closest nation, Japan. China has also quietly become the largest producer of gold in the world. And it has also been buying a plethora of hard assets with its reserves and engaging energy exporting nations, some of whom have not traditionally been allies of China.

From purchasing gold mines in Kyrgyzstan, mineral producers in Australia, signing long-term oil contracts with Russia, who has traditionally not been friendly to China, and aligning itself with Nigeria, the 8th largest exporter of oil in the world, China is, in effect, repeating what the U.S. did after WWI-- preparing itself for the future and, most likely, the leader superpower of the 21st century. Although this time, China, which is and will be in desperate need of energy in the near future, is doing the smart thing-- it's buying hard assets and paying for future contracts in U.S. dollars, while the dollar still has some value.

"What do you mean, 'While the U.S. dollar still has some value?'"

The Chinese government currently owns approximately 25% of the United States' debt or roughly $739.6 billion. (Japan currently owns approximately 20% of U.S. debt.) China has been, until recently, more than willing to purchase U.S. debt. In fact, one might say that China was buying the U.S.'s debt in order to grow its own economy.

Think of the cycle as such:

U.S. consumers looking for cheap goods, buy from China, China increases its foreign exchange reserves in U.S. dollars and spends it on building its own infrastructure. The U.S. is a credit thirsty economy in the midst of a huge credit bubble, the biggest on record, and issues even more debt. The Chinese are more than willing to buy it and, in turn, use the dollars to grow its infrastructure and economy even further.

The Chinese, aware that the U.S.'s credit-based economy is unsustainable, decides to par back on its credit purchases, thus collapsing the cycle and the U.S. economy. Granted, the latter is not fully accountable for the U.S. mess, nor its consequences yet reached, but it is currently underway. Even more advantageous to China, it also heeded Warren Buffett's words of wisdom on derivatives, which have brought the financial community in the West to its knees.

In Berkshire Hathaway's 2002 annual report, Buffett warned that derivatives were "financial weapons of mass destruction," due to their grossly inflated mark-to-model accounting value, extreme complexity and ability to manipulate credit ratings, which, in turn, can mislead investor confidence as to their viability. While most of the developed world turned a blind ear (and eye) to his words-- Buffett, incidentally, has since sold a bunch of derivatives into the marketplace, putting Berkshire at potentially significant risk if the S&P 500 is not around its current level in 10 years time-- an educated China listened intently and, thus, avoided, for the most part, the wrath of the financial tsunami that has taken the Western world by storm.

So what does this mean for China going-forward?

Although China is still heavily dependent on the world to buy its goods, there is good reason to believe that China will use this global downturn to focus its resources on building itself from the inside out rather than its historical outside-in approach.

China is still a poor country, and although its government would like to portray the country as communist, it is clear to the outside world that China also has a capitalist appetite. Not only that, but its leaders are from a much older generation, and one can soon envision China walking down the same path that Russia did during the late 1980s/early 1990s.

Don't get me wrong, I don't believe China will break up or that there will be a revolution of sorts, at least not from a militaristic sense, but many of its industry leaders have attended university abroad, and one cannot doubt that those same citizens would like nothing more than to see China, at a minimum, share the same standard of living as the West. And the only way to accomplish this is to build the Chinese middle class from something that barely exists today.

Unemployment in China in 2009 is officially around 4% (unofficially as high as 8%). This, along with energy, which China is currently working on securing, will probably be China's biggest problem going-forward. However, it is difficult to imagine that China, which was so smart to avoid the financial meltdown of the West, is not aware of this. And since China knows that it probably cannot be reliant on the rest of the world to purchase its goods in the near-term, given that the U.S. credit bubble has forced many nations to take on an extraordinary amount of debt, it is, in my opinion, safe to hypothesize that China will turn its focus to building its middle class (re: ensuring employment for its people, mostly likely through its continued focus on manufacturing) so that it can be more self-reliant, much like the U.S. has been for the last hundred years, prior to 2000.

There have also been recent reports suggesting that China is trying to make the Renminbi the next world reserve currency. The reports point out that China is, as stated above, buying hard assets with its dollars, buying less U.S. debt (with a focus on short-term bills), and starting to make contracts with other nations in Renminbi. This last fact is a huge turning point, and quite possibly, a paradigm shift for China.

Recently, China signed an agreement with Brazil that will make contracts payable in each other's currencies. As previously mentioned, China is the #1 holder of U.S. debt. Brazil ranks #5, with nearly 5% of all U.S. public debt. As I also mentioned, China is the #1 holder of foreign exchange reserves. Brazil ranks #5, with an increase of over 100% in 2007 alone. If China and Brazil are exchanging each other's currencies, they are, in effect, dumping the U.S. dollar. China is already buying hard assets with its dollars. Is it likely that Brazil, if it isn't already, will do the same? Absolutely.

While I am not suggesting that the Renminbi will, for certain, be the next world reserve currency, especially any time soon, the facts speak for themselves. China is distancing itself from the U.S. dollar, which its currency, ironically, is currently pegged to.

I believe that it is very safe to assume that China will, at some point, likely within the next decade, unpeg the Renminbi to the U.S. dollar. When it does, it is, likewise, safe to assume that the world will probably prefer the Renminbi and its strong, tangible asset backing versus the dollar's debt-laddened "assets." While one cannot be sure when China will allow the Renminbi to float freely, it is quite certain to believe that it will have to if it wants to overtake the dollar as the world's reserve currency.

(It is my belief that China is currently trying to figure out how exactly to separate itself completely from the U.S. dollar without completely damaging its economy due to an inevitable rise in the Renminbi afterward.)

Based on many assessments, I believe it is safe to assume that the Renminbi, which the U.S. has stated several times during the past few years is being manipulated in order to maintain China's status as low-cost producer in the world, is currently at least 50% undervalued. In the future, however, I believe that its value can and will rise much more, perhaps several times that, versus the U.S. dollar, especially since it is now difficult to obtain, specifically in large quantities.

Therefore, it is my belief that one should buy the Renminbi while it is still illiquid and before most people (and nations) are likely to obtain it and, by definition, create demand for it.


Disclosure: The author currently owns Renminbi.

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