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CHINA: ECONOMIC, POLITICAL AND MILITARY POWER

CHINA: ECONOMIC, POLITICAL AND MILITARY POWER

China has many geopolitical interests and wants to be the world’s pre-eminent super power.  Their thinking is long term, which contrasts markedly with the short term, short sighted, politically expedient thinking found in the Europe/Japan/U.S. axis.  China continues to set itself up to be the world’s greatest economic power in twenty years.  Here is how we believe they will do it.

  1. China is a gold buyer and holder, giving their currency a strength not shared by other nations.
  2. They are moving toward more bilateral trade agreements.  They have signed six recently where the Chinese Yuan was the medium of exchange.
  3. China is making their opinions felt on the world stage with comments on how the U.S. should handle their deficits, and how the IMF should behave (selling gold to help poor countries and giving money to whom and when).
  4. By announcing that they would become a major trader in metal commodities like the London Metals Exchange, they are stating that they will be holding metal for their own use, and acting as an agent for the purchase of commodities by others.  This insures the availability of resources for themselves, and gives them a lever to withhold commodities for military or political adversaries.
  5. At about the same time as these other events were announced, China staged a show of their naval forces to exhibit to the world that they are also a burgeoning naval power.
    China is following through for their long term goals to be the world economic, military and political superpower.  As an outside observer, I would say that they are making good progress implementing their plan.  In an article from the April 23rd, Financial Times, Jim O’Neill, chief economist at Goldman Sachs says it well:

China Shows the World How to Get Through a Crisis
By Jim O’Neill, FINANCIAL TIMES 

Call me mad but this crisis is good for China. It is also good for China’s role and responsibilities in the world.

Yesterday, we upgraded our gross domestic product forecasts for China for 2009 and 2010; we are now looking for 8.3 and 10.9 per cent, respectively, up from 6 and 9 per cent.

Why the optimism? It was clear that the massive rise in exports, the mainstay of the China growth model until 2008, was not sustainable. At one stage in late 2007, Chinese exports to the US alone were about 12 per cent of total GDP. This meant that exports would suffer badly in the event of something going wrong with demand in the US, and the risk of a protectionist backlash.

This led some of us to expect an end to the fixed Rmb8.28 exchange rate to the dollar and a gradual shift to a more flexible, stronger exchange rate a few years ago.

Fast-forward to the crisis. When this intensified post-Lehman, global trade suffered enormously and quickly, and it was clear that Chinese growth would suffer. It was also reasonably clear that, just as they did in response to the Asian crisis in 1997, Chinese policymakers would react swiftly and shift gears. That they have done.

Three policy initiatives stand out, and the results are starting to bear fruit, hence our upgraded forecasts.

First, in November the authorities announced massive fiscal expansion, centred on fresh infrastructure spending. While my industry has quibbled about its true size ever since, this misses the point. The statement of intent was clear; interestingly, the stock market noticed and has rallied since.

Second, and ultimately perhaps the most important development in the world economy, the government announced plans to develop a full medical insurance policy for the still vast rural community, the beginnings of which it plans to have fully implemented for 90 per cent of the rural community by 2011. This could result in an end to the excessively high Chinese savings rate and allow much stronger consumption.

Third, and critical to our forecast upgrade, the authorities, led by the People’s Bank of China, embarked on a timely reversal of tightening financial conditions of the previous two years. According to our Chinese financial conditions index, conditions have eased a huge 520 basis points since last October.

These three measures have set the scene for an acceleration of Chinese domestic demand for the rest of 2009 and 2010, just the right recipe for China and, critically, the world.

The next stage of China’s development has started and is likely to go on for years. It was partly in anticipation of this that we highlighted owning China "A" shares as one of our most favoured trades for 2009. As they have risen 50 per cent since the November stimulus announcement, the entry point is now less attractive but, as evidence of rising demand accumulates, many investors are rightly going to be attracted back to China.

The "C" in the Bric economies (Brazil, Russia, India, China) has always been the most important of the four and the events of the past five months continue to justify our excitement for the longer term.

Amusingly, in the past year many people have suggested that the Brics story is over. Nonsense – it is still in its infancy. Indeed, the updated longer-term projections we published last summer, suggesting that China could overtake the US by 2027 and that the Brics collectively could be as big as the G7 by 2027, still look decent bets to me.

At some stage in the coming months, once it becomes clear that Chinese GDP growth is safely back above 8 per cent, policymakers will allow for some tightening of financial conditions again, possibly led by the exchange rate.

In the next two years, China is very likely to overtake Japan to become the second-largest economy in the world. Some say that China might get old before it gets rich, but it is getting bigger and richer, that is for sure. One or two of its ageing G20 partners may wish to take a closer look at Chinese economic policy to see how it’s done.

INDIA
The Indian stock market has been doing well after the Satyam scandal.  Now, the elections are underway and results will be made public May 16th.  Some investors will wait until after the national elections to make sure the probable coalition government will be effective.  If the parties on the left, the Marxists, communists, etc. are included, you could have an ineffectual government which could result in a market setback.

COMMODITIES

The U.S. Federal Reserve has tripled the size of its balance sheet in recent months.  Deficits in the U.S., Japan, and Europe are at record percentages of GDP.  This, plus the big money supply expansion in many parts of the world, both argue strongly for a resurgence of inflation, most probably by the second half of 2010.

Stock markets are discounting mechanisms.  One need only look at the current stock market rally worldwide, while world economies continue to weaken, to see that they are discounting a recovery.  Is the recovery one year away?  Two years?  The market thinks it is more likely 12 to 18 months.  In any case, the eventual resurgence of inflation is good for commodities, especially gold, agriculture, and oil.  We believe that the recovery will include a slow growing, but stable economy for a few years in the developed world, and steady growth in China, India, and a few other countries.

GOLD

Who holds the gold?  Recently announced numbers show that China has upped their gold holdings to over 1,000 tons, making them #5, after the U.S., Germany, France, and Italy.  India is #10.  China’s recent announcement that they had increased their gold holdings indicates once again China’s efforts to strategically position themselves to be a leader in the community of nations.  Remember the old cliché about the golden rule?  He who holds the gold makes the rules.

China Doubles Gold Holdings and Raises Questions on Reserve Policy
By Jamil Anderlini in Beijing and Javier Blas in London, FINANCIAL TIMES 
China has quietly almost doubled its gold reserves to become the world’s fifth-biggest holder of the precious metal, it emerged yesterday, in a move that signals the revival of bullion after years of fading importance.
Gold rose to a three-week high of more than $910 an ounce after Hu Xiaolian, head of the secretive State Administration of Foreign Exchange, which manages the country’s $1,954bn in foreign exchange reserves, revealed China had 1,054 tonnes of gold, up from 600 tonnes in 2003.

The news could spark interest in gold among other central banks.

"When the largest holder of foreign exchange reserves discloses an increase in gold holdings, other countries may decide to think more carefully about underweight gold positions," said John Reade, a precious metals strategist at UBS.

The increase in China’s gold reserves has come primarily from domestic production and refining. However, the news raises questions about the future of Beijing’s foreign reserves policy.

Ahead of the G20 summit in London this month, China suggested that the global financial system’s reliance on the US dollar as a reserve currency should be reduced.

China has been diversifying away from the dollar since 2005, when it broke the renminbi’s peg to the US currency and officially marked it to a basket of currencies, but it still holds more than two-thirds in US dollar denominated assets by most estimates.

As its trade surplus and foreign exchange reserves ballooned in recent years, Beijing continued to buy huge amounts of US Treasury bonds while raising the proportion of purchases it allotted to other currencies and to gold.

China’s accumulation of gold has taken place as European central banks have gradually cut back gold sales following a 1999 agreement to prevent the market from being flooded after prices were dragged sharply lower after the UK decided to sell part of its reserves.
"China’s announcement signals a broader shift in central banks’ attitude towards gold," said Philip Klapwijk, chairman of GFMS, the precious metal consultancy.

Paul Atherley, Beijing-based managing director of Leyshon Resources, said that even after the latest purchases China had a very small percentage of its reserves in gold, far below the US or other developed countries.

AGRICULTURE

Global demand for grains will once again establish itself as the global de-stockpiling of grains while prices fell will have to be reversed.  Globally, grains are in short supply, and this bodes well for the price of grains and of fertilizers.  The amount of disinformation and outright BS (a popular scientific term) about grain and fertilizer demand remains huge.

OIL
Oil prices have been stable while demand has been weak, due to falling supply.  OPEC has been disciplined, and the cheating by OPEC members on their quotas has been minimal.  So, we anticipate that oil prices will stay in the $40-$55 per barrel range for a few months, before rising to about $60 per barrel by year’s end.  We have been buying Canadian and U.S. royalty trusts on price weakness, especially those which produce oil.

REAL ESTATE

Commercial real estate is experiencing substantial demand decreases, especially in the shopping center and mall markets.  Residential real estate prices are in a long term downtrend driven by demographics, an oversupply of housing, and a shortage of cheap financing.

Homeowners who bought too much house, and have been trying to sell, have been slow to mark down the price to realistic levels.  Now, they are starting to do so.  This is counter balancing the seasonal up tick in home sales in May through August in the northern hemisphere.  We do not believe the bottom has arrived in housing prices, but we may see a short term uptrend during the spring and summer selling season

SUMMARY

Investors are enjoying a durable market rally in stocks in China, India, Brazil and the developed markets as well.

As we stated last week markets could rise or fall about 20% from the level last Monday April 20, 2009. Clearly the markets fell early last week but the small size and short nature of the pull back made us more optimistic about the rally continuing. We look for higher prices for stocks in coming weeks. Further confirmation of the uptrend has been created by the markets’ hugely positive reaction in spite of the fears about a global flu outbreak. This argues strongly for higher stock prices over the immediate future.

Thanks for listening.


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