Hello! I hope you had a fabulous weekend and remembered to call your mama on Sunday.   🙂

Today I have more for you from the Casey Conference, where we continue our international travels, moving now from Europe over eastward to China.

Gordon Chang, columnist for Forbes.com, gave an impassioned talk on China’s faltering economy but ended on a surprisingly upbeat note for the good ol’ US of A! Gordon has lived and worked in Hong Kong and China for almost two decades and is the author of Nuclear Showdown: North Korea Takes On the World and The Coming Collapse of China (so I guess you’ve probably gleaned his view of China’s economic future from that title!).

I encourage you to read the key points from his talk, however, as he brings up many interesting factors, particularly about global trade and dealing with Iran, and how all of these items might affect the price of gold and other commodities.

If you enjoy these reports, I highly recommend you get the audio recordings — I only captured a fraction of the discussion in my notes (although today’s is quite detailed because I am very interested in China).   🙂

Enjoy!

Gordon Chang — China & Global Commodities Markets

Gordon kicked things off by discussing China’s demand for commodities this year, which depends on two factors:

  1. The general state of its economy (meaning that except for one special metal, China’s demand for almost everything will level off)
  2. That special metal…China will need much more of it this year

(Kung Fu Girl Note: hmm…what metal could that be?)   🙂

China’s Faltering Economy

Gordon had a ton of statistics to back up his position that the Chinese economy is slowing.

Here are just a few…

This month, the National Bureau of Statistics in Beijing said that China’s economy grew at 8.1% in the first quarter of 2012, off from 8.9% in 4Q’11 and 9.2% for 2011 overall.

This might sound terrific to us Americans who would die for 8.1% growth(!), but apparently this spooked everyone else because it came in far below estimates and was below Beijing’s own forecast of 8.4% released as late as April 3rd (which shows how quickly the Chinese economy is decelerating).

And Gordon said that even that overstates China’s economic performance by a wide margin, because it doesn’t correlate with other information he knows from other official sources.

Gordon believes the Chinese economy is growing by only 6%, maybe only 5%, and says that the best indicator by far of Chinese economic activity is the generation of electricity.

And that is dismal…apparently in the January / February time period (these two months are combined to eliminate the distortion caused by the Chinese New Year holiday) electricity output gained only 7.1% year on year, and in March it increased to 7.2%, the “lowest monthly increase for a non-holiday month” in a year.

Gordon says that because the growth of electricity always outpaces the underlying growth of the overall economy, we know that China’s economy cannot be growing by more than 6% (and he said that due to other factors, it actually looks closer to 5%).

More Gloomy Statistics

Some other signs the Chinese economy is slowing…

  • Car sales are down 1.8%, year on year
  • Commercial vehicle sales are down 10.8%
  • The HSBC Purchasing Manager’s Index (PMI) was down for the 5th straight month in March
  • There have been declining property sales for both residential and commercial markets, down 14.6% in Q1’12

And apparently even the “positive-territory” indicators for the first quarter of this year were disappointing, because the percentage increases were not as much as we saw at this time last year.

Gordon was especially troubled by the imports statistic…imports grew at only 5.4% which he said was a sign of weakening consumer demand, and he said that would have been even lower if it weren’t for government-directed stockpiling of commodities, especially oil.

Gloom, gloom, and more gloom…

The momentum is clearly to downside, according to Gordon, and is increasingly difficult to reverse.

This month’s HSBC PMI was also negative…apparently it improved slightly but was still “deep in negative territory” (I sound like a CNBC reporter!) at a time when the economy and manufacturing should be rebounding, particularly after the Chinese New Year holiday period.

Foreign analysts said that because this number looked a little better, it showed that Q1 was the “trough” of the Chinese economy, but Gordon believes it is much too early to say this.

Foreign Exchange Reserves

Given the sudden deceleration of the economy, Gordon said that it is not surprising that there is a new pessimism inside of China. Foreign exchange reserves have been growing for years, but now they have declined by $20.6 billion in the last quarter of 2011, which apparently is the first quarterly outflow since 1998.

Gordon believes that this small net outflow masks an important trend…

Capital Flight

He dug more into the actual numbers and said that foreign exchange reserves increased by $72.1 billion in October and declined by $92.7 billion in November and December.

Why the sudden reversal?

Gordon said that most analysts attribute the turnaround to capital flight—they believe there is approximately $100 billion worth of outbound hot money in the 4th quarter, which followed an estimated $34 billion of outbound hot money in the 3rd quarter.

Gordon believes that Chinese businesses and citizens are getting worried and are taking their money out of the country.

Inflection Point

So, after 35 years of virtually uninterrupted growth, Gordon believes that the Chinese economy has hit an inflection point and that September was the peak.

Now, post-September, we are seeing unmistakable signs of flattening growth, and he went as far as to say that the “wheels are coming off” of the Chinese economy.

He said that many analysts don’t worry about a bad quarter or two, and believe that these problems are temporary and will be forgotten because China is in a great upward super-cycle. But Gordon professes that sweet spot era in history is now over, because the conditions that created it either no longer exist or are disappearing quickly.

He explained that:

  • China is no longer reforming,
  • The international system is no longer benign,
  • China’s demographic boom has turned into a demographic bust, and
  • Their political system is falling apart.

He said that leaders in Beijing are not paying attention to the economy—they are much too worried about doing each other in and there is much troubling and disruptive infighting going on today.

He gave a few examples of this, and said that last month Premier Wen Jiabao said China could fall into another cultural revolution.

What Does This Mean for Commodities?

Gordon believes that all of this spells big trouble for the world’s miners and oil drillers.

He said that many commodity analysts seem to think that China will be buying metals in ever-increasing quantities for the indefinite future…

But he disagrees (vehemently, I might add…) and said that the laws of economics do apply in China, and as the Chinese economy heads for zero growth or worse, China’s demand for commodities will fall off and their purchases of commodities will decline.

Gordon says this is going to happen, and that we are going to start to see it happen in the next few months. In fact, he thinks it may already be happening…

Apparently in March, on a month-to-month basis, Chinese oil imports dropped 5.8%, copper was off 4.6%, and iron ore shipments were down 3.2%.

Gordon says that those declines are significant because they happen at a time when the Chinese economy traditionally recovers from the NY holiday.

He said that we should not be surprised if China starts to dump commodities on the global markets, and that it has previously exported commodities that have been stockpiled and this could happen again if manufacturing continues to falter.

He quoted a report from Credit Suisse from late March, which said something to the effect of, “China made the commodities cycle a lot more powerful on the way up, but now it can also work the other way.”

Gordon seemed surprised that commodity suppliers around the world do not seem to be particularly troubled by this news (at least so far).

Iron Ore

Apparently iron ore miners are a case in point, and a senior executive of BHP Billiton rocked global equity and currency markets last month when he made pessimistic remarks about the state of Chinese steelmaking. Gordon said that you would think this pessimistic forecast, made on the eve of an important global iron ore and steel forecast conference, would have some effect on the industry, but that iron ore miners are NOT cutting back on their ambitious expansion plans.

On the contrary, BHP is ramping up production and Rio Tinto, another large miner, plans to increase its mines and its output by 50% by next year. He mentioned a few other iron ore miners who are also upping production, including one from inside of China.

China accounts for 60% of global trade in iron ore, and iron ore is the main business for BHP and Rio Tinto (and China is their biggest customer, accounting for 28% of BHP’s sales and 31% of Rio’s).

Gordon said that these companies are now getting into interesting and unrelated side businesses to bail out their core business…literally some companies are moving from pig iron to pig farming, and China’s fourth largest steelmaker is now raising pigs and farming fish and organic vegetables!

The Chinese Iron Ore and Steel Association recently predicted that output in China this year in steel would only increase by 4% (and Gordon said that if this is what a traditional and semi-official body says, we know the number at the end of the year will actually be much less!).

He concluded by saying that if China’s problems turn out to be just temporary, then global iron ore miners will be in good position to take advantage of eventual upturn….but if China’s economy continues to falter and if the country faces decades of recession, like Japan did after its bubble, then the expansion plans of its iron miners could prove to be one of the worst business bets of this year. (Ouch)

Oil

Across the various commodity sectors, Gordon says that the story is much the same.

He did say, however, that oil has a “special wrinkle” to it…China’s Special Petroleum Reserve.

The reserve today is only 1/6th of its eventual size of 700 million barrels, so Gordon said that we can expect that oil purchases by Beijing will continue for some time (until its reserves are adequately built up).

Copper

From all indications, China is now hoarding copper in addition to oil (Gordon says you can tell this because its purchases appear to be much greater than its anticipated demand).

Why is China buying so much copper?

Analysts say there are many reasons:

  • Beijing perceives there is a shortage of this metal
  • They are taking advantage of price declines
  • China is dressing up their trade statistics… apparently they are very concerned about export / import imbalances and can dress them up without buying manufactured goods from other countries by instead increasing their purchases of these commodities

Politically-Directed Stockpiling of Metals?

Gordon also said that there is one explanation that does not make much sense…the one about how the Chinese Central Bank (The People’s Bank of China or PBOC) is buying copper because it wants to replace its U.S. dollar bonds with hard assets.

He said that there is some of this going on, but much less than analysts say.

He pointed to the fact that the PBOC is insolvent, and is therefore constrained from replacing assets that produce current income (like US bonds) with assets that don’t produce current income (like copper). The central bank needs income-producing assets in order to service its own debt in renminbi, which it incurred in order to buy the foreign exchange that went into the country’s foreign exchange reserves.

Gordon said this isn’t to say that the PBOC never buys metals, because it does, but that there are limitations on its ability to do so.

Why is this politically-directed stockpiling significant?

This is significant because it misleads the global commodity community and economic analysts, and hides the problems of the underlying Chinese economy.

This will eventually catch up with the world’s miners and drillers.

That covers China’s general economy…now onto that “special metal”, which sure enough, is gold!

Part 2 – Gold

There are three principal reasons why the Chinese are buying gold now:

  1. The Chinese just love gold,
  2. They have renminbi to burn, and
  3. They are concerned about China and inflation — ordinary Chinese citizens are buying gold as a hedge

But, Gordon says that purchases by Chinese citizens are increasing while the inflation rate is decreasing..why?

Gordon believes that the purchase of gold by ordinary citizens is a substitute for capital flight.

Not every Chinese citizen is in a position to open offshore account, so gold is the next-best substitute…it serves as a refuge from plunging property prices, declining equity markets, and as a potential haven from a depreciating currency.

Chinese asset values have not yet crashed across the board, but this buying of gold, this leading indicator of panic, is a troubling sign that Chinese citizens would head for the exits if they had the opportunity to do so.

Gold purchases by ordinary citizens and businesses have unnerved Chinese bureaucrats…at end of December, they closed every gold exchange in China except for two in Shanghai.

Gordon says that the second reason the Chinese are buying gold is because the government wants to “dress up” the renminbi. Gordon doesn’t think that China wants to go on a gold standard, but he does believe that Beijing wants to accumulate gold to make its currency more acceptable and attractive around the world.

Beijing wants to dethrone the dollar as the world’s reserve currency, but it knows it cannot implement the structural reforms necessary for that to happen so it is doing the next best thing — it’s creating the impression that its currency is backed by a stash of gold.

Finally, Beijing is planning to avoid U.S. sanctions on those countries that buy oil from Iran. China’s imports are already large and by buying gold they can avoid those sanctions (and you can imagine what its purchases of gold will do to global prices…although careful here, keep reading!).

On 12/31/2011, Obama signed the National Defense Authorization Act (NDAA), which attempts to reduce Iran’s revenue from the sale of oil by imposing sanctions on foreign financial institutions that have dealings with Iranian financial institutions in connection with Iran’s sale of oil.

These sanctions would effectively cut off foreign financial institutions from the U.S. financial system.

The sanctions go into effect on June 28, 2012, and the act (NDAA) gives Obama authority to waive these sanctions in limited circumstances.

China has received waivers on U.S. / Iran sanctions in the past, but it is now Iran’s largest purchaser of oil, Iran’s largest trading partner, and Iran’s largest investor in Iranian oil fields.

Gordon says that because of this, Beijing cannot be confident that Obama will give China a waiver this time.

China is in a bind with this…their geopolitical interests align much more closely with Tehran than with Washington, but they also know their economy is becoming increasingly dependent on the U.S. economy.

So how can Beijing please both? Well, Gordon says it’s simple—China can buy Iranian oil with gold, thereby avoiding the financial system.

China has already been trading its produce with Iran for oil…and its washing machines, etc.

As Iran is about to be cut off from the global financial system, the next best thing (to cash) is gold.

So, in February, the Iranian Central Bank announced it will accept gold in payment for Iran’s oil.

Last year (2011), China imported $21.7 billion worth of oil, and exported only $14.8 billion in goods and services to Iran.

Gordon believes that as the NDAA goes into effect, we can expect Beijing to start shipping gold to Iran to make up for this difference.

But gold bugs shouldn’t be all too happy about this for four reasons:

  1. Tehran in February also said it would accept local currencies for oil (so China will press Iran to take non-convertible renminbi for oil)
  2. China is increasing oil purchases from Saudi Arabia, and is buying increasing amounts of oil from the Emirates, Vietnam, Russia, and Africa, and every drop they buy elsewhere is less that they need to buy from Iran.
  3. Other countries are taking advantage of Iran’s plight by negotiating large price reductions (so it will take less gold to buy oil)
  4. If the Iranians are willing to accept gold and produce, will also accept another metal…silver.

Finally, Iran needs cash, not gold. So Gordon believes that as China increases their purchases of gold to trade with Iran, Iran will turn around and sell that gold to raise much-needed cash (so China’s buying will increase the price and Iran’s selling will decrease it).

Conclusion

This year, China will become the largest importer of gold, finally surpassing even India.

But Gordon says that while this seems like a byproduct of China’s success, it is actually simply a combination of Beijing trying to please Iran and of ordinary Chinese citizens buying gold as a hedge…what Doug Casey tells us to do.

Gordon believes that this is not good for the world economy, but he was surprisingly optimistic for the U.S. in the post-speech QnA.

He said that there are a lot of problems in the U.S., but that our problems are not nearly as bad as those in Europe or Asia, and he thinks that in 2 – 3 years the United States will be the “toast” of the global economy!

He says this is somewhat sad, because of course our economy won’t be good, but it will be so much better than everyone else’s!

In the Great Depression he said it was the current account surplus countries who had the most trouble and who suffered the most, and we Americans should know that because we were the current account surplus country and we suffered the most. But this time, we are the deficit country and we have the world’s largest internal market.

So, if the rest of the world falls apart and international trade goes away, Gordon believes the U.S. of A will be much more powerful on a relative basis.

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That’s it for today! What do you think about China and it’s effect on global commodity prices? I would love to hear your opinion in the comments!

Back with a few more Casey reports soon, and some more old-school Kung Fu wealth-building articles!

To your financial success,

—Kung Fu Girl