China is a hot topic these days, and rightly so. It's the storm cloud gathering over our backyard. And as much as we try to reassure ourselves it will blow over, it's time to move the party indoors - or perhaps start planting seeds.
Of course, there are always deniers. Recently, we heard a short seller suggest that China's real estate market was in a bubble on the grounds that the nation was building commercial space equal to 25 square feet for every citizen – as if that was excessive.
Of course, that building program won't be completed for another couple of years. More to the point, in the U.S. we have more than 400 square feet of commercial real estate per person. So 25 sq. feet doesn't seem that ambitious for a nation that's fast becoming the world's factory floor.
Sure, a few cities in China that could accidentally find themselves with too much space for rent. It happens. But don't think that means the nation as a whole is becoming overbuilt.
One thing we know for certain is that China maintains an inscrutable poker face. It's a tough read. Moreover, the Chinese don't play by the same rules we do, and they think very long term. For instance, one recent unexplained change in China's policy has huge implications for investors...
CHINA'S PLAN TO CONQUER THE WORLD (ECONOMICALLY)
Until last year, the Chinese public was officially forbidden from owning precious metals. Now, in a stark reversal, the Chinese government encourages its people to buy gold and silver – to the point of broadcasting television programs promoting these metals as savings vehicles.
We also note that China has recently become the largest producer of gold in the world. That's entirely surprising. China is the world's largest producer of a lot of things, including many of the vital commodities the U.S. imports. But in this case, it signifies something more.
(Incidentally, consider the vital industrial minerals which are so rare that the U.S. has to import over 50% of their supply. A decade ago, there were 27 such minerals, four of which came mainly from China. Today, there are 37 such minerals and China is the major source of 11. Of course, gold is not a metal which is vital to industry. Its primary uses are in jewelry and as a financial asset. Silver is a little different, since it also has many industrial uses.)
Nonetheless, we have to wonder what China is up to with this new precious metal policy? While it's hard to say for certain, all the evidence points to a future in which gold and silver prices move considerably higher while the U.S. dollar value falters. We can't say when this will happen, only that it will.
At the moment, China has some $2.4 trillion in reserves, most of which are in U.S. dollars. At the same time, everyone in the West complains that the Chinese yuan is undervalued and should be allowed to move higher (meaning the U.S. dollar would move lower). In addition, China clearly believes that American financial policies (debt, deficits, money creation, etc.) will be bad for the dollar over time. Before the dollar falls too far, China might like to trade some of its dollars for something less likely to lose value, but there aren't many alternatives, apart from … gold.
Let's also consider that China thinks long-term. It looks at the trends for the next two decades, while caring little for this year or next. So although the dollar has had a small bounce recently and may even go a little higher this year, China can see that the greenback’s long-term prospects are poor. While China is not likely to sell its dollars or switch to a free-floating currency tomorrow, it will prepare itself for what is coming.
Now let's also consider the real bubble China may be seeking to avoid...
THE REAL CHINESE BUBBLE RISK
The real bubble China would want to avoid isn't a bubble in commercial real estate, but a bubble in housing. By encouraging people to put their life savings into precious metals, rather than real estate, China may prevent such a housing bubble from arising. After all, every yuan invested in gold is a yuan not invested in real estate speculation or buying bigger homes. However, that's only a short-term objective. Longer term, China faces the problem of not owning enough gold to effectively hedge against a downtrend in the dollar.
The dollar basically has two things going for it. It has high liquidity and is backed by America's military dominance. We know China is spending a lot on its military at the moment. As for the liquidity issue, here's one way China might handle the situation.
Let's say Chinese consumers start buying large amounts of gold in exchange for yuan. The yuan will be deposited into Chinese banks, which creates bank reserves that can be used to increase lending, which adds liquidity.
At some time in the future, the Chinese government could decide to turn the silver and gold held by the public into currency (as it once was). China could start minting gold and silver coins and invite the public to swap their old gold for new coins with a face value. Or perhaps create a paper currency fully exchangeable for gold (as the U.S. once did).
This two-part process would expand the money supply – making the Chinese currency liquid enough, while at the same time attaching it to the timeless solidity of gold. The result would be a very strong currency. The main challenge would be getting enough gold to sufficiently back a highly liquid currency.
Right now, 20% of the world's gold is owned by central banks. It adds up to roughly $1 trillion. Yet, China has $2.5 trillion in reserves. China would have to sell its dollars slowly over time while acquiring gold. But it has the money to buy as much gold as the rest of the world's central banks put together. Even if some of that gold is sold to the public as currency, China could have the world's hardest currency a decade from now.
Consider, too, that China will become a net importer within the next decade, which will encourage worldwide use of yuan as a reserve asset itself.
Also consider the rapid expansion of China's economy. This year, its GDP growth could easily return to double-digits, while the rest of the world trails behind, and despite the shifting import/export balance.
If China buys large amounts of gold over the next 10 years as it encourages its citizens to buy precious metals, the citizens are going to become a whole lot wealthier. The return on their investment could be tremendous as all that buying pressure drives gold and silver prices higher. Consequently, the majority of nouveau riche this century will likely speak Mandarin rather than English.
That doesn't mean we can't be part of that group. It just means we have to look at the long-term picture. Instead of shorting China over temporary concerns, we need to buy the dips in both Chinese stocks and precious metals.
Incidentally, people forget that China has a lot of experience with double-digit growth. In the 1950s, its GDP grew in excess of 10% annually and actually topped 20% in 1958. In the 1960s, there were four years in a row in which growth ranged from 10-17%. Granted, there were storms as well, during the Great Leap Forward and Cultural Revolution, for instance, and more recently in 1988-91, when China's growth dipped as low as 4%, partly due to a surge in home prices. However, for the past 60 years, the state’s sovereignty has been in place in China. That's a lot of collective experience that China will use to manage its growth better this time.
Bottom line: Gold and China are becoming closely correlated and will remain major sources of investment returns from now on. Invest in these two areas both as hedges and long-term growth investments. Unless our nation makes some fundamental changes, they will likely do much better than U.S.-based investments.