Long Yuan = Long Gold?

http://www.kitco.com/ind/Coffin/nov142007.html

By David Coffin Printer Friendly VersionNov 14 2007 9:33AM

www.hardrockanalyst.com

It may sometimes seem that China is somehow both unaffected by andindifferent to the spiraling shifts of the world's currency andbanking sectors we are in. Neither is true. In spite of strong growthrates, China's economic re-emergence continues to be pinned to aseries of measured shifts by resilient party insiders to continuouslyrefine the "market communism" concept.

They appear almost ready toreap the rewards of a trade strengthened currency, and we believe thatwill signal further strength for gold. Without question the huge gains for gold and silver prices over thepast several months can be related to thrashing of the greenback. Thebreakdown of the US$ accelerated by bad housing debt is what we and,in increasing numbers, others have expected for several years.

The inverse relationship that helped push gold higher has been part of abroader relationship - Short Dollar = Long Commodities – in which goldhas actually been a laggard. Concern is growing that recent paraboliclooking moves for paper currencies and oil could mark the beginning ofa global downturn.

The concern is understandable, but we view it asunavoidable turbulence in the shift of economic weight across thePacific. Oil price gains chart both geopolitical concerns and the fallingDollar, but are well past any supply fundamentals. There is currentlyenough oil in the system to match demand, but since its suppliers areunhappy with their US$ contracts they have done little to sway thespeculators who have pushed prices higher. We have mused in the pastthat if the world needs a neutral commodity-based currency, it shouldbe the calorie. Traders are effectively making this happen by parking Dollars in long oil contracts.

This is hurting US consumption as muchas declining house values do. Further US dollar decline can beexpected, but oil can't continue to rise inversely to that declinewithout killing other US consumption and greatly denting Asian growth.Despite western consternation about Asian indifference to this, Chinaactually appears ready to deal with the issue.

Several influential Chinese have indicated they favour a rebalancingof its foreign exchange holdings to emphasize "balancing stronger andweaker" currencies. This may in part be aimed at trade sanctionproposals in Washington, but also we think at soaring oil prices.Markets have read this to mean Dollar dumping that will exacerbate theweakening of $/€ rates.

We actually think the impact on the Yen willbe as large (say sayonara, carry traders) as the push on the Euro,thought that is an aside for now. These musing bespeak the "controlledflexibility" that is becoming a hallmark of China's economicmanagement. China changed its foreign exchange policy several years ago from ahard Dollar peg to a basket of currencies in which the Yuan shifts value in a "managed float" band ("floating peg") that is 0.3% per daywide. The basket is "trade weighted".

An exchange of weaker forstronger currencies within its basket should mean that the Yuanappreciates more quickly. That would make it a more effective part ofthe floating exchange system, without China's governors having to giveup the "managed" part of the deal. A rising Yuan will also takepressure off the Dollar in due course, by making Dollar priced oil,and given the recent BHP-Rio Tinto merger "letter", also things likeiron ore cheaper per unit in the economy that is their one majorgrowth area. So, does that mean the gold run is over?

In the past decade China has made a strong move up the gold producerslist and is now generating more of the yellow metal than Canada orAustralia and getting set to take over number two spot from the USA.It does hold some gold in its Yuan basket. Adding to this by soakingup its domestic gold supply would allow China's central bankers to exchange Yuan for an anti-Dollar that has a liquid market, withoutraining on anyone else's parade. At $100 billion a year, gold'smarket may not easily become a significant part of the currencysystem, per se.

But China's current US$6+ billion a year of gold production would still help to offset the worrying decline in theDollar. Even if China's currency system is not about to become a significantgold buyer itself, a strengthening of the Yuan would add cost pressureto the yellow metal's output in the same way that rampaging Rand,Canadian$ and Australian$ rates have. In all cycles metal supplyshortages proceed rising metal prices, and these have always been feltlast in the gold sector.

The only difference in this prolonged secularbull cycle is that significant cost gains have been recognized by the market and become support for higher base metals prices. Goldproducers have not really gotten on top of cost gains yet, andfundamentals like this do, eventually, have their day.

A rising Yuan and China's increasing importance to the gold supply should combine underscore the lack of new gold supply, at current prices. Long Yuan will equal Long Gold.

David Coffin