China, U.S. Economy, the Dollar and Gold

This is an update to developments since my previous series, “Monetary Mess, the Dollar, Gold—and You.” (See link)

China has ramped up imports of gold and taken steps toward making the yuan a global currency.

In December, China's state-run news agency reported that China imported 209.7 metric tons of gold in the first ten months of 2010. In all of 2009 it imported only 31 metric tons, according to Gold Fields Mineral Services. Chinese regulators have begun allowing mainland Chinese to invest in foreign gold ETFs. This unleashes for the first time the full buying power of the world's second largest economy into the international gold markets. Lion Fund Management Co. received permission to invest in exchange-traded gold funds outside the country.

Meanwhile, at the Shanghai Gold Exchange trading volume increased 43 percent, to 5,014.5 tons in the first ten months of 2010. And on December 1, 2010, China's Ministry of Industry and Information Technology reported the nation's gold production reached 277.017 metric tons from January to October, up 8.8 percent. China is the world's largest producer of gold.

Also, China began trading its currency for the first time in the U.S. According to Lingling Wei, this is “an explicit endorsement by Beijing of the fast-growing market in the yuan and a significant step in the country's plan to foster global trading in its currency.” Bank of China limits yuan conversion by U.S.-based individuals to $4,000 per day, but there are no limits for businesses. Many analysts say it will be years before significant amounts of world trade are denominated in the Chinese currency, rather than the dollar, euro or other currencies. But recently the major corporations McDonald's and Caterpillar became the first U.S. non-financial companies to sell debt priced in yuan in Hong Kong, where trading in the currency began in July. Yuan trading there has ballooned from zero to $400 million per day in six months. “We are preparing for the day when the renminbi [also known as the yuan] becomes fully convertible,” said Li Xiaojing, general manager of Bank of China, 70 percent owned by the government.

In the U.S., Blackrock's gold ETF, second largest in the world, boosted it physical gold holdings by 36.9 percent in six months since undercutting its competitors' management fees. Its major competitor, SPDR Gold Shares, saw its gold volume decline 3.6 percent over the same period. Blackrock lowered it fund management monthly fee to 0.25 percent while SPDR and many other gold ETFs remained at 0.40 percent. That doesn't make much of a difference to small investors, but for multimillion dollar investors it can be very significant. The Soros Management Fund, founded by billionaire George Soros, bought five million shares of Blackrock's ETF in the third quarter, while shedding about one-tenth that amount in SPDR. It still retains about 4.7 million shares of SPDR.

Given the collapse of residential real estate and problems with the dollar and other fiat currencies, former Fed Chairman Alan Greenspan, speaking at the Council on Foreign Relations, warned that “fiat money has no place to go but gold.” Even Robert Zoelick, president of the World Bank, has called for considering a role for gold in a new monetary system, noting, "Although textbooks may view gold as the old money, markets are using gold as an alternative monetary asset today.” And Thomas Hoenig, president of the Kansas City Fed, in his final public remarks as a voting member of the Fed's Open Market Committee, stated, "The gold system is a very legitimate monetary system."

Housing prices in the U.S. are still dropping, more bad news for the economy and banks holding the mortgages. The Home Data Index Market Report shows a decline nationally of 4.1 percent in 2010 and expects a further 3.7 percent drop in 2011. The National Association of Realtors reports that sales dropped 4.8 percent to 4.91 million units in 2010.  Foreclosures reached a record 1 million homes, and Realty Trac Inc. predicts 1.2 million more will be lost to foreclosure in 2011.

The number of shaky U.S. banks increased in 2010 as bad loans piled up and capital levels eroded, with smaller banks hit the hardest. Ninety-eight banks that got bailout funds from the federal government are now in danger of failing anyway, based on their third quarter statements, up from 86 in the second quarter. Seven have already failed, although the eight largest banks have repaid their TARP (Troubled Asset Relief Program) funds. The Wall Street Journal calculates that 814 of the nation's 7,760 banks and saving institutions are “troubled,” up from 729 at the end of the second quarter. The FDIC, using different criteria, counts 860 on its troubled list.

As part of its $814 billion stimulus program, the federal government gave billions of dollars to state and local governments. This was done with the expectation the money would be spent and re-spent in a chain reaction that would stimulate the economy with a “multiplier” effect, as decreed by economist John Maynard Keynes. Keynes was wrong. It didn't happen. Commerce Department data show “state and local government purchases of goods and services did not increase at all in response to the large federal stimulus grants,” say economists John Cogan and John B. Taylor. The fed money merely allowed states to postpone solving their own debt problems.

That program of federal grants expired December 31 and was not renewed by Congress. Lacking that influx of federal money, California, New Jersey, Illinois and other states that for years have been spending beyond their means are now going to have to cut spending, lay off workers, raise taxes and refinance parts of their debt. This will also be true of municipalities and school districts that have depended on state funds that are now being cut. Their refinancing needs will put enormous strains on the $2.9 trillion dollar municipal bond market. One of Wall Street's most respected analysts, Meredith Whitney, predicts that within just a few months we'll start to see bankruptcies of 50 to 100, maybe more, municipalities and other local governmental units. If this happens, it will have major impact on U.S. banks, which hold vast amounts of municipal debt. Of course that, in turn, would have major impact on the value of the dollar in international markets and on gold.

In Europe, the monetary crisis has been widening. The dominoes have been falling, and more are likely to fall. It began with Greece. Then Ireland. Portugal is likely next, followed by Spain. Now Italy is increasingly being mentioned, and concern about Belgium and Hungary is surfacing. Moody's Investors Service has cut Hungary's credit rating two notches, to just above junk-bond status, and said it has a “negative outlook” on the nation's finances. Hungary's populist government has imposed heavy temporary taxes on a handful of industries, rather than cutting social spending or implementing other austerity measures. Dietmar Hornung, a Moody's vice president and lead analyst for Hungary, says, “We expect a significant deterioration in the structural deficit.”

The monetary pact that established the euro as a common currency requires member countries to limit their budget deficits to 3 percent of gross domestic product and their government debt-to-GDP ratios to 60 percent. The euro crisis began when Greece's budget deficit reached 12.7 percent and it debt to GDP hit 113.4 percent in 2009. A rescue fund of almost $1 trillion was established through the European Central Bank to bail out Greece and other countries if necessary. After bailing out Ireland, there should still be enough left in the fund to bail out Portugal and Spain. But what happens then? Italy has the third-largest economy in the euro-zone and a debt-to-GDP ratio of 118.5 percent, and half of its debt is financed from abroad. Belgium is considered less risky because it has high household savings and stronger economic fundamentals than the bailout recipients, but it has a debt-to-GDP ratio of 100 percent. The country's debt is fully funded until April, but then what?

Where is all this going? The 17-nation euro zone (Estonia was recently added) as a whole has a budget deficit of around 6%—twice what is supposed to be the maximum, while its debts are around 84% of GDP, again far in excess of the maximum.

The brunt of the cost of the bailouts thus far has been borne by Germany, the largest and economically strongest country in Europe, but other countries in the European Union are required to contribute. Even those who themselves have deficit problems. Thus each bailout to which the other weak countries are forced to contribute further weakens their own economies, making it more difficult for them to correct their deficits and more likely to require a bailout.

The markets are expressing great skepticism about the future of the euro. The struggling European countries are forced to borrow money at rising interest rates that reflect increased risk. In early January, Portugal had to pay about 1.6 percentage points higher than its last 6-month auction in September. Portuguese 10-year notes were selling 4.07 percentage points above comparable German debt. As the struggling countries are forced to pay higher costs for borrowing, it becomes more difficult for them to revive their economies and reduce their deficits.

Will Germany continue to pay the bulk of bailout costs? Will German taxpayers and voters ultimately refuse to pay the cost of bailing out most of the rest of Europe? Nobody knows. The markets, however, are not displaying optimism that a satisfactory solution will be worked out.

For now, much of the investment world views the dollar as a safer haven than other currencies, especially the euro, which has been declining steadily against the dollar. But how long will the dollar remain strong if U.S. housing prices continues to slide, banks face renewed difficulties, state and municipal bond markets are stressed, unemployment remains high, and our own federal deficits continue to climb as far as the eye can see? The U.S. is already running a budget deficit of over 11% and has a debt-to-GDP ratio of about 92%. Who will bail out the U.S.? At this point, it is worth reflecting on Alan Greenspan comment “fiat money has no place to go but gold.”