China should return more wealth to its people

As G20 finance ministers gather in South Korea today, the central issue is around exchange policies and avoiding the outbreak of a global trade war.

China is under intense pressure from the U.S. and other emerging markets to revalue its currency, which is pegged to the US dollar and widely believed to be undervalued by 20-40%.

China has resisted such pressure by pointing out to potential disruption to its export-led economy and its recent efforts in stimulating domestic consumption. The central bank PBOC has recently raised benchmark interest rates by a quarter point, the first time since the onset of the 2008 financial crisis, despite signs of cooling economic growth. This may be the beginning of a series of interest rate hikes to rein in inflation.

Much of China's recent growth has been fueled by injecting loose credit into the banking system, which may have caused excessive domestic inflation, especially in the property sector.

These are happening in an environment that developed nations are trying to continue or enhance their loose monetary policies in a bid to spur growth, or at least to avoid Janpanese-style deflation.

Recent discussions (e.g. by Li, Dongrong) out of the PBOC make it very clear that Chinese officals are very aware of the international financial environment and the challenge facing China.

Leaving it at the status quo, China may face a greater risk of hot money chasing after higher returns. The flood of easy money, through various channels such as private equity, may contribute to rising asset inflation and consumption-good inflation.

Inflation, while necessary for growth if it's moderate, chips away citizens' purchasing power and helps to increase economic inequality and social unrests.

On the surface, China has become a rich country. Commentators often point to its ballooning exchange reserve (about $2.6 trillions). But much of this money cannot be used to help ordinary citizens; instead it's financing the U.S. government which in turn help to lower the already-low interest rates. In terms of GDP per capita, ordinary Chinese are still quite poor. China should return some of the wealth to its people, by appreciating its currency more and bringing down actual inflation and inflation expectations.

Raising intereat rate and the Yuan may actually go hand-in-hand in a gradual fashion, to power both domestic and international consumption. Higher interest rate puts more moeny in the hands of savers, and a more valuable currency obviously puts more purchasing power to any Yuan holder.

And, a lower inflation gives ordinary people a much needed break in the race to save enough for purchasing an apartment.

What precious metal market might be telling us?

Vanguard's precious metal fund (VGPMX) is one of my personal holdings since 2008. It was among the best performing funds of the fund family for 2009, returning 77%. For the first week this year, it shot up 10%, ranked at the very top. But by Feb.8, it had become the worst performing fund in the family, returning -10% YTD.

Gold ETF GLD and gold miner ETF GDX behaved similarly. These are driven by the gold spot price which went from the recent peak above $1200/oz to about $1065/oz as we speak over the last one and half month. The most important factor appeared to be China's announced intention to tighten its monetary policy to comeback over-heated property market and the blewing inflationary pressure. Recent sovereign debt anxiety has added to the dollar strength, helping to bring down the gold price.

What does this reversal tell us? Is precious metal on the secular way down?

The bullish case for precious metal has two sides to it. One dominant thesis is that gold is a good hedge against pending inflation or inflationary expectations. We don't see much inflationary pressure in the TIPs. In fact, economists are expecting deflation in the US as the nation battles the high unemployment rate. How does one square with that observation?

Another theory is that gold is a great store of value, a de facto reserve currency. When US dollar or other major currencies are debased, gold should shine. This argument has gained more support recently. For instance, at the height of the credit crisis of 2008, USD actually strengthened due to flight-to-quality effect (other major currencies such as Euro were even weaker). Gold prices went down briefly as a result, before the global stimulus efforts were kicked into gear. Similarly this last week when Greece's debt crisis resurfaced, dollar strengthened and gold saw a big selloff.

We think the reversal is not something new. The market is telling us what it has been telling us all along: there are deep concerns about future inflation that are coming from global economic growth. That often manifests itself with price increases of commodities. This concern is now compounded by government deficit spending on an unprecedented levels. Market has also been concerned with governments' ability to trim back these spendings when it is time to do it. If there are signs that the governments of major economies will act responsibly, then gold prices have less reason to go up.

When China tightened, the market appeared to be surprised that the pro-growth regime was not as headstrong as many had come to expect. Thus the selloff.

The strengthening of USD due to Euro zone problems may have pulled down the gold price some, but it is only temporary. US deficit spending will either continue to weaken US dollar, or threaten to usher in an era of runaway inflation. Either case is gold bullish. This long term picture may be punctuated by some short term reversals, as we have just seen.