Dear Investor,

Who can blame you if you’re anxious, uncertain and don’t know what to do next in this turbulent economy…which itself seems poised for some kind of nervous breakdown?

• Continuing high unemployment…
  
  
• Median household income that has slid back to 1996 levels…
  
  
• Anemic consumer spending and confidence…
  
  
• Still depressed home prices…
  
  
• A record and still growing national debt with little hope of achieving genuine budget reform…
  
  
• Fear about the prospect of a financial meltdown in the Euro Zone and its effect on the U.S.
  
  
• The possibility of a new round of ‘quantitative easing’ by the Fed – which may have a short-term stimulative effective on stocks, but means the ongoing devaluation of the dollar…
  
  
• The looming threat of inflation…
  
  

• Resource Scarcity For Key Commodities and Sources of Energy
• The Inevitably of Serious Inflation

• The Explosive Economic Rise of China

The following analysis comes from the research I’ve conducted for my new book, Red Alert: How China’s growing prosperity threatens the American way of life.

Like (or believe) it or not, America isn’t the master of its own economic destiny anymore.

While we fight our own internal battles with unemployment, budget deficits and sluggish and even negative growth, there’s a new international superpower whose every move affects what happens here. I’m referring, of course, to China.

China is without question engaged in the largest and most ambitious process of national economic development in world history, the leader and biggest of the dynamically growing group of emerging economies that includes India, Brazil, Indonesia, Russia and other nations mostly from what was called ‘the Third World’.

It has the largest population in the world, with 1.34 billion inhabitants. More than half of them are currently still living and working in agricultural areas, and China’s push to modernization entails a massive shift of people to the cities, requiring a rapid building out of urban infrastructure, the growth of a new, more prosperous middle class, and rising standards of living and consumption.

China became the world's largest exporter in 2009, shipping some $1.2 trillion of exports. The figure for 2010: $1.58 trillion – a huge year-over-year increase of 21.6%! Chinese factories employ low-wage workers to assemble everything from iPods and laptops to running shoes, clothing, toys and the myriad household items that populate the shelves of America’s discount stores.

China has also overtaken the US as both the world's largest auto producer and the world’s largest auto market. Two decades ago, a car industry barely existed in China; only a few years ago, the Chinese car maker Geely International bought out the venerable Volvo name.

China is already the world’s second-biggest oil importer. And just recently, according to IHS Global Insight, it has overtaken the US as the world’s largest manufacturer, with 19.9% of the overall market. The US only has 19.4% of the world market. Things have truly changed.

And the truth is that China is just getting started. While its GDP is only 9.4% of the global economy, and its population 19% of the world population, the huge scale of China’s requirements for materials and resources are indicated by the following figures, representing percentage of global demand:

China is now stockpiling gold and building up critical reserves of commodities like iron, copper and aluminum while prices remain low…or, at least, low compared to where they’re likely to be a year or so down the road.

Another especially crucial area of China’s commodity acquisition is reflected in the fact that it is now the utterly dominant world leader in every aspect of renewable energy – wind, nuclear, solar and hydropower. And it is the only country that mines the 17 so-called rare earth elements (REEs) that are essential in the development – currently producing 97 percent of the world’s rare earth elements. For example…

By contrast, what is the U.S. doing to ensure its own supply of these increasingly vital resources?

The answer is alarming. Our country has ceased its own production of REEs and has gone from being self-sufficient to relying entirely on imports – most of which come from -- you guessed it -- China.

How did this happen? In the 1980’s we did mine rare earths in America. But then China began to sell these elements at prices well below the costs of our mines. You see, they not only have the advantage of cheap labor, but also a cavalier attitude toward pollution and the highly toxic processing processes involved.

China’s ruthlessness in pricing REEs completely undermines the emergence of competing providers in countries where free enterprise rules, i.e., where without the possibility of enough profits to cover development and operating costs, there’s no point in launching a business. But China, a nation governed by state capitalism, operates by different rules and calculations; it’s not profit-and-loss calculations that determine industrial activity, but rather the long-term strategic interests of the state are paramount. Thus they are willing to forsake profits so no one else can compete.

That’s not the only way China is outmaneuvering us when it comes to achieving a strategic advantage regarding commodities.

Take the area of foreign policy.


Today the U.S. is concentrating on a variety of perceived threats, which we address with diplomacy, force and dollars: Iran, Iraq, Afghanistan, Pakistan, North Korea. But by focusing on political, security and military objectives, we’re missing the huge and critically important problem of resource scarcity that’s going to affect us for generations to come.

To compare the U.S. and Chinese approaches, consider what’s been happening in Afghanistan.

While we have been spending many billions of dollars fighting there (actually, to date our wars in Iraq and Afghanistan have cost the American economy something on the order of more than $3 trillion) and risking the lives of our soldiers in support of a corrupt regime in a land neither the British nor the Russians were able to conquer, the Chinese have quietly entered the country with their own army – an army of geologists, mining experts and engineers. Their objective is not an elusive military victory, or the even more elusive project of bringing democracy to a population that has shown little indication of wanting it. No, China’s aim is to secure access to one of the most critical of the world’s major metals, copper.

China Metallurgical Group Corporation, a state-owned conglomerate, paid $3.4 billion for the rights to a copper deposit located in a former al-Qaeda stronghold south of Kabul that may contain 13 – 20 million tons of copper. The Chinese bid was a staggering $1 billion higher than bids from U.S., Canadian, Russian and Kazakh companies. Plus, it paid a $30 million bribe to the Afghan mining minister, according to a November 19, 2009 article in the Washington Post.

Such bribes are illegal for American companies; for the Chinese, just part of doing business.

Besides the mine itself, the company will build a smelter to refine the copper ore and a 400-megawatt power plant to run both the mine and the smelter. Ultimately the operation will employ around 10,000 people, but for now the work is mostly carried out by Chinese nationals behind barbed-wire fences in fortified positions, protected by a private armed Chinese security force – not to mention the general security also provided by the U.S. and its allies.

This is just one of a number of examples where China’s actions clearly indicate how resource scarcity is the paramount factor in their foreign policy, and their determination to secure as much as they can of those resources and materials that are available only outside their borders.

Nowhere is this more evident than in Africa, which contains enormous but still largely untapped deposits of everything from oil, coal and iron to zinc, copper, industrial diamonds, platinum, silver, gold, and more.

Rather than marching in and seizing power by force, which was the model of earlier 18th and 19th century colonialism, China comes with a blank checkbook and an army of construction workers offering to help African nations build up their infrastructures and create all the trappings of a modern state. And Africans have welcomed them, providing unfettered access to their lands’ immense mineral deposits in exchange.

Of course, the roads, railroad lines and hydroelectric dams that make up the bulk of their aid to Africa are ostensibly being built for the benefit of Africans. But they also serve the purpose of speeding the extraction and transport of resources to China, as well as generating revenues for Chinese construction companies, as most of the materials used in construction projects are imported from China.

The exact size of China’s direct investment in Africa is unknown, but at this point it has clearly surpassed the U.S. and France as Africa’s largest trading partner.

As in Afghanistan, corruption often plays a role in securing these deals, with suitcases full of cash, Swiss bank accounts and the funding of presidential palaces not uncommon. But Chinese companies don’t have a Foreign Corrupt Practices Act to be concerned about, the way American firms do. And whereas American development aid is frequently tied to improved human rights and democratic reform, China’s policy appears to be totally pragmatic, apolitical and amoral.

Yet China’s nominal communist and “anti-colonialist” identity makes it a more welcome partner than Western countries in most of the Third World, whose prior histories are associated with an exploitative past.

 

A similar pattern is repeated around the globe: in Myanmar (Burma), whose military rule has made the state an international pariah, China has been provided military hardware, concessional loans and hydroelectric dams in exchange for access to oil and nickel.

In Latin America, China’s goals have centered on access to crude oil primarily, but also include arrangements regarding natural gas, iron ore, copper and other minerals, in deals signed with Venezuela, Brazil, Bolivia, Ecuador and Argentina.

Given all of these examples around the world, could China’s intentions and objectives be any clearer? And yet the overwhelming majority of U.S. policy and political leaders seem to be paying little or no attention.

One final very key aspect of the China and Commodities picture needs to be mentioned here, and it’s something that involves an important consideration concerning how you manage your own investments, now and in the future:

Despite some mixed messages from the People’s Bank of China (BOC), it is clear that China wants to accumulate as much gold as possible and as quickly as possible.

Ji Xiaonan, a leading official, was quoted in the Chinese press recently as saying that within 3 to 5 years China’s gold reserves should reach 6,000 tons, and 10,000 tons within 8 to 80 years.

By comparison, the United States currently holds the largest amount of gold, with about 8,100 tons.

Interestingly, besides increasing government stockpiles of gold, China is also encouraging its citizens to make individual purchases of gold. Not only are there television and other ads presenting gold as an excellent investment, but rules that limit the profit Chinese banks can make on sales of gold (one percent or less, according to our sources).

See that thin dark line in the chart? The line that indicates private gold buyers?

That's the path to $5,000 an ounce gold!

Consider this:  If China's domestic gold consumption were to match US levels, the world would have to produce an extra 12.4 million ounces of gold.

That's more than China itself—the world's single-biggest producer—turns out in a year.

And since world gold production has dropped for eight out of the past ten years, producing an extra 12 million ounces of gold per year to meet the demand will prove difficult, if not impossible. We won’t see another bull market like this in our lifetime.

In addition to being a major buyer of gold on the world market, the Chinese are making a concerted effort to extract every ounce of the precious metal that can be found within its borders. Even though its reserve base of gold yet to be mined is much smaller than in other countries (e.g., less than half of that of South Africa) during the past several years China has been far and away the world’s largest producer of gold.

The country’s desire for the metal has been so intense that mining accidents are on the rise. And gold is an important aspect of the highly toxic and hazardous process of extracting metals from scrap computers and electronic devices, in which China is a leading global practitioner.

All of this is solid evidence that the Chinese are more determined to accumulate gold than any other country.

And it should give pause to the many commentators, pundits and other investment ‘experts’ who scoff at the importance of gold, describing the current run up in price as a “bubble” and refusing to even consider gold (and other precious metals) as a legitimate asset class.

Let me explain why I’m so certain that the price of gold, even at its current near-record price, is likely to increase still further.

Take a look at two charts. First, the 1970s gold bull market chart below:

Now let’s zoom back and take a look at the longer view, from 1973 to the present:

The fact is that for two generations now, gold has outperformed the S&P 500 with dividends reinvested. As far as more recent history, from a low of around $250 an ounce in the late 1990’s, gold today costs roughly 7.5 times more.

This is hardly a modern phenomenon, as gold has been prized as a store of value for five millennia. Traditionally regarded as an inflation hedge (e.g., as shown above in the chart for the 70’s), when we look deeper we see that more accurately it is really a hedge against the debasement of paper currencies – thus functioning more like a currency than a commodity in this respect. This essentially monetary character of gold also stems from the fact that unlike other precious metals such as silver or platinum, it has relatively few industrial uses for which there is no substitute.

Now, today and for the foreseeable future, debasement of currencies is rampant in the U.S. and Europe. The Fed’s ‘quantitative easing’ programs of pumping money into the financial system was but one factor. Record levels of government debt and the apparently great difficulty of achieving any semblance of budgetary reform form are other factors.

As a policy option, the idea of printing money and thereby debasing a currency as a way of funding government projects, paying debts and making a nation’s products more attractive to foreign buyers seems to be widely endorsed by the central bankers of nations throughout the world – what is essentially a terrible race to the bottom. Our own Mr. Bernanke is among them.

A devalued dollar (among other currencies) is only one, albeit a very important one, of the factors driving the rise in gold at present. All the current problems with the economy and markets discussed at the beginning of this presentation also cause buyers to purchase gold as a safe haven.

Indeed, a summary of top financial news stories over the past few months might serve as mileposts on the now very steep upward path of gold, a few examples being

• the debate this spring and summer over the debt ceiling extension, which both brought the government to the brink of default and highlighted the enormous amount of the government’s debt (currently over $14.7 trillion)

• the subsequent loss of its AAA credit rating visited on the U.S. government by Standard & Poor’s

• ongoing sovereign debt crises in Greece, Italy, Spain, and Portugal, which threaten bondholders in France and Germany as well; and the decision by the Swiss National Bank to peg the Swiss Franc to the weak Euro so as to cap the appreciation of its currency – thereby ending its status and use as a safe haven currency for investors

• and then there’s the threat of inflation, which of course is directly tied to devaluation of the dollar but having other causes, as well – most prominently, the rise in prices caused by resource scarcity.

This is why we reject the contention by an increasing number of nervous commentators and pundits that gold now represents a giant “bubble” that’s about to burst. A bubble, to be precise, is an explosive increase in the price of an asset that cannot be justified by underlying fundamentals.

Gold, to be sure, has certainly been on a tear. Since its bottom in August 1999 the metal has risen more than seven-fold. What’s more, since its bottom in 2008 gold has climbed more than 2 and a half-fold. No one would argue that these are not major, and since 2008, even explosive gains. But such gains are hardly unprecedented and by themselves are predictive of nothing.

For example, between late 1988 and late 1999 the OTC market climbed more than 2 and a half fold – about one-third of the time it took gold to make the comparable recent move. And from that point in late 1999 the OTC rose another 50 percent in less than a year. Moreover, there are loads of individual stocks that did much better than the OTC.

So for starters, though the rise in gold might be called explosive, parabolic, you pick the term, there are many other assets that have climbed even faster and then continued to climb much further.

The more important point is that the slope of the curve does not define a bubble. The bubble in the OTC stocks burst because the earnings underlying the stocks in the index disappointed. In many cases, projections of 20 or 30 percent long-term gains turned into little or no gains and in a lot of cases outright losses. In other words, the bubble burst – as bubbles always do -- when the underlying fundamentals no longer supported the gains.

But in the case of gold, what is perceived as “extreme” pricing is actually a realistic reflection of the extreme devaluations and economic conditions that are causing investors to lose faith in paper currencies. Price is a relative, not absolute, concept – i.e., relative to value.

Or to put it another way: if a stock already trades at a ‘high’ price but it’s earning are proportionally considerably higher, we don’t say there’s a bubble in that stock; we call it undervalued.

If you believe as we do that at a certain point inflation is likely to break-out on a wide basis, the implications for gold, scattered corrections notwithstanding, are that the yellow metal will be one of the only games in town.

And to get back to the subject of how gold figures in China’s strategy…

Imagine you’re the Minister of Finance for a country which is offering its extensive copper deposits for sale, and China along with other buyer nations are offering the same price, But China is willing (and able) to pay in gold vs. its competitors’ debased currencies. Which offer would you take?

Alternatively, a massive hoard of gold makes it possible to back up a paper currency with the precious metal, i.e., you can exchange that currency for a certain amount of gold.

Either way, in a world of resource scarcity, controlling gold is as close as you can get to controlling your economic fate.

At this point, you may be asking yourself

What does all this mean to me?

What can I do about it?

And what are the specific things I can do to protect myself and my family in a world of resource scarcity and increasing Chinese dominance?

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