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February 26, 2004

China
by John Lee

For those that follow the NBA (National Basketball Association), you know that Houston's Yao Ming knocked LA's Shaquille O'Neal out of the All-Star Game's starting line-up for the second season in a row. But O'Neal expected this, and hardly flinched when the final balloting was announced Thursday, January 29.

"That's cool," said O'Neal, who counts himself a fan of the Chinese-born Rocket's center. "Where he's from, there's two trillion people. I was just happy to be there."

But China gets blamed a lot for . . .

Jobs: China steals jobs from the US.

Deflation: China exports cheap goods and depresses manufacturing pricing power.

Inflation: China imports many basic commodities such as copper, iron, soybeans and oil, which just caused the CRB to reach more than a decade-high mark.

The all-star balloting does demonstrate the power of the internet. The Chinese today are now louder both in voice and in money. Accenture, a business consulting company based in Bermuda, once estimated in 2001 that by 2010, Chinese websites will outnumber English ones. And now we offer our view on China.

Geography and population

Now with more than 1.2 billion people, China has the largest population in the world-one-fifth of the total. And every year the country adds another 12 million.

However, China only has 7% of the world's arable land and fresh water, 3% of its forests and only 2% of its oil. And although China's land mass is roughly the same size as the United States, it has 4.5 times the population. In addition, China's enormous population is unevenly distributed, with 94% living in the south eastern part of the country. In the United States, this distribution would translate to nearly one billion people living east of the Mississippi River

Most of the affluent people live in urban cities. There are over thirty cities with over five million in population. Shanghai, the biggest of them all, topped twenty million in 2003. We visited Shanghai and Hong Kong last year. There were just so many people, day and night, that only NYC compares in terms of population density. And in terms of marketing, one really only needs to capture these top cities.

What about the rest of China? In rural areas, clean water and food are a tough go for many. Public sanitation is lacking with many catching deadly parasitic worms. The AIDS epidemic is serious with illegal blood trading. Farming is still one of the top occupied professions in China.

Through the transformation to capitalism, the poor are ignored and public services are cut.

Trade

"China is now the single largest contributor of export recovery in the Asian region," says Jonathan Anderson, a China economist at UBS, "and provides a third of the region's bank loans." China now assumes that economic role, buying 31 percent of the region's exports as it currently prepares to become a source of regional funding.

To be sure, China's economic fuel in Asia is a recent phenomenon. In 1990, for instance, China only imported 6.8 percent of the region's exports. And in 1999, China accounted for only 11 percent of total Asian trade. Butit is about fifty percent today!

In the past year, China has taken in 40-50 percent of Asia's exports, accounting for all of Taiwan's, and the Philippine's, export growth last year and over 50 percent of each of Japan's, Malaysia's, South Korea's and Australia's. Such intake has driven more than 7 percent of the GDP (gross domestic product) growth in Taiwan, Malaysia and Singapore, 5.8 percent in South Korea and 4 percent in Thailand, according to UBS figures.

But despite having a trade surplus of $56 billion with the US, China is running a large deficit with Asia. Contrary to the belief that China is enjoying a large net trade surplus, it just reported its first trade deficit in 10 months- as imports to Asia's second largest economy exceeded exports by 20 million dollars in January.

Currency

The Yuan (also known as the renminbi) is pegged at 8.28 to the Dollar.

Recently talks surfaced along the lines of China considering raising the exchange rate by 2.5% to the dollar as soon as summer of 2004. We are not particularly bullish on the Yuan due to China's trade deficit and low interest rate.

Banking and Wealth

China's banking system is developing rapidly with growing deposits denominated in both local and foreign currencies in all its financial institutions (including foreign-funded ones). They reached RMB22 trillion at the end of last December. This is an increase of 20.2 percent year-over-year, or RMB3.7 trillion compared with a year earlier. However, 80% of these total bank deposits today belong to just 12% of the investing public. China only recently started offering car loans. Credit cards are still not available to most Chinese (China has no nationalized social security number to check credits against). And there is little consumer debt to speak of.

There has been much talk about a Chinese banking crisis. China's non-performing loans (NPLs) by State owned enterprises (SOEs) deserves a closer look than we have time for right now. However, it seems to us that NPL is a term under capitalism and surfaced as China has been attempting to adhere to western standards and to join the WTO.

NPLs are really subsidies to SOEs which are not for profit. These are indirect loans by the state-owned banks to the state itself and thus should properly be included as part of the public debt. By the end of June 2003, outstanding NPLs of these institutions stood at 2.54 trillion yuan (US$306 billion), which was 19.6 per cent of the total outstanding loans during the period; 3.51 percentage points down from the beginning of the year.

With 2003 GDP clocked at $1.4 trillion, NPLs were 20%of that figure, considerably lower than the public debt to GDP ratio of many other countries. The US national debt ($7 trillion) is about 60 percent of GDP ($11 trillion). US private-sector debt is about 250 percent of GDP. Moreover, it is also clear that the Chinese banks will never be allowed to fail in a way that hurts depositors. There is, in fact, universal implicit insurance for bank deposits. Thus it is purely technical that Chinese state banks have a capital/loan ratio problem.

In the end, NPLs are just another inflation scheme to fund government works. The USA has two powerful tools to avoid NPLs. One is the US tax code, which gathers income to fund public works, and the other is the so-called 10-yr treasury note-in which the US has $trillions outstanding. Since Chinese treasury notes have lesser appeal than American ones, and the Chinese don't believe in paying taxes, China has to resort to state bank loans to the state itself to fund its public works. So in the end it's really the same pie. The US can never earn enough to pay its treasury debt, just like SOE's can never earn enough to pay their loans off. Think of the US's $10 billion+ per year farm subsidies programs, or the $billion plus Amtrak bailout. These would have to be included in the NPLs in China but not under the US system.

So why is China going through the hoopla to create an NPL problem and pretending to be solving it?

The Chinese are quickly learning the American Way understanding in today's world that it's far quicker and easier to absorb others' wealth than to generate it. The grand China plan is as follows:

 • Join the WTO and adhere to the international banking code.

 • Take NPLs off the banks' balance sheets through AMCs (asset management companies; a stolen chapter from Enron).

 • Dispose NPLs to foreign banks, such as Morgan Stanley, for 10 cents on the dollar.

 • Increase the performing loans amount so that a lower percentage of NPLs will show in total loans outstanding.

 • Prime state banks for IPOs to receive $tens of billions in foreign capital.

The result is everyone's eyeing for Fidelity's Magellan, Pimco's bond funds and the purse of CALPERS. China already has over dozens of ADR's at the NYSE and NASDAQ, with a combined $200 billion in market capitalization (LFC, SHI, HNP, SNP, PTR, CHINA, NTES).Industries span from life insurance, utilities, chemical, oil, and dot coms. Soon you will hear ICBC (Industrial and Commercial Bank of China) alongside JPM and Citibank.

Watching some hamburger-flipping Americans who own 3000 sq. ft homes, the Chinese are quickly realizing that money will come easily once they step into the American financial gates. Take a few dozen state officials claiming the ownership of a steel factory, working with a Hong Kong banker to structure capitalization manufacturing some earnings reports, drafting a prospectus and then you have $1 billion in market cap. on the NYSE. We encourage you to visit Vancouver, Canada to get a glimpse of these wealthy Chinese and their money at work.

There are two things to consider when buying Chinese ADRs:

 • Officially no money can be taken out of China. You can invest money in China but you can't take it out

 • To think the NYSE will protect you when your ownership of the company is in question, think again. We had Enron, SBC, WorldCom and Qwest easily dodging auditors-and Fannie Mae and Freddie Mac still can't produce reliable and certifiable quarterly and annual reports.

Today, with dividends next to nothing, investors will never earn back the capital they initially invested-Chinese ADR's or not. GE, at last count, had $290 billion of debt and less than 10 billion in cash.

Consumption

Consumer consumption stands at around 45% of GDP (vs. 66% for the US). This shows the potential of China as a source of demand for goods and services. However, in the near term, China has too much excess raw resources and manufacturing capacity. The State Council this year has ordered a halt in investment in three key industries: steel, cement and electrolytic aluminum. At this juncture we would caution investments in commodity stocks. We think the end of the first leg of the bull run of PD, NRD, and N are near.

But over the long term we are bullish on China. If global consumption of Chinese goods tails off, there are ways to spur domestic demand. Easy money and credit is always welcomed by the public. Easy credit boosts consumption, creates inflation and results in higher prices and concludes with a tougher recession. We will wait and see how the Chinese government tackles the cooling economy and loss of jobs that's to follow with the current red-hot Chinese economy.

Conclusion

We think the new Chinese leader Hu-Jin Tao is an ambitious one. He has befriended the Thais, Vietnamese, Russians, Europeans, Cambodians, Koreans, and Japanese. He lent several $hundreds of millions to Asian partners. He has played the leading role in taking in Asian exports. With no storage problems, he wisely bought up all the natural resources from abroad. And he is making huge efforts to clean up China's capital markets to attract foreign investment. We will research more of Mr. Hu and share those insights with our subscribers in future issues.

Data were taken from the following sites:

http://www.pbs.org/sixbillion/china/china.html
http://abcnews.go.com/wire/World/ap20040219_2158.html
http://www.time.com/time/asia/magazine/article/0,13673,501031208-552154,00.html
http://www.atimes.com/atimes/China/FB10Ad05.html
http://www1.chinadaily.com.cn/en/doc/2003-08/09/content_253508.htm
http://www.channelnewsasia.com/stories/afp_asiapacific_business/view/70534/1/.html
http://www.publicdebt.treas.gov/opd/opds012004.htm
http://www.icbc.com.cn/e_index.jsp
http://www.tdctrade.com/econforum/sc/sc010402.htm
http://www.atimes.com/atimes/China/FB14Ad03.html
http://www.atimes.com/china/DF01Ad05.html
http://www.pbc.gov.cn/english/xinwen/detail.asp?col=xinwen&ID=354

Investing - Pick the right guy to follow!

We follow many newsletters and pay more attention to those that interpret the markets than to those that have a preconceived notion on what the markets must do next in the long and short term.

We don't feel the need to pay to read stuff just to make us feel better. No offence to Mr. Ian Gordon of thelongwaveanalyst.ca, but every day he tells us that the Dow is going to 1,000 and repeats that debt is deflationary. We can follow your advice (while ignoring rising prices of just about everything), go out and buy put options, lose money, read his detailed analysis and then lose more money.

As we said before, some analysts sound good but they can hurt your pocket book. We watched RobTV's debate on Wednesday between Brian Ackers and the honourable John Embry (http://www.robtv.com/channels/hubs/pastprograms_highlights_wed.html).

Mr. Ackers is another example of a good-sounding analyst that is pretty much an idiot, the same term used by Mr. Embry to describe Mr. Ben Bernanke. But Mr. Ackers' fund's performance is at http://ca.us.biz.yahoo.com/p/a/ack*cef.to.html (20% on par with the S&P 500 in 2003)

Compare that to Mr. Embry at http://www.sprottassetmanagement.com/pdf/SGPM.pdf (a 72% return in 2003 in Canadian dollars andbeating all the major gold indices).

Trading

We will go over 50-day and 200-day moving averages briefly here. We recommend reading Mr. Stan Weinstein's Secrets For Profiting In Bull And Bear Markets. Our rules are simple. For stocks, we like to buy at around the 200-DMA and sell 1/3 to 1/2 when stocks run up and dip below the 50-DMA. The important thing is to have a plan that's tested, or you will be like those who rode the gold train all the way from $800 to $250. A transaction is made on a stock between two parties who agree on the price but disagree on the value. Perception of value is often irrational and highly emotional. So why the 200- and 50-DMA? We don't know, other than it has to do with human psychology.

Market Watch

The Stock Market

Our subscribers know we pay little attention to the Dow until it has two consecutive days of declines of 1% or more. Well, almost one year going, we still have not had such an event.

Mr. Jesse Livermore said:

I knew something was wrong somewhere, but I couldn't spot it exactly. But if something was coming, and I didn't know where from, I couldn't be on my guard against it. That being the case I'd better be out of the market.

This is precisely how we feel about the general markets today. We have an idea that the Fed is behind this rally and we mentioned, on 7/25/03, the two factors that will cause us to go bearish on stocks:

 • A substantial increase in S&P contract short interest by the commercials (50k-100k)

 • An SPX, Dow and Nasdaq dip BELOW their 200 DMAs.

The Commitment of Traders report published on Friday shows commercials are actually net long S&P contracts.
http://www.cftc.gov/dea/futures/deacmelf.htm.

We think the 200 DMA, commercials, and the Fed will give us the green light to go bearish. But so far the light is red.

Gold and Gold Stocks.

We were at Whistler for a mini-break with our favourite book, Reminiscences of a Stock Operator, on hand for a reread. So please let us quote again from Mr. Livermore:

There I was - right and busted!

I tell you it was remarkable. What happened was this: I looked ahead and saw a big pile of dollars. Out of it stuck a sign. It had "Help yourself," on it, in huge letters. Beside it stood a cart with "Lawrence Livingston Trucking Corporation" painted on its side. I had a brand-new shovel in my hand. There was not another soul in sight, so I had no competition in the gold-shovelling. Before I could reach the dollar-pile my wind went back on me and I fell to the ground. The pile of dollars was still there, but I had lost the shovel, and the wagon was gone& I had seen real dollars and not a mirage... Thinking about the reward for my excellent sight kept me from considering the distance to the dollar-heap. I should have walked and not sprinted&

This is why we do not advocate margins and never utilize options. You never want to strike out.

The HUI and the XAU look to retest their 200 DMAs of 195 and 92, respectively. Gold broke down from its 18-DMA of 408 and looks to retest its 200 DMA of $380. The dollar rebounded with a vengeance on Thursday and Friday (2/19-20/04). Will gold and the gold indices retest their respective 200-DMAs? We don't know.

We think the dollar rebound is staged. A few hands were tipped as gold shares started tanking on Wednesday before the sizeable correction in gold and a rise in the dollar began. If the dollar rebound continues next week, silver and copper will lead the decline, which will take the HUI down even further. We believe gold's downside is limited from here. Gold, in euros, is within 3% of its two, separate and yearly lows established in both the summers of 2002 and 2003. The risk in buying gold here in our opinion is low.

We do think the next bull phase is starting soon, when the euro-gold price breaks out of the 350 area. However, we can't be sure when. No one can be.

Silver and currencies:

We publish subscription email alerts in-between Gold Insider issues.
(http://groups.yahoo.com/group/goldinsider/)

We went bullish on the Canadian dollar and silver. The Canadian dollar, having tested its 200-DMA of 74 US cents, is a low-risk buy here. We also like the yen at 109. Having visited Japan last year, we believe the yen at these levels presents an excellent value both long- and short-term. Look at it this way: shoring up some yen never hurts if you plan to visit Japan: buy a Sony Playstation or that next Honda Accord.

We'd like to expound on silver since we like silver more than gold at this juncture.

The silver price, short-term, is looking extended and far above its 18 DMA. However, the long-term, 20-year silver chart looks very bullish as explained by the Aden Sisters at http://www.safehaven.com/showarticle.cfm?id=1294

We like the upside of silver and we follow Mr. Ted Butler and Mr. David Morgan's work on COMEX short interest. If silver really deserves to be trading at $10 or $20 an ounce, would the market make itself obvious and let everyone get on board so slowly? We think not. Our approach is to establish a small position now, and then add to it if the first position turns out to be right.

Silver Stocks

There are only a handful of silver mining companies with market capitalizations over $100 million.

For example CDE, a $1.4 billion company in market capitalization, stated its total silver resources at 175 million ounces (including reserves of 75 million ounces).

On the surface, CDE looks great as it produces 15 million ounces of silver a year at a cash cost of $3. Think of the cash flow CDE brings in when silver is $10! This annual cash flow approach, in our opinion, is highly flawed. What happens when CDE runs out of silver to mine? We estimate the mine life of CDE to be 10-15 years at the most. Afterwards, who is left holding the $1.4 billion bag?

Another flawed approach used by many for assessing the operation of a mine is IRR (Internal Rate of Return). But IRR doesn't take into account market capitalizations already baked into companies. If the company has a mine that costs little to start and generate cash flow from day one (therefore with a high IRR since there is no cash outlay), most likely the company's market value will reflect such.

Stocks like CDE, HL (and others) actually offer negative leverage on silver. For the information on CDE:
http://www.coeur.com/media/pdfs/profile.htm
http://biz.yahoo.com/prnews/040219/sfth027_1.html

We can calculate the true value of CDE starting with the value of all the silver in the ground, minus the cost of getting the silver out.

With the most optimistic assumption that CDE can mine ALL of its 175 million ounces of silver at a cost of $3 per ounce, CDE is worth: (- $3 to $6.5) X 175mil oz = $612.5 million.

The calculation points to a fair price of $3 for CDE (which trades at $6.86).

In the extremely overvalued case such as CDE, one can buy more silver (215 million ounces) with CDE's market value than all of the silver CDE has underground (175mil oz).

We didn't say CDE won't go up from here. CDE in our view, however, is not an investment. It's a gamble.

We compiled the true value of PAAS, SSRI, and some of our favourite gold plays in a spread sheet on the last page of this issue (the spreadsheet is available to paying subscribers). Our analysis concludes that none of the silver mining companies PAAS, SSRI, CDE, HL offer much leverage to silver. At this time we believe it's a much safer play to leverage silver, the metal itself, than through the shares. We therefore recommend buying silver contracts at 50% margin for the aggressive investor, or straight bullion as a safe investment.

Portfolio Update

Transactions:

2/20 sold 2205 sh of als.v @ cdn $3.15
2/20 sold 938 sh of wtz @ $7.28
2/20 bought 1846oz of silver @ $6.5 with 50% margin
2/20 bought 51.3oz of palladium @ $234 with 50% margin

We are up 2% since the last letter, published on 2/1/04. WTZ has performed well with silver outperforming gold. Our laggards (ARQ and DNI) are experiencing corrections. However, we like both companies' properties and management.

At this stage, we would like to take half of WTZ off the table. We would also like to take off half of ALS.V,using the proceeds to purchase silver and palladium with 50% margin.

With limited capital, as most investors have, we have to judge the risk and reward of each investment choice. We feel the upside of silver and palladium is greater than ALS.V and WTZ at this time.

Next Issue

As we've said repeatedly, politics drives the direction of money flow. To make market predictions disregarding politics is like taking random walks in the dark.

In the next issue, to be published on March 15, we will look into the political and monetary climates of the late '70s and early '80s, when gold ran to $850 and compare them to those of today. We believe there are many similarities with distinct differences. We will explain how we take those insights to predict the path of gold and the general stock market of today.

Please note that this is the last free issue of Gold Insider. The subscription rate is $179 a year. We publish once every 3 weeks in pdf format with frequent email alerts on an as-needed basis.

Only PayPal or GoldMoney.com payments are accepted. Send funds to admin@goldinsider.com with the email you wish the issues to be addressed to. You can reach me personally at +1 604 710 7876.

John Lee, CFA
www.maucapital.com

John Lee is the founder and principal of Mau Capital Management and the portfolio manager of a mining equity hedge fund. He is a CFA charter holder and has degrees in Economics and Engineering from Rice University. Mr. Lee has a keen interest in the history of money and economics, and has previously studied under Mr. James Turk, a renowned authority on the gold market.

If you would like to receive subscription of Mr. Lee's Stock Chart of the Week and 4 other famous newsletters for the price of $89.95/3 months, click here to find out more. http://new.goldmau.com/stockchartsubscribe.php

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