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Lending: The Good, Bad, And Ugly

Lending: The Good, Bad, And Ugly

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The Problem With Modern Monetary Theory

The Problem With Modern Monetary Theory

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Gold - The Implications of a China-centric World

Gold broke through $400 per ounce driven by investor concerns over the health of the US balance sheet, weakened by the most stimulative set of economic policies in U.S. history. Gold and its relationship with the US dollar have been in a lockstep. Gold has risen over 60 percent since touching a twenty-year low of $250 per ounce in August 1999. The dollar on the other hand has dropped some 35 percent since reaching its stratospheric high in October 2000. The greenback is expected to fall at least another 40 per cent during the next twelve months, which augers well for gold. Gold now looks poised to test the $420 level.

We continue to believe that gold is in the early stage of its bull market following an extended two decade bear period. History shows that in a bull market staying long is the best strategy. Gold is always volatile and shakeout opportunities afford excellent buying opportunities. Noteworthy is that gold has established successfully higher major support levels and thus technically is in excellent shape. We continue to expect gold to surpass $510 an ounce and eventually a new high. We thus recommend purchases of gold and gold stocks at current levels. Gold is a good thing to have.

We expect the dollar sell-off to continue with downward pressure from the rising current account deficit. The Americans consume more than they produce and use debt to pay for the rest. The Americans have not financed their own share of the deficit and with US interest rates at forty-five year lows, rates must go up to attract capital, an unlikely scenario during an election year. Whether the US likes it or not, the fate of both the deficit and the dollar are out of their hands. As the dollar weakens, so does America's purchasing power in overseas markets. The willingness of foreign investors to buy or hold dollar-denominated securities, of course declines as well, which further undermines the dollar.

China's Growth Will Reshape America

Alan Greenspan recently warned, "during the past year or so the financing of our external deficit was assisted by large accumulation of dollars by foreign central banks." Financing the debt was a cinch when American assets were attractive to foreign investors. Conditions have since changed. Ironically, recent protectionism measures designed to help the US dollar has only added pressure to the dollar. The dollar must decline further to correct America's external deficit, which is running at a whopping 5 percent of GDP. In dollar terms, the US requires $50 billion monthly to balance its deficit. Over the past year and a half, the American treasury market has benefited from purchases by the Bank of Japan and the People's Bank of China, aimed at keeping their currencies in line with the dollar. But the ratcheting up in protectionist tensions has caused even Alan Greenspan to worry, "some clouds of emerging protectionism have become increasingly visible on today's horizon," and "could erode" the flexibility of the global economy. His cry to halt increasing protectionism was ignored.

The US budget deficit has gone from below zero to half a trillion dollars under the weight of three years of multi-trillion dollar cuts and Bush's War On Terrorism. The budget deficit has exploded, not because of a shortfall in revenues but because of a substantial increase in spending. Overall spending by the Bush Administration increased by twenty-one percent over the past two years, the largest since the LBJ years. The United States is awash in red ink, flooding foreign and domestic markets with money, in an effort to get the economy going through the 2004 elections.

The excessive monetary policy of the past few years have been surprisingly reminiscent of the early Johnson years, when the United States fought the Vietnam War and provided for the "Great Society" without raising taxes. In the 60s, Johnson promised "guns and butter" that eventually resulted in big government and easy money which was a perfect recipe for inflation. The Johnson years were followed by an economic crash that saw gold go from $50 an ounce to $850 an ounce. It's déjà vu all over again.

The Americans are in a box. Savings rates are near zero as a result of record household borrowing and a huge federal deficit. They can ill-afford to finance their own deficit. Foreign investors currently own at least half of the US Treasury and agency bonds. The Bush Administration is playing politics with the dollar and the recent politicized tariffs on bras are an indication of the Administration's desperation for votes and could cause a "tit for tat" retaliation. After all, the last American-made bra was made over twenty years ago, so just whom are the "Bushies" supposed to be protecting.

The effect of the dollar's weakness on the demand for dollar-denominated assets is having an impact. In September, inflows dropped dramatically to less than $4.2 billion or 10 percent of a year earlier and the lowest in five years. In October, net inflows were a paltry $27.7 billion, well short of the $50 billion needed to fund the deficit each month. The Bank of International Settlements (BIS) said oil-producing countries and Asian banks have been repatriating funds rather than holding dollars. Since May, inflows have dropped from $110.4 billion to $49.9 billion in August. The United States depends on the largesse of foreigners because over $2 billion a day is needed to finance its current account deficit. The $374 billion budget shortfall, with the fiscal year ended on September 30 is the largest dollar amount ever but is expected to rise to $525 billion in the current, or a swing of $650 billion since Mr. Bush's term began in 2001.

While the US dollar has been the weakest currency in the world for much of the year, its decline is being blamed on China. America's protectionist stance is self-inflicted and comes at a time when China's enormous trade surplus with America is expected to rise to a record $125 billion this year. China has become the target of over half of the anti-dumping cases brought by U.S. companies. In an election year, protectionism and competitive devaluations are policy choices with far-reaching implications, and we believe there is no justification for both. The Americans have yet to realize the implications of a China-centric world.

China Is Making An Impact

There is no question that the Chinese economy is booming. China produces more steel than the US and Japan combined and yet they are still importing steel. With 1.2 billion people, the economy is growing at better than 10 percent per annum. While China is an important market, it is particularly important to the Motorolas, GMs, Coca Colas, and Wal-Mart, who have subsidiaries based in China, taking advantage of the lower wage rates. But it is important to note that China is not dependent upon outsiders and their brands. The largest computer seller is not an IBM, or Dell but Legend. The largest air conditioner company is Chinese. China is the biggest beer market in the world (but still lag on a per capital basis). Chinese car production is up 87 percent in the 12 months to September and at the current growth rate, will produce more cars than the United States in just three years. China, as well, is doing its best to help imports. China's nouveau riche have snapped up so many yachts that Shanghai is planning to build ten new marinas. Bentley recently unveiled its $4 million 2004 model and upon a recent visit to Beijing, we learned that Bentley has sold 28 Bentleys in Shanghai alone. To service these vehicles, Volkswagon will send four fulltime service mechanics to China. Oh yes, Canada was only allocated three Bentleys for 2004.

....And Resource Poor

However China is resource poor and thus dependent upon importing oil, copper, timber, and iron ore. China is the world's largest consumer of copper and zinc, and also a major buyer of iron ore and in the case of nickel, the fifth largest producer. While the Chinese have immense reserves of coal, iron ore and gold, they have not been able to successfully exploit them due to the lack of technology and funding. At one time everything was controlled by the State and there was no incentive to explore nor develop mines. Also the Chinese have been slow developers of their resources due in part to their cumbersome regulatory framework and the desire to centrally manage foreign investments. We believe that there is a golden opportunity in China since there has been little exploration by western companies.

The Chinese sell a lot stuff to the Americans, but at the same time they are accumulating substantial foreign currency reserves and buying substantial purchases of U.S. Treasuries, funding the spendthrift, debt-ridden ways of the Americans. Without the Chinese purchases, the Americans could not finance their twin deficits and keep interest rates low. While the Americans have become the biggest debtors in the world, the Asians have become the biggest creditor. The question now is what will the Asians do with their surplus dollars?

The United State is savings short, and overly indebted. The logic is simple. The huge US deficits must be offset by huge surpluses elsewhere. The Chinese are savings long and have huge surpluses. The Chinese have accumulated $385 billion in dollar reserves and more than $125 billion in US Treasuries. It is particularly hypocritical of the Americans to criticize China for its cheap currency status. The real cause of the trade deficit is America's insatiable appetite for imports, which coupled with a low savings rate, stimulative policy and chronic budget deficits has fueled a new round of China bashing.

China's Golden Opportunity

The U.S. Federal Reserve's latest data shows foreign central banks holding $799 billion in Treasuries and $203 billion in government agency bonds. The majority of these holdings are held by Asian central banks, the biggest foreign holder of U.S. Treasuries is the Bank of Japan, which spent $70 billion in the third quarter, to keep the yen from rising. During the depression of the 1930s, many countries adopted competitive devaluations in a "beggar thy neighbour" policy, to give their economies an advantage, but it only worsened their performance. In the 80s too, efforts to drive the U.S. dollar down led to a 70 percent reduction but manufacturers still lost out to foreign competitors.

What is lost on the Administration is that in trying to press the Asians to revalue their currencies upward, it only worsens their trade position. Shortly after the call for "flexibility", the dollar fell not only against the yen, but equally against the euro. The problem is not the Asians, but America's insatiable appetite for imports. While the U.S. dollar has strengthened in line with improvements in the economy, its schizophrenic economic policy has made the U.S. lose its position of choice of being on the receiving end of capital inflows. Instead, China has now become the recipient of the world's largest capital inflows.

For thousands of years the Chinese have traditionally saved gold and worn gold ornaments. During special holidays or birthdays, the Chinese tradition gives taels as gifts. We believe that with this liberalization, China will import gold, which will have positive implications for the gold price. Outstanding individual bank savings in China amounted to $1.3 trillion at the end of July. This month an investor in Chengdu bought five ounces of gold, becoming the first to be allowed to buy physical gold in China. Some 45 percent of China's population is under age 25 and gold is a new form of wealth. China is the world's third largest gold consumer and the fifth largest producer, producing about 200 tonnes per year. China is the largest potential jewelry market in the world with currently 90 percent of the gold consumed in China used to make jewelry.

China's growing foreign currency reserves of dollars are now at levels that the government is diversifying from dollars into euros, gold and recently we understand, the Canadian dollar. After all, unlike others who bought Van Goghs and golf courses, gold and Canadian dollar have gone up against the greenback. Now that individuals can buy gold, it is believed that initial demand can amount to 300-500 tonnes. We expect China to increase their gold reserves to at least 10 per cent of total state reserves from the current 2 percent holding. China has increased its gold reserves by a third in recent years to 600 tonnes, worth about $12.4 billion. With China's economy growing and with the entry into the WTO and other global institutions, China would like to have sufficient reserves comparable to the western economies. The United States, for example, has over half of its reserves in gold, while Switzerland has over 35 per cent in gold. The European Community has more than 10 per cent of its reserves in gold, backing the Euro.

China is the world's fifth largest gold producer but has never officially released production figures. The largest production areas are in Shandong and Hainan provinces followed by Hebei province. China has many deposits but mostly shallow and lacking in western technology. A recent visit, last month, to China revealed that many of the mines not only lacked technology but also lacked the proper infrastructure to exploit. There are some 800 mines in China, employing a workforce of 400,000 but other than a few, most are small producers with limited resources and few are profitable. Eighty per cent of these producers have a daily processing capacity of less than 15 tonnes, which is modest. In the first half of this year, China's national gold output hit 2.8 million ounces for an increase of 13 per cent, while profits were estimated at 974 million yuan or $117 million, which works out to only to $42 per ounce. Since the average price of gold for the first half of this year was $350 an ounce, the cost price per ounce was $300. There is no question, there is attractive geology but there has been little drilling to support the geological theories. The Ministry of Geology & Mineral Resources and its provincial counterparts, and the State corporations undertake much of China's mineral exploration. Prospecting is few and there is little private investment.

Other obstacles remain Banks provided more than 90 percent of financing and capital structures are overly leveraged. Title is also a big question since the State owns the country's resources. Today, many of the Canadian plays in China don't even have title, let alone proper joint ventures. Permitting has been streamlined but is still cumbersome. And because of the thin capital markets, the stock market is underdeveloped. Until 1990, China had no stock market. Nonetheless a golden opportunity exists. China is evolving, as it brings gold trading and exploration into the twentieth century. China for example has established a national gold exchange in Shanghai, the financial hub of the country. The Chinese can now buy gold. Li Ka Shing has sponsored a gold trading operation. We expect further liberalization to build up its domestic gold industry and China will be open to technical upgrading, western technologies, and eventually western type financings.


Agnico-Eagle Mines Ltd.
Agnico-Eagle shares have recovered following an analyst mine tour at its La Ronde mine in November. Following a visit at Agnico's office, we learned that the company has changed its mine plan for 2004 and Agnico-Eagle expects to produce between 70,000 ounce to 75,000 ounce in the fourth quarter. They will easily meet this target. We believe that the problems are finally behind Agnico-Eagle.

First, the company is now mining within 60 feet of the rockfall Second, the company is hauling 3,300 tonnes per day from the bottom which is substantially ahead of next year's target. Consequently the company expects a stockpile in excess of 100,000 tonnes by yearend. We believe Agnico-Eagle is ahead of its development and currently has eight drills working at LaRonde. With a blasting change and better mill reconciliation, we believe that the surprises are behind the company. As well the ventilation and last raise was completed and the heating problem is also history. The company expects to produce 300,000 ounces next year and with the recent increase in base metal prices will help Agnico-Eagle's cash operating costs.

Unfortunately, the rockfall has diverted management's time as well as investors attention. We believe that with the problems behind them, investors will soon focus on Agnico's extensive exploration efforts on the largest land package in the Cadillac-Malartic belt (Lapa, Bousquet, Ellison, Goldex). The company has one of the largest exploration programs in Canada and in the next few months we expect exciting exploration news. At Bousquet for example, three drills are expected to test the lower horizons. At Lapa over $3 million and 190,000 feet of drilling is planned to test the bonanza type high-grade gold zone. Lapa currently has 1 million ounces delineated and will have seven drills turning. We believe Lapa will be Agnico's next mine. Lapa is open along strike in all directions and the high-grade intersections at depth are particularly appealing. At Goldex, located about 35 miles east of LaRonde, Agnico plans to complete a feasibility study, which calls for three slots to test the grade. Goldex material could be shipped to LaRonde and costs will be less than $160 million. We like Agnico-Eagle shares and view the pullback as an excellent purchase opportunity. Agnico-Eagle has a balance sheet with $100 million in cash, over ten miles of excellent ground along the Cadillac break and a management that has something to prove. Buy.

Barrick Gold Corp.
Barrick, the world's third largest producer, shocked the Street by announcing they will not hedge nor roll over contracts over the next 10 years. The company currently has about 16 million ounces of its 87 million gold reserves hedged and the realisation that hedging does not work when gold price rises have caused the arch-hedger to abandon the strategy. Indeed, for a time, Barrick made more money from hedging than mining. The lack of contango, low interest rates and investor criticism likely caused Barrick to capitulate. Importantly, Barrick has finally reversed course. However it has not yet set the timetable for the elimination of those 16 million ounces of hedges, which currently stands at three years of production sold forward. Barrick will continue to deliver into its hedges, although the elimination of the hedges could cost Barrick serious money. For tax reasons we understand that Barrick's hedge program was conducted in Barbados. Barrick generated more than $2.3 billion in additional revenues from the program and over the years has sheltered much of the profits. However, should Barrick repurchase those contracts, not only would a tax loss be created in a nontaxable jurisdiction but the sale of its production would also attract a higher rate of taxation. Ironically, Barrick has benefited from a declining gold price but would be hurt by a rising gold price since higher tax rates will hurt margins.

Last year, the gold industry bought back 250 tonnes of gold, which added to overall demand. Following Barrick's announcement, we expect other miners to follow suit, particularly heavily hedged Placer Dome and some of the South African miners. Acquisitions were part of Barrick's successful growth. To quickly get out of this hedge box, we expect Barrick to return to its acquisitive ways. Are there any unhedged 2 million ounce producers out there?

Claude Resources Inc.
Claude is a Canadian junior mining whose primary asset is the Seabee goldmine in Saskatchewan. Claude produces about 50,000 ounces of gold per year and has a strong balance sheet. The Seabee goldmine is about 125 kilometers northeast of La Ronde. Claude has successfully mined this high-grade narrow vein underground operation and has consistently replaced reserves and has about an 11,000 acres land package surrounding the Seabee mine with two drills working and 45,000 metre drill program is planned. The company also has interest in the Madson mine property in Red Lake, Ontario with Placer Dome earning up to 55%. Next year Placer Dome plans to spend $4 million and hopes to find another Campbell mine. Placer has an option to earn up to 55% by spending $8.2 million and delivering a positive feasibility study by the end of 2006. Next month Placer Dome plans to drill the promising Treasure Box target, which is about three kilometers from Madson. We like Claude Resources for its steady cash flow base and the exciting potential at Madson. We continue to recommend the shares of Claude and the stock remains on our list of Top Ten Juniors.

Crystallex International Corporation
Crystallex completed a positive feasibility study for Las Cristinas and is awaiting government approval. In addition to the 20,000 tonne per day base case, Crystallex is reviewing an increase in tonnage to 40,000 tonnes per day, which would see production increase from 311,000 ounces to 500,000 ounces. Crystallex plans a multi-phase approach with initial capital costs estimated at less US250 million. The company expects that the permit will be awarded by end of the second quarter next year when construction could begin. Crystallex also announced the sale of the San Gregorio mining interest, which reduces their hedge book and eliminates the reclamation cost. Crystallex has centralized its office in Toronto and built up its management team. In adding Todd Bruce and Ken Thomas, Crystallex has an experienced management group, capable of executing their mine plan to be among the intermediate mining companies. Unlike other projects, the Venezuelan government is highly supportive of Crystallex in putting this deposit into production. Moreover there are no local issues. As for geology and mine plans, not only did Placer Dome complete exhaustive studies, but Crystallex retained both SNC-Lavalin as well as Mine Development Associates (MDA). Crystallex recently completed a private placement of $38.2 million leaving cash at quarter end of $46.3 million. We expect the company will go to the equity market to finance Las Cristinas. We continue to recommend the shares of Crystallex because our belief is that this is one of the cheapest undeveloped 10 million ounce deposits around.

Kinross Gold Corp
Kinross has closed its deal to acquire Crown Resources, whose major asset is the Buckhorn Mountain gold deposit in Washington. The Buckhorn gold deposit has 2.12 million ounces of reserves grading 0.39 opt. Kinross plans an underground mine and will process the gold at its nearby Kettle River facility. Consequently, Kinross has made a silk purse out of a sow's ear since the Kettle River facility was to close. Kinross expects to announce shortly that it will reopen the Refugio heap leach gold mine in Chile. The open pit mine was closed about two and half years ago, but new resources and a higher gold price will allow Kinross and its partner Bema Gold to reopen the mine. Production is expected to average about 220,000 ounces of gold per year at a cash cost of $220 an ounce.

Kinross produced disappointing results in the third quarter, but the shares have done well because of its excellent leverage to the gold price. Kinross should produce 1.7 million ounces next year with better output from Fort Knox and Round Mountain. Porcupine was a contributor but New Britannia was a drag on results. Kinross has over twelve mines in its portfolio and is levered, not only to the gold price but its holdings are also useful chips. For example, at Kubaka, the company is still negotiating with the Russians and the Birkachan and Tsokol deposits could be added to reserves but some agreement is needed. We continue to recommend the shares of Kinross, not only for the array of assets but also for its aggressive management who are considered among the best deal makers on the street.

Miramar Mining Corporation
Miramar Mining has been one of our "Top Ten Juniors" for some time. The Canadian gold producer operates two mines in Canada's Northwest Territories, but more importantly will begin construction at the long awaited Hope Bay mine next year. Currently, Miramar produces 130,000 ounces per year, but the Con mine will close and the Giant will be kept open at a production rate of 40,000 ounces per year. The Federal Government is paying Miramar to keep the Giant mine open because it would cost the government more to shut the mine down. Miramar plans to bring on Hope Bay with the development of the Doris North zone and build a small tonnage mill and develop a mine, which is expected to cost less than $40 million with initial production forecasted for 2005. The game plan is to begin with the Doris and then develop the Madrid and Boston deposits later. As a "second leg", Miramar recently announced a deal with Kinross to develop the George Lake and Goose Lake deposits in the North. Miramar must spend $25 million to earn a 60 percent interest and the company plans to spend about $30 million. Both George Lake and Goose Lake have excellent high grade potential but tonnage has always been a question mark. Miramar's plan is to develop further tonnage and its expertise in working in the North is a major plus. We continue to recommend the shares at current levels.

Newmont Mining Company
Newmont Mining shares have been a brilliant performer. The company recently raised $1 billion dollars, giving the company a virtually debt free balance sheet. There is speculation that Newmont would be an acquisitor but we do not think the company will be active preferring instead to wait for the higher gold price to destroy the balance sheets of the heavily hedged players. Newmont then could be an opportunistic buyer. Newmont should produce 7.4 million ounces this year and the pickup in copper prices will help Batu Hijau. Exploration results from Gold Quarry and Twin Creek should offset any declines in Nevada. In addition Newmont plans an ambitious program to develop a major camp in Ghana. Newmont is expected produce about 7.3 million ounces next year. Given its rock solid balance sheet, negligible hedge book and sizable portfolio of mines and potential mines, we expect the stock to receive a premium multiple and therefore continue to recommend the shares.

Placer Dome Inc.
Placer Dome has benefited from the pickup in copper prices, which has helped the Zaldivar copper mine. Production next year will be lower due to closings of the Misima mine and declining output form Golden Sunlight in Montana. Cortez in Nevada continues to be a big producer and the company has shed light on the Cortez Hills discovery. However, continuing problems at South Deep in South Africa is costing Placer more money. The shaft installation is taking more time and we believe that South Deep will continue to be an albatross. Moreover, the strength in the rand and the South African empowerment bill has had a negative effect on the overall value of Placer's stake. The hedge book remains at a hefty 11 million ounces, which has a negative $400 million mark to market value. Looking ahead, Placer seems solidly stuck on the treadmill. Donlin Creek appears to have been put on the backburner and as mentioned South Deep deepening is delayed. That leaves Pueblo Viejo in the Dominican Republic, which is a world-class deposit. Placer is expected to produce a pre-feasibility study in the spring, which will address the metallurgical and environmental obstacles. Placer is considering either an autoclave operation or geobionics facility. Placer Dome could be producing 500,000 ounces a year but so far have given few details. We prefer Newmont, which is unhedged.

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