The biggest of big pictures

I have had a request from Mrs Macleod to write down in simple terms what on earth is going on in the world, and why is it that I think gold is so important in this context. She-who-must-be-obeyed does not fully share my interest in the subject. An explanation of the big picture is also likely to be useful to many of my readers and their spouses, who do not share an enduring interest in geopolitics either.

That is the purpose of this article. It can be bewildering when a casual observer tries to follow global events, something made more difficult by editorial policies at news outlets, and the commentary from most analysts, who are, frankly, ill-informed. Accordingly, this article addresses the topic that dominates our future. The most important players in the great game of geopolitics are America and China. But before launching into an update, I shall lay down the disciplines required for an informed analysis.

Do try to look at issues from all sides in order to understand both strategic considerations and prospective outcomes. Understand that characteristics which may apply to one side do not necessarily apply to the other. For example, financial analysis that applies to the US economy does not necessarily apply to China’s. Do try to remain neutral and objective, analytical and unbiased. Remember the old stockbroker’s adage: where there’s a tip, there’s a tap, meaning that the dissemination of information is usually designed to promote vested interests.

The list of don’ts is somewhat longer. Don’t believe what governments say, because they will tell you what they want you to believe. Don’t believe anything coming out of intelligence services: if the information is good it is highly unlikely to come your way, and if good information does come your way, it will be indistinguishable from conspiracy theories. Don’t believe conspiracy theories because they are almost never true. Don’t believe government statistics; in fact, you shouldn’t rely on statistics at all, except in the broadest sense. Don’t believe western analysts, financial or otherwise, particularly when commenting on China or Russia. Don’t believe the mainstream media; it usually toes the establishment line, something we recognise of the Chinese and the Russians, but not in our own organisations. Don’t be swayed by nationalism or patriotism: remember Dr Johnson’s aphorism, that patriotism is the last refuge of a scoundrel (he was referring to those who invoke it).

Bearing these rules in mind, let us begin with America, and her position in the world because everything else flows through her accelerating descent from post-war influence.

America - becoming introspective?

America’s global dominance, unquestioned after the dissolution of the old USSR, is now being challenged by China, which plans to absorb the whole Eurasian continent within its commercial sphere of influence. Before President Trump assumed office in January 2017, the threat to America’s hegemony was not widely seen as a public issue, and her policy was to protect US interests through diplomacy, trade, and military presence. Covert operations were used to destabilise regimes which were deemed to be a threat to American interests, particularly in the Middle East, but also in Ukraine, an important buffer-state between Russia and NATO member states in Europe. It was the continuation of persuasion by guns and butter, even though as a global policy it has been getting somewhat tired. The supply of metaphorical butter from America has diminished, and that is now increasingly supplied by China.

Then there came Trump. His surprise election as president brought a several-times bankrupted businessman with little more than an outsized ego into the White House. His understanding of economics and the political process was zilch, but to his electoral base, that was his attraction, particularly compared with the Clinton alternative. Trump stood on a platform of anti-immigration, anti-globalisation, anti-foreign trade, and anti-foreign wars. He was pro-business and pro-America. In short, he was elected to overturn the tired policies of the Clintons, Bushes, and Obama. America was to become introspective in its foreign relationships, reversing the established globalisation trends.

Trump is politically at odds with America’s allies, particularly in statist, predominantly-socialist Europe. His insistence that European members of NATO must pay more of NATO’s costs was seen as a signal that established relationships could no longer be taken for granted, and Germany in particular should assert greater independence. In fact, the post-war establishment and all its institutions were threatened by the Trump rhetoric. However, the prospect of a better relationship with Russia, one of Trump’s pre-election hopes, faded with allegations of Russian interference in the presidential election. But probably the most disruptive Trumpian policies are over trade.

Trump is a firm believer that trade deficits are the result of unfair trade agreements. In this he is supported by Peter Navarro, White House Director of Trade and Industrial Policy, Wilbur Ross, Commerce Secretary, and Robert Lighthizer, US trade representative. Including Trump, these four are on one side of the trade issue, while nearly all the other senior staff, particularly at the Treasury, are on the other. So far, Trump has torn up NAFTA, the trade agreement with Canada and Mexico, which has been “renegotiated”, as has KORUS, the trade agreement with South Korea. He pulled America out of the Trans-Pacific Partnership, which included Japan, Australia, Chile and South-Eastern Asian allies. He initiated a trade dispute with the EU, which has been put on ice for now. He has introduced high tariffs on imported steel and aluminium.

Trump’s actions on trade have been despite attempts in the administration to stop him, a battle which is ongoing.

America’s overall trade deficit is currently running at over $600bn annually, about two-thirds of which is with China. The current position is that America is threatening to introduce further tariffs on Chinese imports totalling $200bn and in the absence of an agreement extending it to virtually all of China’s $500bn exports to the US. There are hopes this is Trumpian posturing ahead of the mid-term elections on 6^th November. However, whether the US extends sanctions as promised appears to be dependent on the pragmatists in the White House outwitting Navarro and Ross. If they manage to do so, presumably China and America can agree a face-saving compromise. If not, the tariff war will intensify.

American trade policy is therefore undergoing a radical alteration from the days when America was happy to run a trade deficit, so long as the surplus dollars were re-invested in America, financing among other things the government’s budget deficit. All commodities, and importantly energy, are priced in dollars on international markets, meaning there is a continuing demand for them to settle non-US trade. The dollar’s status as a reserve currency, coupled with America’s control over international institutions, such as the IMF, the World Bank and regional development banks, meant that America has been in effect the world’s central banker providing the currency, and through its commercial banks the background financer of all cross-border activities. It has been world domination by monetary means, and the need for dollars would always guarantee its global acceptance and underwrite much of its value.

China is manoeuvring to eat into the dollar’s virtual monopolies in commodity pricing and trade. If it succeeds, there can be no doubt the purchasing power of the dollar will decline. To assess this likelihood, we must now turn to China.

China

China’s recovery from the poverty of Maoist communism has been remarkable. It has achieved this by embracing capitalism, while retaining strict political control. It is said that the Chinese leadership observed the successes of Singapore and Hong Kong, driven mainly by Chinese businessmen. It understood that by copying their economic models of laissez-faire capitalism and with an authoritarian government they could improve the lives and wealth of ordinary people, from which the state ultimately derives its power.

The Chinese state plans and directs its state-owned enterprises towards clear objectives. It does this through a series of consecutive five-year plans, the current being the thirteenth which runs to 2020. Already, the next one has been drafted and dubbed “Made in China 2025”. It features state investment in robotics, electric cars, artificial intelligence, biotech and aviation. The equivalent of $300bn of government money will be spent on these sectors, upsetting the Americans who see themselves being shut out from them in China, and concerned that subsidised Chinese industries will have an unfair commercial advantage in export markets.

China is still improving its own infrastructure and is in the process of moving hundreds of millions of citizens from being trapped in menial agricultural and unskilled factory jobs into joining a growing city-based middle class. China now has more than a hundred cities with over a million people, some of which are mega-cities. We have all heard of Shanghai which has 34 million. Few of us know of Guangzhou which has 25 million, the same as Beijing.

Furthermore, the spread of automation and technological innovation is steroidal, and accelerating. And as if that is not enough, China is building two “silk roads” one overland to Europe and a sea route, both of which will be interconnected at several points along the way. It will be a transport and communications network, bringing together the whole Asian continent through trade.

Already, a Mercedes can be delivered from Stuttgart in Germany to the showroom in Beijing in a fortnight. That will come down to ten days. And Zanussi, the Italian white goods manufacturer, can deliver product from its Chinese factories into its European markets on the same time-scale, compared with thirty days by sea.

So ambitious are China’s plans that she has a continuing need to secure the industrial materials for developing infrastructure. She is in a political and economic alliance with Russia, which is the world’s largest exporter of energy and has substantial mineral resources. The partnership is secured in a number of ways, the most important being through the Shanghai Cooperation Organisation, which can be described as a security and economic forum, embracing military cooperation and infrastructure-building. The SCO membership includes China, India, Kazakhstan, Kyrgyz, Pakistan, Russia, Tajikistan and Uzbekistan. Observer status, which is the stepping-stone to full membership, includes Afghanistan, Belarus, Iran and Mongolia. Turkey, which is also a member of NATO, is a Dialog Partner, which is one step further away from membership from Observer Status, but is a declaration of intent.

The SCO members, Observers and Dialog Partners cover a total population of three and a half billion, 45% of the world’s population. This is, in effect, China’s back yard and her future market. Add to this her expanding commercial links with Western and Central Europe plus the South Asian nations notionally in America’s sphere of influence, and the whole Eurasian continent is hers to dominate through trade.

She has also invested $140bn in sub-Saharan Africa, developing the African continent as a supplier of raw materials. Africa is itself growing rapidly from a very low base and is a potential future market. China is also Australia’s largest trading partner.

Those who think that America controls world trade through the dollar should wake up. She is up against China everywhere. And as we have seen, China exports some $600bn of goods to America, against only $200bn the other way. She is the largest miner of gold in the world, by far. Unless something happens to interrupt China’s progress, she will have the largest economy by GDP in just a few years, if she hasn’t already on a PPP basis. The key to understanding the pace of this change is not to think in linear projections but in exponential terms.

Is putting up trade barriers, which seems certain to diminish her own influence in global trade, the right response by America to this Chinese industrial revolution? Would it not be better to embrace it, as so many American businesses have done by including Chinese production in their supply chains? Obviously not for those who believe with Trump American nationalism is paramount.

Instead of being realistic, America’s antagonistic approach to China has effectively pitched America into a financial war with China. China follows Sun Tzu’s dictums. Sun Tzu was a Chinese military general and strategist who lived 2,500 years ago and is still quoted today. An appropriate aphorism of his goes as follows: “Be extremely subtle, even to the point of formlessness. Be extremely mysterious, even to the point of soundlessness. Thereby you can be the director of the opponent's fate.” And here’s one appropriate for dealing with Donald Trump: “Pretend inferiority and encourage his arrogance”. Perhaps that’s why Trump does all the talking, while Xi smiles politely and says nothing. Trump brags about the excellent relationship he has with Xi. Xi smiles politely and says nothing.

Meanwhile, China is doing away with the dollar as much as possible, developing financial markets for her own currency instead. Admittedly, that part of her plan has been put on hold for the moment, because Trump’s trade wars have weakened the yuan, and the Peoples’ Bank (China’s central bank) has been buying yuan to support the exchange rate. But this is likely to be a temporary phase.

There is another way of looking at this intervention. The other side of buying in her own currency has been selling part of her enormous stockpile of dollars. Measured in yuan, this has been highly profitable. And at some stage, China will want the yuan to rise against the dollar for some very good reasons. She needs to import raw materials in enormous quantities, and that will drive their prices up in dollar terms. The effect on price inflation in China will be largely dependent on the exchange rate between dollars and yuan, so it will be in her interests to have a stronger currency to lessen the inflation impact.

China has also been encouraging her suppliers of energy and raw materials to accept yuan instead of dollars. All this points to a managed, higher rate for the yuan against the dollar, in order to encourage widespread acceptance of the yuan. This brings us to the relative future of the yuan against the dollar, and the effect on the gold price.

A stronger yuan will underwrite gold

As noted above, China must embrace the consequences of a stronger yuan if it is to deliver on its current thirteenth five-year plan, and on “Made in China 2025”. If she fails to do this, not only will rising commodity prices fuel domestic price inflation, but she will still be vulnerable to America’s use of the dollar as a strategic weapon.

It will require China to discard Western thinking that lower currency exchange rates can be used to stimulate demand. Anyway, she is moving her economic emphasis away from the manufacture of cheap goods dependent solely on low prices for their sales, towards the added-values of quality and technology. Instead of employing large numbers of semi-skilled workers on production lines, manufacturing of export goods is becoming highly automated. Capital investment is replacing the wage element in costs. Time taken in manufacturing processes has fallen as a result, so the benefits of having a competitive exchange rate is less of a factor for export profitability.

The supposed disadvantages of managing a currency into continuing weakness are therefore becoming trivial. That being the case, we should expect moves to underscore a change in currency regime. But before we examine them, we must briefly look at the other side of the exchange rate, the dollar.

For the moment, the dollar is strong predominantly against the euro. Despite the US trade deficit with the Eurozone (which creates net buying of the euro by commercial entities), the capital flows the other way are driving the euro lower. Because banks and their hedge fund clients have access to euros through wholesale money markets, they can borrow three-month money at minus 0.3%, sell the euros for dollars and invest in three-month Treasury bills for a yield of 2.3%. Gear it up ten times (which is what banks do) and you have a slam-dunk 26% annualised return on your capital. And because the dollar’s trade weighted index is comprised of 50% euros, the selling of euros for dollars by these interest rate arbitrageurs is why the dollar’s TWI is so strong.

This interest dysphasia between euros and dollars is creating enormous currency strains, a situation that cannot last. Either the Fed and the ECB must devise a managed solution, or it will end in a currency crisis.

For the moment, contrary to current widespread commentary, foreign ownership of dollar deposits and dollar-denominated investments are at an all-time high. The US government depends on foreigners buying Treasuries to fund itself. However, Trump’s tariffs will help drive domestic consumer prices higher, on top of the price stimulation of a budget deficit about to exceed a trillion dollars. In short, a highly inflationary situation is developing, leading to rapidly rising bond yields (which means falling bond prices) and a potential funding crisis for the US government. Rising inflation and funding difficulties make for a falling dollar exchange rate, which promises to be sudden and severe when the speculative tide turns.

A falling currency raises the cost of energy and industrial commodities, fuelling price inflation even further. Does China go with it, by allowing her currency to maintain a dollar peg? The answer, as we have seen above, must be an emphatic no.

Currently, the yuan is split by capital controls between domestic and foreign markets. Chinese residents are not permitted to hold foreign currency, a situation that cannot continue for much longer if the yuan is to have the required international liquidity. No doubt capital controls have allowed the Peoples’ Bank to control the currency rate without the disadvantage of domestic currency speculation undermining it. A rising yuan will discourage the accumulation of foreign currencies, so if capital controls are to be lifted, it must be against that background.

If the gold price was to rise only moderately measured in dollars, it would continue to be good value in China, the world’s largest consumer and savings market for physical gold. That is becoming a worst-case outcome for the price. However, the accumulation of record quantities of dollars in foreign hands is a similar condition that led to the suspension of the Bretton Woods Agreement in 1971, when foreign-owned dollars were being cashed in for gold. Following that dollar crisis, gold rose over twenty times. Only this time, it will be China driving up energy and commodity prices, not the OPEC cartel. Gold’s price rise in dollars this time will depend on how the US handles its decline.

This is a market-based argument for the gold price to rise, and not an economic one. The economic case is there in spades as well, but that might be harder to explain to one’s spouse.

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