China Opens the Flood Gates for Gold and Silver

Now that the world's attention has drifted away from Europe's crisis, the U.S. dollar is back in focus as the troublemaking currency du jour.

After watching the U.S. dollar index drop like a stone in recent weeks, China appears increasingly less willing to remain either a silent bystander or a hapless victim. As the largest foreign creditor to the U.S. -- with $868 billion in Treasury bonds -- China has ample cause for concern.

Nothing to treasure?
Yu Yongding, a member of the government-sponsored Chinese Academy of Social Sciences (and a former advisor to China's central bank), delivered a poignant vote of no confidence this week in the safety of U.S. Treasuries. Dissenting from the prevailing bond market sentiment -- which sees investors still buying U.S. bonds in droves despite historically low yields -- Yu warns: "I do not think U.S. Treasuries are safe in the medium and long run."

This isn't the first time China (or Chinese officials) has expressed deep concern over the health of the U.S. dollar and Treasury bonds. Fools will recall that Chinese Prime Minister Wen Jiabao indicated last year that China was "concerned about the safety of our assets." A few months earlier, China expressed support for a new global reserve currency regime that would replace the dollar as the dominant reserve currency with a basket of foreign currencies (using derivative-based International Monetary Fund instruments called SDRs). The rhetoric from China then grew rather quiet as the dollar met with several rounds of countercyclical strength. This week seems to be about making up for lost time.

The same Chinese Academy of Social Sciences' deputy chief of international finance research, Zhang Ming, warned separately this week that: "The U.S. government has strong incentives to reduce its real burden of debt through inflation and dollar devaluation. Whichever way it is, the yuan-recorded market value of Treasuries will fall, causing huge capital losses to China's central bank." If the dollar's declining purchasing power is now an inevitable fate, as these Chinese officials seem to suggest in their blunt remarks, then perhaps we really are fast approaching a terminal saturation of China's appetite for U.S. debt. If that were true, we might expect to see some corresponding rumblings within China's official stance toward gold.

As if on cue, China came forward with a crucial pair of moves this week with respect to gold. The first was a major liberalization of China's gold market by facilitating greater import and export activity in gold and opening the Shanghai Gold Exchange to additional foreign entities. The second (and arguably more significant) development deserves our close inspection below.

Here, world, have your dollars back
In a landmark development for the precious metal market, China's central bank threw a lifeline to a credit-strapped global mining industry this week by explicitly directing banks to extend credit: both directly to producers of bullion (presumably gold and silver), and to Chinese entities seeking overseas acquisitions in the sector. The bank "will place heavy emphasis on supporting large-scale gold producers in their development and overseas expansion plans."

After carefully tracking China's momentous activities investing in resources and related projects around the globe in recent years, I look forward to following this overlooked acquisitive trend as it flows directly into the markets for gold and silver.

Exploring the possibilities
I encourage Fools to ponder the significance of this announcement for a range of highly promising precious metal deposits around the world that may have been sidelined to date by their sheer scale and/or lack of available credit. The most obvious example is Seabridge Gold (AMEX: SA  ) , whose Kerr-Sulphurets-Mitchell project is so massive an undertaking that even the two principal gold titans -- Barrick Gold and Newmont Mining (NYSE: NEM  ) -- have thus far passed on the property. With a little financial backing from China, however, perhaps that $3.4 billion construction estimate won't appear so daunting after all. KSM's world-class quartet of reserves -- featuring gold (30 million ounces), silver (133 million ounces), copper (7 billion pounds), and molybdenum (210 million pounds) -- is just the sort of music that I think could catch China's ear.

With familiar names like George Soros and John Paulson throwing their weight behind a previously stagnant NovaGold Resources (AMEX: NG  ) , this Fool wonders whether China might provide a final influx of capital to propel NovaGold's strategic assets toward fast-tracked development.

With its development capital focused elsewhere, Barrick Gold (NYSE: ABX  ) has done little with its Donlin Creek joint venture with NovaGold. Boasting gold reserves of 33.6 million ounces, however, the deposit is simply too large for the gold market to ignore. Likewise, NovaGold's Galore Creek joint venture with Teck Resources (NYSE: TCK  ) expects to release a revamped pre-feasibility study during the first half of 2011, and I consider the deposit's prolific mix of measured and indicated gold (7.3 million ounces) and copper (8.9 billion pounds) well-suited to China's two-tiered strategic focus upon industrial resources and -- after this week's announcement -- precious metals. The China Investment Corp. has already dipped $1.5 billion into coal and copper exporter Teck Resources for a 17% stake in the company, so one of the doors into NovaGold may already be open.

Financing outside the box
If China's actions in the energy and commodity markets provide any indication, Fools may be wise to consider the likelihood that China's upcoming involvement in the precious metals sector will take a variety of forms beyond mere acquisition or investment stakes in miners.

For a prime example, consider the meaningful precedent provided by China's $10 billion capital infusion into Brazilian energy star Petroleo Brasileiro (NYSE: PBR  ) in exchange for supply agreements for 200,000 barrels of oil per day through 2019. Similarly, China Power International Development inked a massive $60 billion supply agreement with Australian developer Clive Palmer that secured an astonishing 600 million tonnes of coal supply for China over a 20-year period.

Borrowing a page out of silver stream specialist Silver Wheaton's (NYSE: SLW  ) unique business model, some of China's forthcoming activity in precious metals may indeed be geared toward securing a steady supply of imported bullion in exchange for up-front development capital. Whatever combination of direct investment stakes, supply agreements, or low-cost development loans result from this official policy directive, I believe that the impact will be broadly and powerfully felt throughout the global markets for gold and silver.

Fools interested in investing in China are encouraged to test-drive the Motley Fool Global Gains newsletter service with a 30-day free trial. The Global Gains team keeps a close eye on China for opportunities arising from decoupling.

Fool contributor Christopher Barker carries a silver coin that reads, "Honest value never fails." He can be found blogging actively and acting Foolishly in the CAPS community under the username TMFSinchiruna. He tweets. He owns shares of NovaGold Resources and Silver Wheaton. Petroleo Brasileiro is a Motley Fool Income Investor selection. The Motley Fool's disclosure policy is 0.999 pure.


Read/Post Comments (5) | Recommend This Article (51)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 08, 2010, at 7:21 AM, MyCommodity wrote:

    Best article we've seen so far about these two recent developments out of China regarding precious metals, which haven't as yet had that much of an impact on gold and precious metal prices. Will be interesting to see how the market responds next week and going forward.

    As the author says, with declining confidence in the US dollar and such denominated products, this does seem to be 'on cue'. We have been wondering about how China will proceed in this area for a while, having seen how it has made moves in platinum.

    We would respectfully urge that although these 2 moves could affect some miners positively, it has been intelligently urged by those like Jim Rogers that investing in the end product (the actual commodity) can result in better returns for less risk. We would also cite the Yale University study 'Facts and Fantasies About Commodity Futures' here, and this recent article that shows a significant period of time where mining stocks have not delivered the gearing they are touted to: http://moneyweb.co.za/mw/view/mw/en/page292690?oid=499978&am....

    We do see this is as potentially excellent for the precious metals market long term. How long will it be before China consumes more gold than India...our careful opinion is perhaps a handful of years.

    Regards and good investing,

    MyCommodity.com

  • Report this Comment On August 08, 2010, at 3:32 PM, ChrisFs wrote:

    If China is financing precious metal companies which would enable more gold to be produced, wouldn't that increase the supply of gold and thereby contribute to gold going down in price?

    Unless they have the ability to buy up all that gold and hoard it from the market, it seems an increase in production of gold heralds a fall in gold prices. Which would again leave China with it's wealth in a declining asset.

  • Report this Comment On August 08, 2010, at 10:11 PM, silverminer wrote:

    ChrisFs,

    Please see the discussion at my blog here:

    http://caps.fool.com/Blogs/china-opens-the-flood-

    gates/429652

    "China is the world's leading producer of gold. This policy statement proves that even that world-leading production is insufficient to satisfy emerging gold demand. They will sent those dreaded dollars out into the world to accelerate development of mines that will already have a known associated demand waiting for them. "

    "The impacts, furthermore, will be felt over the course of many years. A 600mt thermal coal supply agreement over 20 years will exert an impact upon coal markets over the course of that entire 20-year period. Through that sort of lens must this development be viewed."

    In short, China is more supply to meet demand that can not possibly be met by presently anticipated production. The resulting supply, in other words, is already spoken for.

  • Report this Comment On August 08, 2010, at 10:11 PM, silverminer wrote:

    P.S. silverminer = TMFSinchiruna = Christopher Barker

  • Report this Comment On August 08, 2010, at 10:18 PM, silverminer wrote:

    MyCommodity,

    Jim Rogers is indeed a formidable intellect on these topics, and I have considered very carefully his guidance on that very point regarding the preference for direct commodity exposure rather than equity exposure to producers.

    I personally believe that a paired exposure to bullion and very carefully selected mining equities present a compelling strategy for investing in this sector. I think the case for quality miners offering leverage to the percentage price gains in the underlying metals remains a solid hypothesis despite the unimpressive performance of the miners to date. Gross margins are expanding rapidly, and some of the best names in the field are growing production concomitantly.

    I certainly agree, however, that some bullion exposure is a critical foundation for a successful precious metals investment strategy.

    Thank you for your remarks

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