For Gold bugs like myself this is a look at the downside, good read

THE BUY SIDE: INTERNATIONAL COMMERCE

Why gold is likely heading down: Blame it on the 'China Price'

AVNER MANDELMAN

Avner Mandelman is president and chief investment officer of Giraffe Capital Corp. and the author of The Sleuth Investor. amandelman@giraffecapital.com

• November 8, 2008

A few months ago, amidst comfy consensus that China's prospects are rosy, this column noted that the country is really a bubble. This contrary opinion generated much e-mail flack. But then, an e-mail arrived from a Canadian engineer in China whose team had just finished a government project in a town so small that (in the guy's words), "dogs were chasing chickens down the street."

Despite the town's size, it sported dozens of condo towers and a posh hotel. And so, to celebrate the completion of the project, the Canadians went to dinner at the hotel's restaurant with the local bigwig (the son of an army general), who, by the way, also owned the hotel and condos.

They were the only diners present - the hotel was empty and dark, the condos emptier and darker. But there were lots of staff members, and during dinner the bigwig kept complaining that the Beijing bank that lent him the construction money was suddenly demanding interest. The cheek! How could one keep restive peasants employed if one had to pay interest?

My e-mailer noted wryly that all over China there are many such empty hotels and condos - and factories too - built with loans to the well-connected and intended to maintain employment, but also (allegedly) to allow loyal bigwigs to enrich themselves.

And, similarly again, just as everyone in Congress knew that Freddie and Fannie would soon come to grief - or just as everyone in Japan in the '90s knew that most corporate loans were unpayable - the same is known in today's China. Yet most China bulls in the West maintain that the country's growth has merely slowed temporarily and will soon resume.

Will it? Not according to my informants. China, they insist, is like Japan of the '90s times three; it is Nortel writ large, maybe even Russia before the 1988 upheaval. You think this is extreme? Think again. Just last week Chinese Premier Wen Jiabao finally admitted that slow growth could risk "social stability." Slow growth? How about no growth? Or even negative growth? It's coming, and here's why.

You see, China, like Nortel and Japan and Soviet Russia, has been selling most things below true cost - which is the direct cost of production plus the cost of capital - and thus lost money on much of what it produced, and so destroyed much of its capital. A company that does so must eventually lay off workers and go bust. China, in my opinion, now faces similar risks, which Mr. Wen finally admitted.

Why does China sell below true cost? Because it is a dictatorship that wants to keep its restive people employed, and so, like (democratic) Japan before it, it keeps throwing good savings at bogus products. I say bogus because if you sell below true cost you create fictitious demand that otherwise wouldn't be there had the product been priced realistically. Thus the large factory you built to satisfy the goosed-up demand cannot be rebuilt once it wears out because you didn't include depreciation in the product's price.

Say you charged a mere $5 for a bottle of a 30-year-old Mouton Cadet because that's the cost of the corkers' wage, the bottle's glass, the unfermented grape juices and the paper label, and charged nothing for the 30 years of fermentation in an air-conditioned cellar. You would, of course, sell a large number of $5 Moutons, but would go bust once you had to rebuild the cellar.

Just like Japan did when it sold transistors for pennies when they really cost dollars if Japan had included the cost of capital; or just like Nortel a few years ago, when it sold products obtained (or improved) through acquisitions, for prices that excluded the amortized cost of the acquisition, in effect treating capital as having little or no cost; and just like China today, which sells nearly everything at the "China Price" - the cost of labour plus (alleged) pay-offs to, for example, generals' sons - while ignoring most capital costs because many loans do not have to be repaid. That's why much of China's manufacturing sector, although impressive to look at, is uneconomical, having been built to produce stuff that, were it priced to include the full cost of capital, might not have sold at all. For a while it worked - just like dot-coms or Japan or Russia - but now the party is over and China is about to meet the fate of all those who sell below true cost: mass layoffs, upheaval and perhaps a change of management.

Why should you care? Because of gold.

Recently gold has been very volatile, and could tack on $50, or even $100, in the short term. But longer term, if inflation - already quashed by Freddie and Fannie's blow-up - is further squashed by China's punctured bubble, gold is likely heading down.

Why? First, low inflation, even deflation, will lessen the need for inflation hedges. But second, and more crucial, as the West buys less of China's more fully priced products, and as China's cash needs escalate, its government, to feed the peasants and to maintain its power, will sell state assets - including gold. This, plus inflation, could push gold much lower than anyone thinks, perhaps to half its current price. How's that for a real contrary opinion?