A Melman Minute — May 25, 2011

Few subjects have garnered the attention of metals investors worldwide during the past several years as much as the economic progress and future of China. The influence of that nation, for many decades the worlds most populous, on the overall international economic situation has been enormous, to put things mildly.

Perhaps the most import impact of Chinas remarkable growth has come from two directions. First, the flood of low-cost Chinese goods into the retail distribution systems of the worlds advanced economic nations has been a major factor in controlling inflation. Second, the demand for the worlds raw materials required by China in order to feed their giant manufacturing enterprises, infrastructure improvements and ever-expanding construction industries both industrial and residential has been a factor in causing the rise in price of many commodity materials.

All of this is known ground, but is worthy of repetition if only to place news of a potentially significant change in Chinas entire manufacturing environment into a proper context. That change is the gradual reduction of Chinas cost advantages compared to the rest of the world, a change which could spell genuine and long-lasting troubles in many areas, but a change which could also have a direct and positive impact on the world of precious metals.

We thank the Times of London newspaper for their in-depth study of Chinas changing circumstance published overnight in Britain and which uses the experiences of one company, Wangjing Poker, a maker of novelty items, to illustrate the growing price pressures which are developing within China. The Times cites comments by Wangjings leader, Yang Junjun, by noting, ...And if the ravages of inflation get much worse, he says, he will have no choice but to share his pain around the world. By the time the European and US retailers start coming to Shenzhen and placing their orders for the end of the year, everyone will realize that Christmas is going to be more expensive this year. The Times then added this comment: Whether through a stronger currency or plain price increases, he says the world is going to have to start paying for the higher salaries of Chinese workers.

The article also cites another executive, Bruce Rockowitz of the worlds largest toy supplier, Li Fung, as declaring, ...The price of every type of product would definitely rise.`` We also learn that, `...Big names in the toy industry with large production facilities in China, such as Hasbro and Mattel, are fresh from imposing price increases between 7 and 8 percent.`

The biggest cost increases of all are coming in the form of higher wages and this is due to structural demographic changes within China. The number of rural migrants willing to come to the cities in search of work is diminishing, meaning employers must offer consistently better terms in order to attract new staff. In addition, the development of new `social networks` such as Twitter have enabled the working public to immediately compare one employer's offers with another's.

As a result, wage increases of even 20-30 percent have proven to be insufficient to attract needed workers and the results are now beginning to show up in the total manufacturing cost structure.

From our point of view, these developments open the door to several important questions. For example, if general prices begin to rise, will that development force the hands of government to significantly raise interest rates to better reflect true costs of tying up funds over time? Will higher prices actually slow economic activity in China and elsewhere, thereby reducing the need for base metals, among other commodities? And, of particular importance to precious metals, will any economic dislocation be met by additional huge increases in money creation by governments desperate to advance economic activity?

In a related story, the `Telegram` newspaper carried an article debating whether rising inflationary expectations would fuel the prospect for an interest rate rise within the U.K.. The Bank of England's Deputy Governor, Paul Tucker conceded that the Bank was very worried about inflation and was indeed considering a rate rise at the next Monetary Policy Committee meeting.

In our opinion, the stage is being set for some very dramatic monetary announcements and it is our belief that these developments will likely prove out to be positive for the precious metals.

Speaking of Great Britain, a negative reaction to a powerful political force seems to be building, one which could truly threaten the efforts of the Tory-Liberal coalition which is working to restore stability and even prosperity in the Queen's homeland realms. Britain, like other countries such as the USA, has adopted a policy of bringing in much-needed government revenues by adopting the well-trod road to `soaking the rich`.

Over the past year, taxes on the wealthy have grown, to use a pet phrase of W. S. Gilbert, like `the flowers that bloom in the spring, tra la.` Not only has the top rate on income taxes been pushed up to over 50%, but special impositions have been enacted against the wealthy in the forms of special taxation against owners of high-priced homes; elimination of personal allowances relating to income taxes; higher national medical insurance premiums; and additional taxes on pension contributions.

As a result, a poll conducted by the Times newspaper showed that 36% of the wealthy said they wanted to emigrate away from Great Britain and 14% said they had already initiated plans to leave within two years.

This is no minor matter. Fully 25% of government revenues come from the top ONE PERCENT of taxpayers and if that elite group decides to leave in large numbers, a frightening hole could be put on the revenue side of government ledgers. Their departure en masse could also put a significant dent in Great Britain's consumer driven economy.

On the other side, many government leaders clearly believe that if the wealthy are not taxed heavily, they will have no ready means to continue the array of government programs which have proliferated over the past few years.

For every answer to this overwhelming dilemma, there appear to be more questions raised than solutions found.

Many commodity items seem to be in the middle of a sort of no-man's land, having corrected upward from the worst of the recent selling waves, but still well below preceding highs and the chart of copper seems to illustrate this point particularly well.

Most markets this morning seem to be continuing this pattern of semi-recovery. As of 9:45 AM PDT, financial markets were moving higher; precious metals were advancing as well with gold making a new recovery high near $1,539; base metals were generally stronger and mining share indexes were up by almost two percent on average.

In other markets, the petroleum complex was slightly firmer; the Greenback is lower in currency markets and most interest rates are little changed.

All quotes US$ unless otherwise noted.

Due to the Memorial Day holiday this coming Monday when many major markets will be closed, our Melman Minute schedule next week is planned for Tuesday, Wednesday and Friday.

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