Part II of a March 31 Interview

By Kevin Michael Grace

Q: I wanted to ask you about China because I interview a lot of presidents of mining companies. Apart from those dealing in precious metals, all the others tell me the same thing, that the Chinese economy is growing tremendously, and the need for stainless steel for steel is going to rise tremendously. One CEO I talked to recently said there’s going to have a bull market in China for the next 30 years. What do you think?

A: I’m sceptical. I have no doubt that the structural bull market is in place, but you have quite a lot of disturbing signs there right now. You have a situation where you’ve got capital expenditures as a percentage of GDP that is now about 50%. We’ve never seen that in history, and anything approaching the current Chinese fixed-investment-to-GDP ratio in the past has ended badly. In addition to that, you’ve got a real-estate bubble. A lot of people think that high and rising real estate prices are not a bubble because there’s not a great deal of mortgage debt collateralized against the real estate, but in fact aggregated debt against Chinese real estate, including the debt of the developers from the local authorities is higher than household mortgage debt indicators would suggest. History is rife with bubbles that have had no significant debt scaffolding, and in all cases they burst anyway. The US stock market in early 2000s is another example. I think that you can’t say that China is not going to be affected by it at some point. To me the interesting parallel is Japan. I lived in Japan in the 1980s, and I heard the same thing, that Japan’s impregnable and the same story about emerging Asia in the first half of the 1990s. We know what happened there, Japan’s bubble ended in 1989; they’ve been in a relative degree of economic stagnation for the last 20 years. The Asian financial crisis came in 1997-1998, and they’ve never really gone back to those high rates of growth. They’ve had reasonably good rates of growth, but they’ve never gone back to the 10%-12% rates of growth since that time. A lot of people focus on the China peg per se, but I think that’s the wrong focus. The real thing that they should be focusing on is the possibility that the capital per-capita ratio in China creates a potential for a fixed-investment bust, and that’s what you had in Japan.

Q: Many companies involved in critical metals are committed to huge investments going online several years in the future, based on this idea of continued high growth from China. Do you think that this is wise?

A: I guess they have to go where the demand is. These guys are in the business of digging holes, finding stuff, and they see demand. They’ve got some economists to tell them it’s going to go on for a long time. When I express the views I’ve expressed, I get some resistance. I’ve had some discussions with economists from BHP Billiton who think I’m being overly bearish. Look, it’s a definite vulnerability that will come into play at some point. I don’t know when it will happen. There are certain commodities which do display depletion dynamics, such as oil or gold; they tend to be relatively insensitive to price rises because there’s declining supply. But there are others which are significantly in surplus, but they’re being controlled by cartel-like groups. I would say that applies to copper for example. The commodities boom could go on for another year, maybe two years, but I think you could easily have a bust at the end of it.

Q: I was thinking specifically in terms of rare earths and critical metals. There’s a great shortage of them now.

A: Let me correct you. There’s been a shortage at a given price, but what seems to be happening now, given that the prices of some of these things have risen so much all of sudden that, miraculously, a number of rare-earths projects are starting to appear in North America and other parts of the world. They weren’t worth developing beforehand, given the low prevailing costs. The price rises are engendering increasing amounts of supply. Granted a lot of that will be required, given the extent to which these things are being used, for example in lithium batteries, but I think they’re not as rare the name would imply, let’s put it that way.

Q: I wondered whether we could see a glut of rare earths and critical metals in the second half of this decade.

A: It wouldn’t surprise me; it’s possible. I haven’t looked too closely at that market, but it’s happened before. In the 1970s, we were talking about the coming era of oil shortages. Now, granted, I think we’re close to peak oil in 2011, but we first starting hearing about the imminent shortages of oil in 1973, and by1986 we were swimming in the stuff. The price plunged to $11 a barrel at the lows, so why should rare earths be any different?

Part I of the interview.
Part III of the interview.

Marshall Auerback is Director of and Corporate Spokesperson for Pinetree Capital Ltd, a Toronto-headquartered diversified investment, financial advisory and merchant banking firm focused on investing in early stage micro and small-cap resource companies. Pinetree, which has a market cap of $439 million, is invested primarily in Uranium and Coal, Oil & Gas, Precious Metals, Potash, Lithium and Rare Earths and Base Metals. Mr Auerback was previously an advisor to a number of fund management organizations, such as PIMCO, the world’s largest bond fund management group, RAB Capital and David W Tice & Associates. He has a BA from Queen’s University and a law degree from Corpus Christi College, Oxford.