The extent to which reform of the capital account is or should be irreversible

One important part of capital account decontrol is commitment. If there is risk that capital controls will be brought back in the future, this can have a variety of unpleasant effects. If there is a fear of fresh restrictions coming in on inflows, a surge of money will rush into the country. If there is a fear of fresh restrictions coming in on outflows, a surge of money will rush out of the country. A long-term commitment to openness is required, in order to rule out such behaviour.

As a consequence, when a country moves to full convertibility, this requires not just the removal of restrictions. It also requires the
removal of bureacratic process including reporting requirements. As long as forms have to be filled up for `automatic approval’, this
can easily swing back and become a capital control through breakdowns of rule of law (as has happened in India). See the MoF
Working Group on Foreign Investment
on issues of rule of law in India’s capital controls. It is important to pour concrete on the
decontrol so as to give confidence that the controls are gone.

We don’t have the exact facts, but in the UK, when they moved to convertibility (back in the late 1970s) this was accompanied by dismantling of reporting requirements.Korea is very open; there are no restrictions on capital flows. But Korea has kept the reporting requirements and through this, they have retained controls in a certain sense. The reason is that people fear that if they report transactions, then the government may come and investigate, and ask why they are doing it. They might also ask where the money is coming from. So, even though the rules may allow capital transactions, people — especially individuals, but also small businesses — remain very wary of these, and refrain from wiring large amounts in and out of the country, apart from some outward investments via mutual funds, where the government can’t actually see who is sending the money out. Through this, reporting requirements perpetuate home bias and inhibit international economic integration.

Today we became aware of one mechanism through which some countries have committed themselves to an open economic system: When the US signs free trade agreements and bilateral investment treaties, there are provisions which limit the extent to which capital controls can then be brought back.

A curious letter has brought this to our notice. It says: Under these agreements, private foreign investors have the power to
effectively sue governments in international tribunals over alleged violations of these provisions.
. How interesting. So
that locks down the possibility of a reversal of reforms in countries where the US has free trade agreements, and quite
a few more
where the US has bilateral investment treaties.

It makes sense for investment and trade treaties to mention capital controls. Trade and finance cannot really be separated: finance
follows trade, and enhanced de facto integration in each feeds the other.

Trade requires currency risk management. When an Indian firm signs a long-term contract to buy/sell with invoicing in Yen, the
Indian firm needs to be sure that Japan will stay open so as to enable INR/JPY hedging in the future.

If an MNC makes a direct investment in a country, it needs some assurance that it can bring in funds (equity and loans) to
finance the investment, take them out when it wants to run down its operations, and repatriate profits in the meantime. It also
needs to be able to hedge its currency exposure.

Hence, entering into trade/investment contracts today is assisted by confidence that liberalisation put in place today will still be there tomorrow.

More generally, there is a big difference between (a) a move today and (b) a move today + a commitment about behaviour tomorrow. Permanent tax cuts yield a much greater consumption response. Permanent capital account liberalisation leads to more FDI and trade. A variety of mechanisms need to be found through which reforms can be given stronger commitment so as to rule out risk of reversal in the future.

Doug Groh: What's Old Is New Again in Gold

Do old investment strategies apply to the new gold market? Doug Groh, a fund manager and senior research analyst with Tocqueville Asset Management in New York City, has been analyzing basic materials and gold equities for more than 25 years. In this exclusive interview with The Gold Report, Doug explains how to view gold’s history when making investments in its future.

The Gold Report: Gold dipped from about $140 per ounce in the bull market of January 1976 to below $105/oz. in September of that year. Ultimately, it proved only a pullback on the way to gold’s peak of $850/oz. in 1980. Are we seeing a similar pattern now, or is this correction simply much ado about nothing?

Doug Groh: It’s hard to say if this is a similar pattern. The market conditions are different than they were 35 years ago. However, cycles can be somewhat repetitive. I think the more important questions are: What does this correction mean and how long will it take?

Looking back at 2010, the gold market did very well with a nearly 30% rise in price. It’s normal to have some type of correction after such an upward surge. Whether the market will experience a 25% correction like back in the late 1970s is hard to tell. But it is not out of the realm of possibility that gold could consolidate at levels seen during 2010 to what was the year’s annual average of about $1,225/oz. before it marches to a higher level.

A correction is a healthy thing because it can shake out the weak players, traders and undedicated investors. It solidifies a base.

TGR: Has the correction led to any changes in the way Tocqueville is managing its gold fund?

DG: It hasn’t motivated any immediate changes. However, we would like to see how this pullback plays out. It appears that we may be through most of it. At the end of last year, we were a little bit more cautious about investing new funds into gold equities. We felt that some of the gold equities were getting overpriced. We were accumulating cash and taking the opportunity to reposition ourselves for when a correction would come along. The market is going through profit taking from last year and a value-seeking phase. Now we’re more interested in some of the companies that we had been looking at last year, but were waiting for better valuations. That is still playing out.

TGR: What market-cap segments did you view as overpriced?

DG: Different segments of the gold mining space were performing better than others on a relative basis at different times. In the middle of last year, the developers and liquid equities did very well. In late October and November, the juniors and small-cap companies did well. In late November into December, the micro-cap names were doing very well.

The market’s imagination was at a point where resources in the ground became more valuable at higher gold prices and the leverage was very compelling to investors. That’s still going on to some extent. Investors are selectively seeking out those micro-cap companies that don’t have any cash flow or earnings yet and bidding them up. Some of the appeal is the fact that they are micro caps and a move from a penny to a dollar stock can be quite a performance enhancement.

TGR: What segments do you see value in now?

DG: The large, liquid major producers are a value opportunity. These companies should do very well as they report earnings during the next month and a half. They had a fantastic gold-price environment. They’ve kept their costs relatively stable. The margins, cash flow and earnings have expanded during the last year.

While companies constantly need capital to redeploy into their operations, there should be excess capital available for dividends and other corporate activities. We don’t feel that the market has fully valued that margin expansion or the fact that there should be excess capital available for distribution. I think that will be somewhat of a surprise. As that occurs over the next several months, some of those major names should get bid up as they demonstrate that they can generate stable and profitable margins.

TGR: You talked a little about the major gold producers. They’ve been hit somewhat hard but seem to be offering value until their results come out in the earnings reporting period during the next five to six weeks. Should investors be looking at those major producers and possibly adding some of those names to their portfolio?

DG: I think a good approach is to dollar-cost average your investments. Certainly, when things get pricey or start performing very well, investors want to back off a little bit on averaging in. Generally, we see an initial pullback earlier in the year. As we get into the reporting season, investors become a little bit more comfortable with their gold positions and may add to them. Springtime to the early summer is probably the best time to add to a precious metals portfolio as that tends to be the weakest point in the year for the sector as far as the gold equity market goes.

TGR: What are some names on your radar right now that are offering value in the large-cap space?

DG: Some of the top holdings that we continue to like have pulled back, such as Osisko Mining Corp. (TSX:OSK), which is developing a new mine in Quebec that should be up and running by midyear. I think investors have discounted the fact that growth will be realized and have sold off the name.

TGR: Osisko is developing the Malartic Project near Val d’Or, Quebec. As one analyst once said to me, “It’s got first world cost and third world grade.” Could that be the reason that funds and other entities are selling off, or do you think that it’s just not the flavor of the day anymore?

DG: Whenever a mine is starting up, typically there are teething problems or initial kinks that need to be worked out in order to get the operation to work to design. There’s probably some concern among investors that there will be delays. There may be problems, which also could mean cash flows aren’t realized as anticipated. I think that’s being reflected in the market at this point. The risk of startup is a concern for the marketplace. However, that is not unusual and it’s understandable that the market would be concerned. Over time, as the operation is up and running and managers gain experience with the facilities and the equipment, I feel that in time Osisko will do just fine.

Another company that we have followed closely is Ivanhoe Mines Ltd. (TSX:IVN; NYSE:IVN). It is building a gold/copper mine in Mongolia. We think it offers a compelling investment opportunity because it is near such a large consumer in China and the resource is so large.

TGR: Do you think there’s a chance that Rio Tinto (NYSE:RIO; ASX:RIO) could just buy Ivanhoe outright?

DG: That is a possible scenario. Rio could take a majority position, dilute out Ivanhoe or perhaps Ivanhoe allows itself to become a minority investor in the project by selling its interest down. It would certainly seem that owning a majority stake or a large percentage is more meaningful to Rio Tinto than just being a partner.

TGR: What about jurisdiction risk? Does the agreement that Ivanhoe and Rio have with the government of Mongolia provide enough security?

DG: It took them a very long time to come to an understanding on the investment policy and an investment agreement in the country. I believe that most of the risk has been addressed and dealt with at this point, yet we appreciate that governments can change. No one knows what could befall Mongolia in the future. However, at this point, it seems as if a solid understanding has been established for how investments are to be made in the country and what is expected of all stakeholders.

TGR: What are some other names that are particularly interesting?

DG: Gold Resource Corporation (OTCBB:GORO; FSE:GIH) is an interesting stock in that the company is producing from a property in Oaxaca, Mexico that has a polymetallic deposit. It’s not just gold/silver, but also zinc, lead and copper. It is on a rather large trend in Oaxaca, where it initially developed its mine. The company has used most of its capital in the last several years to develop the mine and is now, I believe, in a position to generate cash flow to explore further along that trend. There’s a really exciting opportunity to expand its resource base and fully utilize its mill and plant facilities to generate more cash flow.

International Tower Hill Mines Ltd. (TSX:ITH; NYSE.A:THM) is developing an ore body in Alaska in the Livengood district, which historically was a gold producer. Now it is likely to become a large open-pit facility that could go on for the better part of 20 years. The development of this project is a long-term proposition due to the permitting and the various engineering studies that need to be done prior to receiving the mining permit and other regulatory approvals. So far, what we’ve seen is very compelling on an economic basis.

TGR: There are companies with a number of large, impressive deposits in that area, such as Donlin Creek and NovaGold Resources Inc. (TSX:NG; NYSE.A:NG) and the Pebble Deposit with Northern Dynasty Minerals Ltd. (TSX:NDM; NYSE.A:NAK). The capital expenditures (capex) needed to build these mines is quite excessive in the $5–$6 billion range. Does that make Tower Hill more attractive because its smaller, low-grade, open-pit deposits can have capex of $1–$1.5 million?

DG: I think so. Mining companies are depleting their asset base just because they’re mining the ore bodies that they’ve developed. They need to replace those ore bodies. Rather than replace them with medium-sized deposits, the major companies are looking at opportunities where they can actually develop a district. For example, Kinross Gold Corp.’s (TSX:K; NYSE:KGC) acquisition of Red Back Mining Inc. or Goldcorp Inc.’s (TSX:G; NYSE:GG) acquisition of Andean Resources Ltd. (TSX:AND, ASX:AND).

The major companies want to deploy their skills, talents and capital into an area that’s going to be meaningful to them over the long term. Companies the size of International Tower Hill or even Allied Nevada Gold Corp. (TSX:ANV; NYSE.A:ANV) are more compelling for the large gold-mining companies.

TGR: Are there some other projects in the Alaska area that could potentially be open-pit operations with a smaller capex to build?

DG: Alaska offers a lot of potential in terms of exploration for precious metals and related base metals. There’s a company operating in Alaska, Kiska Metals Corp. (TSX.V:KSK), which acquired its property during the past year as Rio Tinto backed away from its involvement in that project. We believe that Kiska offers an interesting opportunity for investors over the long term. It is now exploring and finding resources on its 100%-owned properties and it has potential to expand its resource base to a meaningful degree. This could potentially lead it to become a target of a major mining company, such as Newmont Mining Corp. (NYSE:NEM) or Barrick Gold Corporation (TSX:ABX; NYSE:ABX).

TGR: Kiska had some pretty impressive results at the Raintree West discovery—85 meters of 2.5 grams per ton (g/t) gold equivalent (Au Eq.). That’s pretty good. It also had another hit on Island Mountain.

DG: I think that the Island Mountain area is a very compelling exploration situation. I expect that the company will continue to come up with very good drill results as it develops that project and spends more time on drilling in the area.

TGR: Kiska is planning a 35,000-meter drill program this year.

DG: Right. It has a number of very interesting prospects throughout their property.

TGR: The company must be fairly well cashed up given that kind of drill program. Do you think its likely to find some new discoveries?

DG: Kiska’s land position is very compelling and there are a lot of different targets on which it can drill. My sense is that the company will spend a little money on resource development and a little on identifying new opportunities. So, while the quality of the resource is improved from its drill program, it’s also reasonable to think that with increased geologic information, discoveries will be made.

TGR: In an interview in October, you said investors should keep 5%–10% of their investment portfolios in gold bullion and equities over the long term. Is this strategy still a fit for the current gold market?

DG: I do. Looking back at the past 10 years, equities have not generally provided as generous of a return as gold and commodities. We would argue that a blend of exposure to the gold sector and the general equity market would have provided a better return than just an equity investment. Such an allocation could also reduce volatility. Over time, a diversified approach should reduce risk and enhance returns.

TGR: How much of that gold allocation should be in bullion and how much in equities?

DG: Every investor is different, obviously. People have to consider their own risk tolerance. But I think a fair and good representation of the precious metals market would include 2%–3% of a portfolio in bullion or gold ETFs and 7%–8% in gold mining or precious metal equities, which would include silver and platinum group metals.

TGR: What should investors expect from the gold market through the remainder of this year and beyond?

DG: Gold goes in and out of favor relatively quickly, and I expect a fair bit of volatility throughout the year. Gold had a great year in 2010 and we believe the long-term bull market is still very much intact, which could lead to higher gold prices over time. Having said that, we have to be prepared for some corrections from time to time. And, as we discussed earlier, the market is in a corrective phase right now.

I still think that gold is under-owned by institutional investors, including pension funds, endowments and retirement-managed money. To us, long-term exposure to gold makes a lot of sense considering the overwhelming debt that is accumulating within our economic system globally.

It’s hard to say when the gold price is going to correct and when it’s going to rise. It can respond to anything at anytime. I expected a more bullish response due to the political unrest in Egypt, and yet it seems that the market is looking through Egypt and recognizing that stability will be established eventually, with the current government or a new government. It appears the market is making the foregone conclusion that stability will be the result of the current crisis. If that is not the case in the end, it could present an investment opportunity in this current gold market.

TGR: Thanks for sharing your acumen, Doug.

Doug Groh has 25 years’ investment experience. Before joining Tocqueville in 2003, he was Director of Investment Research at Grove Capital from 2001–2003. Between 1992–2001, as a senior sell-side analyst for JP Morgan and Merrill Lynch, he was recognized as a ranked analyst by Institutional Investor Magazine and The Wall Street Journal for his coverage of basic material stocks in the non-ferrous metals, chemicals and paper and packaging industries. He began his career as a mining analyst and worked as a precious metals portfolio manager at U.S. Global Investors and American Express Financial Advisors in the 1980s and early 1990s. He holds an MA in Energy & Mineral Resources from the University of Texas at Austin and a BS in Geology/Geophysics from the University of Wisconsin—Madison.

Retail Sales Likely Skyrocketing into February

According to the ICSC-Goldman’s retail sales report on Tuesday, same-store sales skyrocketed in the February 5 week, up 2.2 percent.

It was the largest weekly gain since the Easter surge of last March.

The year-on-year the rate jumped nearly one full percentage point to plus 2.5 percent.

The Redbook report, also released on Tuesday, was right in line with a measure that showed a 2.7 percent year-on-year same-store sales growth in the February 5 week.

Additionally Redbook offers a month-to-month comparison which registered a blistering 1.7 percent gain. Keep in mind that annualized that would point to a 20.4 percent retail gain in one year!

Early next week the government will post the January retail sales report amid most predicting a solid gain.

The economy accelerated at the end of 2010 as consumer spending climbed by the most in more than four years. Gross domestic product grew at a 3.2 percent annual rate, Commerce Department figures showed on Jan. 28.

And remember last week the ISM Manufacturing Index pointed to an overall economy in the month of January growing at a GDP annualized rate of 6.4 percent.

Economic Events on February 9, 2011

The Mortgage Bankers’ Association purchase index was released at 7:00 AM EST, and there was a week to week decrease of 1.4% in the Purchase Index and a week to week decrease of 7.7% in the Refinance Index.

At 10:00 AM EST, Federal Reserve Chairman Ben Bernanke will testify before the House Budget Committee on economic, employment and budget issues.

At 10:30 AM EST, the weekly Energy Information Administration Petroleum Status Report will be released, giving investors an update on oil inventories in the United States.

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