If Beijing’s intervention into the Chinese economy justifies U.S.-government ‘retaliation’ to ‘correct’ market distortions created by those interventions, shouldn’t the still-significant lingering negative consequences of Beijing’s interventions into the Chinese economy from 1949-1978 be considered? Shouldn’t Beijing’s artificial destruction, during the middle decades of the 20th century, of production efficiencies in Chinese factories be weighed against Beijing’s artificial creation, in the early decades of the 21st century, of such efficiencies?

The Gold Report: Recent headlines continue to focus on the debt crisis in Europe as more countries are having their debt downgraded. Greg, you have diagnosed the problem as credit addiction and said that the European Union won’t be able to recover until leaders take painful measures necessary to kick their addiction. What does this mean for commodities and commodity equities?

Greg Weldon: It’s critical for asset prices across the globe. It is a debt addiction, debt refinancing and deficit financing problem, not only in Europe, but also in the U.S. and Japan. Austerity is the real answer to the fact that there is too much debt, and austerity measures in an economic sense are not positive.

My fear is that it’s going to be very difficult to see how economies in Europe, the U.S. and Japan can stand on their own two feet without the assistance of central banks debasing currency through debt monetization. I liken it to filling the sink halfway up with water and pulling the plug out of the drain. Of course, the water level will recede unless you turn the faucet on and start more water pouring into the sink. The level of water represents asset prices, the water flowing out of the faucet represents liquidity provided by global central banks and the drain represents the real macro economy, which has not been fixed.

At the end of the second round of qualitative easing, when the Fed shut off the faucet, the water level (asset prices) started to go down. But now the water is running again—particularly with some of the measures instituted by the European Central Bank, with its three-year loan program, the federal liquidity swaps and the back-ended way that it’s managed to involve the International Monetary Fund.

The problem with all of this is it does nothing to fix the underlying problem, which is too much debt. This is not sustainable. Central banks turning on the water faucet is good for asset prices. The real solutions of fiscal austerity, which are probably not palatable to most politicians in Europe, are the real struggle as we go forward. This problem is not going to go away.

TGR: Grant, in your Things That Make You Go Hmmm…. newsletter, you painted a picture of the final implosion of the euro and U.S. municipal bond meltdown. What would this mean for resource stocks?

Grant Williams: That was part of a prediction piece that I wrote at the end of 2011. It was semi-tongue-in-cheek. My contention was that as volatile as 2011 played out, we didn’t actually get any resolution. And it feels like 2012 will be the year those resolutions start to take place. One of the primary ones is the European situation. A Greek deal to solve the crisis seems to constantly be on the horizon, but they can’t seem to come up with an absolute solution to the public sector involvement haircut issue. When they do, I think it’s going to be the start of a whole slew of legal action to try and either trigger credit default swaps or negate any haircut from those who don’t want to sign up. Greece has a big refinancing coming up in March. It has to raise a little over €14 billion (B), and between now and then it somehow has to get a $130B loan package approved from the Troika. It is very hard to see how Europe can just keep pumping money into Greece. It’s very likely we’ll see Greece exit the Eurozone then, and that’s going to focus everyone’s attention on Portugal. I think Italy will be OK. Spain worries me more than Italy because the economy there structurally is in far worse shape. But if a bunch of countries pull out, that leaves the question of how people unwind any obligations they have in the current euro construct.

What this means for commodities is that the money-printing presses are going to be turned up to the max again. Despite adamant claims from politicians to the contrary, money printing—even if by another name—will have to be implemented at a magnitude much, much higher than ever before to meet current demands. Cash is being given to banks basically for free through the long-term refinancing operation on the quid pro quo that the money finds its way back into the government bond market. The problem is that a lot of this money is going to leak out somewhere other than where it is intended and I suspect it’s going to leak into commodities and equities. We are going to see stock markets float higher, not necessarily on particularly good numbers from corporates, but from the simple dynamic of a lot of freshly printed money looking for a home. We have already seen it in gold and silver this year. They both had big corrections in December, but they are two of the best performing assets of the year so far and I suspect the more money they print this year, the faster these things are going to go up.

People are starting to understand that deflation is not an option for the central banks. Once people realize that if we get a brief period of deflation, it will be fought aggressively with inflation, they will start to look past any deflationary period and position themselves for inflation. That is going to mean higher prices in commodities.

TGR: How high could gold and silver go in 2012?

GWilliams: I think gold trades at $2,200 an ounce (oz) this year. I think silver trades at possibly $60/oz this year, but they’re really just stepping stones on the way to higher ground. This 11-year ascent in both precious metals is only going to change when central bank policy surrounding it changes. I just don’t see that happening in the foreseeable future until they get this debt problem under control.

We are going to see periods with crazy spikes. We are going to see corrections. Some will view this as a collapse but the difference between a correction and a collapse is your entry price. If you bought gold at $700/oz a few years ago and you watched it go from $1,900/oz to $1,500/oz in December, that’s a correction. If you bought it at $1,900/oz, it’s a collapse. I think it’s important to try and take a longer view. The rationale for owning gold and silver is still in place. In a world of printing presses and fiat currencies, no one can manufacture gold and silver out of thin air. I think they are both going to go a lot higher.

TGR: Greg, what are your predictions for 2012?

GWeldon: There is a disconnect in the markets. Currencies really aren’t moving much either. The dollar hasn’t appreciated much. This is why gold is stuck in this range, capped just above $1,700/oz, with potential downside toward $1,300/oz. People are liquidating commodities. My sense is that there is more weakness to come in H112. Commodity prices in Q411 have already come down significantly, pumping some relief into margins. There is a little window of opportunity here where equities and some of the commodities markets could have some upside.

Debt could become an issue again in H212 depending on how central banks deal with that and whether we have a big downturn again in the stock and commodity markets. My longer term view is that when push comes to shove and central banks are staring into the abyss of a potential debt deflation, they will choose to reflate at whatever cost. That is bullish for gold long term. If banks can find the political will to do it, there will be significantly higher prices for commodities across the board in the long term.

China, in particular, has a bullish dynamic. Certain commodities, such as copper, have their own supply-demand dynamics that are detached from the dollar and monetary policies. The Chinese imported copper at a record high in December. Copper stocks on the London Metal Exchange have fallen by close to 30% since October. Copper is one of these commodities that has upside potential regardless of what the dollar is doing.

TGR: Grant, you are based in Singapore. There was a lot of talk at the last Cambridge House Conference in Vancouver about whether China is growing, shrinking, landing hard or soft. What impact will China have on commodities and equities around the world?

GWilliams: China faces a lot of problems. A lot of people think it is in for a hard landing. It is always difficult to believe official Chinese statistics, but the message that the Chinese government is sending through those numbers can be useful. For example, the Chinese growth numbers last week showed an 8.9% increase in gross domestic product. In a world of basically zero growth, that’s a pretty good number, but it’s not the double-digit number we’ve been conditioned to expect from China. Whether it was true or not, it shows that the government is saying: things are OK. We are on top of this, we’re in control. We are not going to slow to zero; we’re just going to grow a little bit slower. The big problem China has is inflation. Roaring food inflation in a society in which half the population lives in relative poverty in rural areas would be a big issue. A lot of people talk about property bubbles—and there are definitely bubbles in Chinese property—but as long as the government can keep people fed, it is going to find a way to get through this—at least for now.

China also has vast currency reserves. The Chinese absolutely understand that paper currency is being devalued incredibly quickly. So, until someone puts a sell-by date on copper and iron ore, it will keep stockpiling the stuff because it will need these commodities to continue growing. China will continue to swap paper money for commodities. The Chinese are bringing gold into the country as fast as they possibly can. Gold is in the DNA here in Asia. It doesn’t take an awful lot to persuade the public to own gold.

TGR: Greg, in your book, Gold Trading Boot Camp, you said gold is at the top of the macro-monetary pyramid. Why does it hold such an important position?

GWeldon: It is a rare and unique mineral that has provided a store of value for centuries that is not backed by any government. It is not subject to anyone’s IOU. Gold stands alone in the level of security it creates in people’s minds as a way to store wealth and protect it from governments that are continually debasing the value of paper money.

TGR: You put the dollar second on the pyramid, but said that could change soon. What will be the catalyst for change and what will be the result for investors?

GWeldon: I don’t know what the catalyst for change could potentially be. For me, the dollar stays as No. 2. There’s been an interesting little sequence recently where the dollar has rallied and gold has declined. But gold has not declined to the same degree that the dollar has rallied. Gold is appreciating in a lot of currencies outside of the dollar where it’s actually outperforming dollar-based gold.

Investors have a greater degree of confidence that the Fed will do what it has to do to circumvent a bigger issue. Next to gold, the dollar still is the second place that people feel comfortable.

TGR: Mining equities haven’t been able to keep pace with the price of gold. Do you see that changing?

GWilliams: It continues to surprise me, frankly, that these stocks are on such crazy valuations against the metal. I think once we start to get wider acceptance that inflation is going to be the outcome rather than deflation, people will start to look at these companies in a different way. Mining companies will instantly become some of the most attractive companies in the world.

I think there’s going to be a tremendous wave of consolidation in the mining sector. When it comes is a tough one to call, though. We’re going to see a lot of junior miners get taken out because it’s going to become a battle for ounces in the ground. If you have proven reserves, the majors are going to come looking for you—particularly if you are in a safe political jurisdiction—and they can afford to pay very, very good multiples of where the stocks are trading now.

In the last 10 years, we have seen some tremendous finds. We’ve seen some tremendous small companies that are very, very well run with incredibly experienced geologists. It requires a lot of due diligence to go through the sheer number of gold mining companies and find the very valuable ones, but I think having ounces in the ground and a good, proven management team are the two fundamental criteria that you have to look for in these stocks. Once the consolidation starts to take place and once the scramble for ounces of gold in the ground begins, I think the resulting valuations will be quite spectacular.

TGR: You are both speaking at the Cambridge House California Investment Conference Feb. 11–12. Based on all of these trends that you’ve laid out, how can investors preserve wealth or even profit during volatile times like these?

GWeldon: Investors who are focused on preserving wealth are best served by buying gold on the dip that is currently taking place. The gold price has a chance to reach $1,450/oz—that’s a sizable move downward.

There’s a chance that monetary authorities would take gold coming off that hard as a sign that they need to be more aggressive. It will be interesting to see how that plays out. However, being long gold and silver is clearly the best play in my mind to preserve wealth.

For investors who are looking to appreciate wealth, the commodities markets offer tremendous upcoming opportunities. That is because there is one thing that I can be certain about: Volatility will remain high. We are not going back to a low-volatility environment. It’s treacherous for individual investors trying to do it themselves. We run a long-short commodity program that’s non-leveraged. But there is a lot of talent in the commodities space for individual investors looking to profit from this market environment.

GWilliams: Preserving your wealth is absolutely the right way to look at it at the moment. Trying to make a profit in markets when there is so much uncertainty is a very dangerous thing to do because things change midgame. So I think for the next several years, using gold, silver and the platinum-palladium group metals as a store of wealth fundamentally makes a lot of sense. I suspect you are going to see outsized gains as a byproduct of using that strategy because I think the prices will go materially higher despite low headline inflation numbers. Using gold and precious metals to hedge yourself as a safety trade is the smart thing to do. By doing that, you will not only protect your existing wealth but you can also generate increased wealth through price appreciation in excess of inflation.

TGR: When you say gold and precious metals, how would an individual investor protect wealth using gold? Are you talking about holding the bullion, buying gold exchange-traded funds (ETF) or buying equities?

GWilliams: It depends. I think protecting wealth using highly geared gold mining companies is a dangerous thing to do. Yes, if gold goes crazy, you are going to make some outsize returns, assuming the asset in the ground is good, assuming the management is good and assuming you don’t get any collapsed mines or any other geological anomalies that sometimes are part and parcel of owning gold mining stocks. Holding the bullion itself is absolutely the safest way to do it. You have an asset free and clear with no claims on it. It’s yours. But that’s not necessarily an easy thing to do from a logistical perspective. A lot of people look at the ETFs as a good vehicle, and they are a perfectly good gold proxy. You have a claim on some physical metal there. But for pure safety’s sake, owning the bullion itself or as close to pure bullion as you possibly can is the smartest way to go.

If you’re looking for any kind of leverage or any kind of gearing, then you need to start looking into the mining companies. But outside the major miners, it’s a very dangerous place to be unless you have someone very smart holding your hand, and you need to do an awful lot of work on researching the particular stocks you buy. While the returns can be extremely good, particularly at these low valuations, gold is a very, very tricky thing to dig for and mines are very tricky things to operate and to run. So you have to be aware of that.

Most important, try to steer clear of government bonds. In a world of increasing inflation, and a world where central banks have promised to try and generate MORE inflation, to lend money to irresponsible governments at 0.23% for two years in the case of the U.S is just crazy to me. Over the long term, you are absolutely guaranteed to lose money in real terms by doing that.

TGR: Thank you for your advice.

Greg Weldon started his Wall Street career working in the Comex Gold and Silver Pits after graduating Colgate University. He progressed as an institutional sales broker at Lehman and Prudential before joining Moore Capital as a proprietary trader. At Moore, Weldon honed his systematic trading methodology and risk management discipline before joining Commodity Corporation where he became one of its top risk-adjusted money managers. Today, he publishes Weldon’s Money Monitor, The Metal Monitor and The ETF Playbook in addition to operating his Managed Futures Account Program as a CTA. He has a unique ability to define and forecast the market’s direction through his proprietary dissection of fundamental and technical market data. Weldon Financial is now a highly regarded and profitable publishing company, having garnered some of the world’s most respected fund managers as loyal and daily readers.

Weldon published Gold Trading Boot Camp: How to Master the Basics and Become a Successful Commodities Investor, in late 2006 in which he predicted the current global credit crisis and discussed the impact on golf from intensified central bank debt monetization. You are invited to participate in a “one-time” free trial of Weldon’s research @ www.weldononline.com.

Grant Williams is a portfolio and strategy advisor to Vulpes Investment Management in Singapore—a hedge fund running $200 million of largely partners’ capital across multiple strategies. Williams has 26 years of experience in finance on the Asian, Australian, European and U.S. markets and has held senior positions at several international investment houses. Williams also writes the popular investment letter Things That Make You Go Hmmm….., which is available to subscribers.

John Mauldin: Instead of doing an annual forecast, I’m going to look out about five years, which may be five times more foolish. What I want to do rather than try and figure out where the stock market is going to be at the end of 2012 or what gold is going to do, is look at the choices we have around the world.

In most cases, political events don’t change the economic world all that much. It’ll probably annoy partisans on both sides, but if Clinton had lost to George Bush senior the first time, we would have still had a bull market. We were already in recovery. Yes, we would have had different Supreme Court Justices, but that’s not the economic world. We were set on a path. If Gore had beaten Bush 2, economically I don’t think much would have changed. We still would have had the end of a bull market and a recession in 2001. We would have had a housing bubble. Greenspan would have probably been reappointed either way. We would have had a credit crisis because we were in the process of building up debt that started in the ’50s. Europe was building its debt up. Japan was building its debt up. That is the reality.

Now the private sector is deleveraging, but sovereign debt is in a bubble. The air is coming out. My view is that the wheels are going to fall off Europe this year. I have been researching the Mayan codes and I have determined that the ancient Mayans were not astrologers; they were economists. They weren’t predicting the end of the world; they were simply predicting the end of Europe. That is a humorous way of saying this is the year Europe is going to have to make some very difficult choices. Greece gets to choose what kind of depression it wants, hard and fast or slow and long. It can’t avoid depression completely. It has borrowed too much money. The government is too big. It has come to the end of the ability to raise money at low rates. Italy and Spain are well on that path along with the rest of Europe. So, they have to make a decision, a political decision that is going to have major economic consequences.

Does Europe want to be a political union that looks more like the United States, where the individual entities have to run balanced budgets and can’t print their own money and have some kind of fiscal controls or they go back to a two-tiered Europe with multiple currencies. One way or another, this is the year that Europe is running out of road to kick the can.

Fortunately, in the U.S. we are not there yet. We have some room to make a decision. That decision is going to be made in 2012 because by 2013 we are going to have to decide how we deal with the deficits and debt. After 2014, the bond markets will start to raise rates. Total U.S. debt is continuing to grow because governments are growing debt faster than private citizens are decreasing debt. The bond markets are starting to rebel long before you would think they would for a country that’s the world reserve currency. The key is whether debt is excessive relative to income. If you can make your debt service, people will still lend you money. When they don’t think you can, they will stop. That’s when you have a crisis. It’s a debt super cycle. And, when you reach the end, you have to deal with the debt. You can pay it down. You can default on it. You can print the money, extend it out with lower rates or financial repression, which are all other ways to look at default. But, nonetheless, that debt is there.

The problem we are facing in the U.S. is that gross domestic product (GDP) is consumption plus investment plus government spending plus net exports. If we decrease government spending over time, we decrease GDP. That’s the problem that Greece is going through right now. It has to decrease government spending by 4.5%, thus shrinking the economy. But it can’t increase government spending without increasing debt or taking taxes away, which decreases consumption. Nothing the government does will make things better. The U.S. is on the same path. We can become Greece by continuing to borrow or be proactive and say we are going to get our deficits under control over a period of five or six years. The economy is still going to be slower than we would like and unemployment higher than we would like. That’s just the rules. We’re at the end game. We are at the end of the debt super cycle and that’s what happens.

Printing money doesn’t increase the GDP in actual real terms, but it makes everyone holding gold happy because the value of natural resources goes up. That is why I buy gold every month. I take those coins, I put them in a vault and I hope I never need them. I quite frankly hope gold goes back to $300/ounce (oz) because that means the economy is in wonderful shape. I’m actually afraid that gold is going to go up in value, which means we are not getting our act together.

That leads to questions about fault. Did the banks do things they shouldn’t have? Yes. Were they the cause of it? No. Was Greenspan the cause of the bubble? No. He was part of the cause. I mean, we did a lot of things as a country that weren’t good choices. Should we have allowed our banks to go to 30 and 40 to 1 leverage? No. Should we have repealed Glass-Steagall? No. The problem is that real median household income hasn’t moved for 15 years because real private GDP hasn’t changed. The only thing that has grown is government spending.

John Derrick: In 2011, the European financial crisis moved from the periphery to the core. Central bank policies were big drivers of the decline. The European Central Bank and China raised rates early in the year and again in July as fears of a China slowdown grew. That early tightening to fend off inflation had a big impact on the course of events throughout the year. The other big events were the U.S. credit downgrade in August and currency intervention, particularly in the Japanese yen.

Frank Holmes: There is a huge amount of borrowing around the world in Japanese yen because it is so inexpensive. That includes investing in commodities, resources and emerging markets. And, every time we see this huge signal move by the yen, you get this rippling effect that takes about six weeks to resolve itself with commodities being sold down. Therefore, a lot of fund managers borrowing in Japanese yen are long energy stocks, resource stocks and emerging markets, which leads to a lot of selling.

JD: The second half of last year was very volatile, but the market ended essentially flat. In fact, much of the volatility was concentrated in the last month, which made for a very difficult psychological environment, as the market has been somewhat schizophrenic with weekly rallies and selloffs.

Spikes in the yen caused market selloffs. This hit commodities especially hard. So the secret for 2012 is to use the volatility. Buy on the volatility spikes. Unfortunately, what most people do is just the opposite. Another thing to look for in 2012 is a positive fourth year of the presidential election cycle as the government tries to implement policies that will get them reelected.

Brian Hicks: There has been a lot of concern about money supply growth in the emerging markets, particularly in China, which reduced bank reserve requirements last year. A reacceleration of global money supply can be particularly constructive for commodities going forward as there has been a high correlation between money supply growth and commodities.

If you were to take all the global money and back that by gold, the price of gold could go to $10,000/oz. If you just use half of the global money supply, gold would trade at about $5,000/oz, up from approximately $1,600/oz right now. The more U.S. dollars in circulation, the higher the price of gold. This has been the main factor increasing the price of gold since 1998 and will continue to be the case in the years to come. Gold has a lot of running room to go.

Another driver for the price of gold has been federal deficits. Government spending is way above revenues. We hit a point in 2000 where spending as a percentage of GDP greatly exceeded taxes as a percentage of GDP. This could be a point of no return and could potentially drive the price of gold even higher. There has been a large bifurcation between the price of gold and gold equities, particularly in the last couple of years as risk aversion has prompted many investors to buy the bullion as opposed to gold equities. This is creating opportunity. We feel like there’s going to be a catch up in gold equities, many of which are trading at very low multiples to cash flows and earnings. Stocks such as Newmont Mining Corp. (NEM:NYSE) look like value stocks now paying high dividend yields and trading at sub 10-times price to earnings ratios. This could really present an attractive opportunity in 2012.

JD: Just a comment on all the takeovers. We were seeing 6% premiums on takeovers in ‘06. Now we are talking 60+ premiums. That’s another reflection of how undervalued the stocks are relative to commodities.

BH: That’s a great point. We have seen tremendous value creation based on mergers and acquisitions.

Shifting gears a little bit, crude oil and refined product inventories ended the year at the lowest level on record (about 685 million barrels). That’s 6% below the prior year. It’s particularly interesting when you consider some of the geopolitical factors that have arisen with Iran talking about blocking off the Strait of Hormuz. This is a primary factor behind oil price supports despite the tenuous economic environment. Many investors don’t realize that Russia is very important for non-OPEC (Organization of Petroleum Exporting Countries) supply, a key factor in containing oil price spikes. Russia is increasing production while other non-OPEC production in Mexico or in the North Sea have been declining significantly, which has helped to bolster OPEC’s market share. It has also limited the ability of oil markets to increase production out of the Middle East due to the inability to invest in those troubled areas. In fact, Russian production has been quite steady since 2006, increasing anywhere from 100 to 400,000 barrels per day (bpd), mid-single digit growth. But, forecasters predict in 2012 we will see flat production growth, which is troubling given the fact that we continue to see demand increase in other areas of the world, mainly out of China. This will be a driving factor going forward for crude oil prices.

Evan Smith: Oil supply threats include geopolitical problems at a time when oil supply and spare capacity at OPEC is rather low—a little over 2 million bpd. Nearly 40% of global supply is under autocratic rule. Iran has threatened to disrupt the supply of crude oil and products through the Strait of Hormuz where about a third of global oil supply passes. So, any disruption, even temporarily, would cause a severe spike in oil prices. We think oil prices could support $100/barrel. One of the things we like in 2012 is higher exposure to master limited partnerships partly because of their steady cash flows. They are becoming a growth business now. The capital expenditures here in the United States have grown from $3.5 billion (B) in 2005 to nearly $16B this year. This is partly because of the growth in many of the shale plays, which require increased infrastructure. We think this is an excellent investment opportunity. We also see a big opportunity for the global oil services. We can see that capital expenditures have been rising. We expect them to rise from about $500B to nearly $.5 trillion this year, an increase of 15%. So, we see tremendous opportunity for some of the oil services contractors and equipment providers. Another key driver is the impressive amount of money that has been invested in North America. Just over the last three years nearly $129B in mergers, acquisitions and joint ventures has occurred. Global companies are coming to North America to invest in these shale plays because the economics are so attractive due to improved technology. They want to learn that technology and take it home. So, we think there is continued opportunity for investors in the resource play here in North America.

Shifting gears, one of the base metals we will target is copper. It is our favorite base metal. The demand side is holding up relatively well compared to some of the other base metals. Even in China, which is the largest market for copper growth, the build out of the grid is really a key driver. That is holding up quite well. On the other side of the supply/demand equation, supply has been a problem. Through most of the boom in copper prices, mine output has lagged forecasts. Causes included weather, labor strikes and just poor grade. The bottom line is that supply has not kept up with demand. We have not solved that problem so we think 2012 should be a relatively good year for copper prices.

Another theme we like is the agricultural space. Global population continues to grow. The emerging middle class continues to consume more grains, principally through the production of more meat as people consume more protein in their diets. There has been a huge surge in the need for the production of grains, yet no more land is being created. One of the key ways we’re seeing increased yields out of croplands is through higher applications of fertilizers. That has created a fairly tight situation for potash, specifically. But, other fertilizers such as nitrogen and phosphate are also benefiting from this trend.

FH: I would just add that the world’s population has doubled from the ’70s when we had rising commodities. There’s a very different factor and China and India have a global footprint that they didn’t have.

Xian Liang: China remains the biggest driver of world demand for energy due to a rising middle class, but it is in a very early stage when it comes to discretionary spending. Take for example passenger cars. Despite a tremendous growth in auto consumption in the last decade, only 18% of Chinese households own a car. Car ownership in China is just one-tenth of U.S. levels or the same level it was in the U.S. in 1914. Air travel remains at the U.S. equivalent of the 1950s. This illustrates a great growth potential going forward. Urbanization is one of the most significant trends driving consumption. In 2011, the number of urban residents in China exceeded rural residents for the first time in Chinese history. But, China won’t stop at this 50% urbanization rate if the historical trajectory of its richer neighbor, South Korea, is any guide. We could have another 30% of growth by the year 2013. South Korea outgrew its urbanization rates in a 40-year time span. And, if China continues to urbanize, there will be about 200 million new urban households in China, which creates enormous demand for consumer staples, durable goods and housing.

China’s government policies signal the trend will continue. China raised reserve requirement ratios 12 times since January 2010. We view that as an early signal for the next easing cycle. The last time China eased reserve ratios in October 2008, that triggered a big market rally in Chinese stocks. This should bode well for stocks. We don’t think the Chinese auto boom is over. Actually, in the last couple of days, officials in China hinted that new measures may be introduced to support auto and home appliance sales.

Outside of China, we see government policies remaining very positive in southeast Asia, especially in Indonesia and Thailand. The money supply in the past two years has not deteriorated in these two countries, in fact, it is growing at a healthy 16% year over year. This is part of the reason why we remain positive on southeast Asia. Indonesia is rich in natural resources, but it doesn’t depend as much on exports. In fact two-thirds of its GDP is driven by domestic consumption, which is how it managed to escape a recession in 2008 and 2009. Favorable demographics is a factor. It is a very young country. More than 45% of the population is under 24 years old and 2 million people a year are joining the work force. Second, urbanization is creating new consumer demand. Just like China, Indonesia’s household debt is low. Total mortgage loans outstanding account for only 3% of GDP. Consumer credit is still at a very early state. I see tremendous growth potential going forward.

FH: The money supply is growing very rapidly in the entire region. I think it’s not just a China story. It’s a whole emerging market. And, I like to characterize it as the American dream trade as all these countries want the American dream. They all want a house. They want a car. They want all the lifestyle that we have.

John Derrick joined U.S. Global Investors Inc. in January 1999 as an investment analyst for the U.S. Global Investors money market and tax free funds. In March 2004, he was promoted from portfolio manager to director of research and now manages the day-to-day operations of the investment team. Prior to joining U.S. Global Investors, Derrick worked at Fidelity Investments. He has appeared on CNBC and Bloomberg TV and has also been a guest on Marketwatch Radio and NPR. Derrick has been featured in stories for BusinessWeek, The New York Times, the Associated Press and USA Today. A graduate of The University of Texas at Arlington, Derrick earned a Bachelor of Arts in finance. He sits on the board of directors for the CFA Society of San Antonio.

Frank Holmes is CEO and chief investment officer at U.S. Global Investors Inc., which manages a diversified family of mutual funds and hedge funds specializing in natural resources, emerging markets and infrastructure. In 2006 Mining Journal, a leading publication for the global resources industry, chose him as mining fund manager of the year. Holmes coauthored The Goldwatcher: Demystifying Gold Investing (2008). A regular contributor to investor-education websites and speaker at investment conferences, he writes articles for investment-focused publications and appears on television as a business commentator.

John Mauldin is the author of New York Times Best Sellers list four times. They include Bull’s Eye Investing: Targeting Real Returns in a Smoke and Mirrors Market, Just One Thing: Twelve of the World’s Best Investors Reveal the One Strategy You Can’t Overlook and Endgame: The End of the Debt Supercycle and How it Changes Everything. He also edits the free weekly e-letter Outside the Box. Mauldin also offers The Mauldin Circle, a free service that connects accredited investors to an exclusive network of money managers and alternative investment opportunities. He is a frequent contributor to publications including The Financial Times and The Daily Reckoning, as well as a regular guest on CNBC, Yahoo Tech Ticker and Bloomberg TV. Mauldin is the President of Millennium Wave Advisors, an investment advisory firm registered with multiple states. He is also a registered representative of Millennium Wave Securities, a FINRA-registered broker-dealer.

Evan Smith joined U.S. Global Investors Inc. in 2004 as co-portfolio manager of the Global Resources Fund (PSPFX). Previously, he was a trader with Koch Capital Markets in Houston where he executed quantitative long-short equities strategies. He was also an equities research analyst with Sanders Morris Harris in Houston where he followed energy companies in the oil and gas, coal mining and pipeline sectors. In addition, he was with the Valuation Services Group of Arthur Andersen LLP. Smith holds a Bachelor of Science degree in mechanical engineering from the University of Texas in Austin.

The Gold Report: In a recent edition of Morning Notes, you referenced some “sprouting” problems in China. What are those problems and are they likely to affect China’s economy?

Michael Berry: We spent a couple of weeks in Shenzhen, China, and Hong Kong last month. On the surface, there do not appear to be any real problems in China. The infrastructure is fabulous—new roads, tunnels, bridges and stadiums. There are a lot of institutional investors in China with a tremendous thirst for knowledge. But old China hands—and I’ve been there many times since the 1960s—feel that there are serious problems beneath the surface, including inflation, slowing exports, bad loans and overbuilding.

During our visit to China, investment bankers we met with indicated that there are vacancies and see-through buildings in many cities. This is always a precursor of problems to come. China has an export-led economy and the U.S. and Europe, two of its main customers, have slowed down considerably. We may see a recession in Europe this year, which would bode ill for China, which counts the Eurozone as one of its largest trading partners.

An important question is how quickly can China transform itself into an economy with healthy domestic demand? That’s going to take years. There are also concerns about whether China can continue to grow at a breakneck speed of 9% or 10% per year. Most of the forecasts show China’s gross domestic product (GDP) will slow considerably over the next six years; however, it will still maintain growth levels above the Western economies. But problems are lurking in China, no doubt. The best we can hope for is a soft landing in 2012.

TGR: Paul Krugman recently wrote in The New York Times that China is on the verge of a massive real estate bubble. The World Bank recently lowered its GDP forecast for China to 8.4% from 9.1% in 2012.

MB: Growth will certainly slow, but China is better positioned to handle problems with overbuilding and bad debt than the U.S. China has been running huge surpluses for years and has accumulated significant foreign exchange reserves by pegging its currency to the U.S. dollar at artificially low levels. Japan recently inked a deal with China to buy its bonds. The Chinese currency and economy are slowly coming out of their self-induced isolation.

We remain cautious, however. China has a cushion here, but as we said before, there are some lurking issues and Paul Krugman touches on one in his piece.

TGR: How could a slowdown affect copper demand?

MB: Copper is probably the single metal that reflects good times in the world and growth. It is called the metal with a Ph.D. in economics because it’s so necessary for and indicative of economic growth. Expect supernormal growth of 5–7% in a number of emerging economies, which will keep demand for copper strong going forward.

The real question is from where will additional supply of copper come? There are the beginnings of a supply crunch in copper, which is affecting a number of mines worldwide. We are witnessing a combined supply-demand issue, not just a demand issue. Resource nationalism, falling grades and adverse weather are just a few issues affecting copper today. This is troubling but ultimately a good omen for junior mining companies involved in copper exploration.

Chris Berry: China is responsible for about 40% of global copper consumption, and copper is a 16-million-ton-per-year market. If GDP growth in China slows even from 9% to 8%, copper consumption has to fall in line unless other countries can pick up the slack in demand. What countries hold the potential to do this? Looking at demographics, potential demand and infrastructure build-out, several emerging markets come to mind including Brazil and India as well as “second tier” emerging markets such as Indonesia, Turkey or Colombia. If these countries do indeed grow at above-trend growth rates, you must then ask where additional supply is going to originate from—and supply appears tight going forward.

A notable example of a supply disruption is Freeport-McMoRan Copper & Gold Inc.’s (FCX:NYSE) Grasberg mine in Indonesia, where company management recently declared force majeure on copper exports. You can add labor strife to the list of issues potentially curtailing copper supply. Labor issues at mines promise to remain front and center as high metals prices make mining a more financially attractive pursuit. Grasberg is one of the largest copper mines in the world and the employees there have agreed to a 40% increase in pay over two years, however, I don’t believe the strike is fully settled yet, highlighting how thorny labor issues can be. Issues at the Grasberg mine have some very serious implications for copper supply going forward. So to summarize, between supply and demand, I think copper supply is the more important of the two to focus on.

TGR: The junior resource sector had a difficult time in 2011. The Toronto Stock Exchange Venture Composite Index, which is mostly composed of junior resource companies, was at about 2,400 in April, but had fallen to 1,450 by the end of December. Do you think we’ll see a sector rebound in 2012?

MB: There are strong headwinds for a lot of these companies and 2011 was unkind to the junior mining space in general. Very few junior mining companies have escaped the wrath of the pullback in commodities and overall panic at issues that have developed around the world. Investors must now focus on which companies can sustain themselves until we’re over the hump. We’re not there yet. The question will be which stocks can stand the test of time, can sustain their exploration and development activities and raise sufficient capital to fund operations in a difficult environment, to put it mildly.

TGR: Revett Minerals Inc. (RVM:TSX; RMV:NYSE.A) had some potential catalysts coming to the forefront this summer. What’s new there?

MB: Revett produced 3 million ounces (Moz) silver equivalent and earned about $16 million (M) in the third quarter. The company also recently announced a $20M revolving line of credit from Société Générale. It produces the best copper-silver concentrate in the country from its Troy mine in Montana. The mine has a perpetual seven-year life because it keeps finding more copper and silver resources as it mines. It’s building in production and the kind of liquidity and strength it will need to manage any economic downturn.

We visited the company in early September. The management team is very much together. It got a good ruling from the Ninth Circuit Court of Appeals on the environmental impact of Rock Creek on grizzly bears and endangered fish. Rock Creek is a second ore body fully drilled out, and environmentalists have tried to block its development. It has 229 Moz silver and a couple billion pounds of copper in virtually identical geology to the currently operating Troy mine. There’s a good chance the company will be able to mine Rock Creek within the next couple of years.

Revett should prosper and could be the target of a takeout. It’s a very positive situation. The stock trades around $5/share, but it was $0.07/share a few years ago. That speaks well for the management and investors in Revett Minerals.

TGR: The line of credit is at London Interbank Offered Rates (LIBOR) plus 3.5%. Do you think that’s a bit high?

MB: Possibly, but certainly Revett can handle it. It’s producing and selling all the silver and copper concentrate it has, so a revolver is a good deal for it. These are catalysts that you want to see from time to time.

TGR: If Rock Creek moves ahead as planned, when would it reach production?

MB: I don’t think the environmentalist group will appeal to the Supreme Court. Even so, I don’t think the Supreme Court would hear it. It’s probably three to four years away from production.

The Troy mine will certainly sustain the company in the meantime. Management presentations indicate that Troy has perhaps 10 to 15 years of production left.

TGR: Is $5/share a good entry point for that stock?

MB: This stock is fairly volatile. If Rock Creek comes on, yes, I think $5/share will be an incredibly good bargain for investors. I’ve been watching Chief Executive John Shanahan now for several years and he’s completed everything he said he wanted to do.

TGR: In a recent edition of Morning Notes, you discuss some of the recent ups and downs of Quaterra Resources, Inc. (QTA:TSX.V; QMM:NYSE.A). You called the company’s Yerington copper project in Nevada “a company maker” even though Quaterra also has the high-grade Herbert Glacier gold project in Alaska.

MB: Tom Patton, the chief executive of Quaterra, bought Yerington out of bankruptcy for $250,000 in stock. Historically there are about 5 billion pounds (Blb) of copper at the Yerington Bear deposits. This past May, he announced he was exercising Quaterra’s option on it. There is going to be a large copper district there. There are three companies now in the area. Nevada Copper Corp. (NCU:TSX) has a very large, high-grade skarn deposit. Entrée Gold Inc. (ETG:TSX; EGI:NYSE.A) has some properties to the east of Yerington, which include the Bear deposit, a large, partially drilled out porphyry, and the MacArthur, an oxide-chalcocite run-of-mine project with 1.4 Blb of mine-ready, leachable copper. Quaterra drilled out the MacArthur oxide quite nicely and found a fair amount of higher-grade copper averaging about 0.5%. It could be leached directly and brought into production within two to three years for about $250M. The key to the entire district is the MacArthur property that Quaterra owns, in my opinion.

Quaterra has been cut in half in this pullback. We hope management will move to monetize some of its assets, either its Nieves silver property in Mexico, which may have 100 Moz silver in all categories, or even its 35% stake in Herbert Glacier, a high-grade, gold-silver resource north of Juneau, Alaska, which was recently discovered through drilling.

I may be a loner in this regard, but the MacArthur oxide-chalcocite deposit and the fact that it has a huge water resource are the keys to the entire Yerington district. I think the district holds 50–60 Blb copper. When I visited Yerington in September, Quaterra had five drill rigs turning. You don’t have five rigs turning on a property if you don’t think you’re really proving up and increasing the resource significantly.

TGR: Nevada Copper was shopping its project before its share price went down considerably. Which one—Quaterra, Entree or Nevada Copper—is most likely to be taken out first?

MB: Nevada Copper is the furthest along. A company like Antofagasta Plc (ANTO:LSE) might want to take it out. However, whatever company comes into the district is going to want to consolidate it. Having Nevada Copper would be a coup, but it would not help consolidate the district. From a strategic view point, Quaterra’s Yerington pit, MacArthur pit and Bear deposit are really the keys to the district.

There are already some big players in the district. Rio Tinto (RIO:NYSE; RIO:ASX ) owns 25% of Entrée Gold. Ivanhoe Mines Ltd. (IVN:TSX; IVN:NYSE) owns 12%. But Entrée is three years behind Quaterra and Nevada Copper.

TGR: Arizona has some vast reserves of copper as well. Do you see a renaissance in developing copper juniors in Arizona?

MB: I do. On our way to China, Chris and I visited Tucson, where there are several great porphyry discoveries. ASARCO LLC, Rio Tinto and BHP Billiton Ltd. (BHP:NYSE; BHPLF:OTCPK) are there. One junior miner in particular, Redhawk Resources (RDK:TSX; QF7:FSE; RHWKF:OTCQX), has been drilling and it’s onto something.

Arizona, Nevada and Idaho are great states for mining. Given the unemployment in some of these regions, there is a new lease on life for junior mining companies to work in these states.

TGR: Redhawk is trading at about $0.42/share. Do you like that as an entry point?

MB: The stock is cheap, there’s no doubt about that. Its property, Copper Creek, is quite spectacular. When we visited in December, it had three rigs turning. There are close to 400 breccia outcrops of fairly small tonnage, but very high-grade copper, gold, silver and molybdenum. Red Hawk is looking for deep, but high-grade, thick veins that characterize big discoveries like Butte in Montana. I like the management team. It raised $20M earlier this year and it’s probably going to have to go back to the market again or do a joint venture. There’s lots of interest and it has confidentiality agreements signed with the big boys. There are smelters literally all around it. It’s got great infrastructure. There’s a good chance for a world-class discovery there.

TGR: What about Quadra FNX Mining Ltd. (QUX:TSX)?

MB: Quadra is a great case study. It has done a great job. You want to see that event that monetizes the shareholders. The Polish firm KGHM Polska Miedz S.A. (KGH:WSE) offered $15/share for the company. There is a lot of interest in U.S. deposits now. There’s a new life on mining and exploration, and there’ll be more takeouts in the future.

TGR: Do you have anything to add to that, Chris?

CB: There has been a lot of talk lately about what makes a metal critical. Certainly, copper is a critical metal based on its ubiquitous use throughout all facets of the global economy. Mineral deposits where resource nationalism isn’t a top concern, or a concern at all, like Arizona, Idaho or Nevada, deserve a second look and a premium in share price based on their location. I think we are sure to see more cross-border mergers or take outs like the KGHM/Quadra example as copper’s importance to economic growth is only magnified by an emerging middle class of billions in the years to come.

TGR: You gentlemen are about to launch a new product, the Discovery Investment Scoreboard. Tell us about that.

MB: About 10 years ago, I defined a technique called Discovery Investing because I was interested in discovery. All great wealth creation starts with discovery. I defined 10 rules or factors and continued to refine them over the last decade. Dr. Terry Rickard, a brilliant mathematician and former senior fellow at Lockheed, finally convinced me to put my discovery investing discipline in a software format. We use a powerful mathematical technique that he developed. It allows users to rate stocks in English vocabularies and develop an ordinal ranking. The number of companies that the system ranks, the database, is getting quite large. The most interesting aspect of the database is its ability to build a crowd score. It takes each individual user’s analysis and builds it into a single score, which allows investors to check their analysis against the crowd.

CB: The toughest part about the nano cap space is in trying to evaluate these companies, because traditional metrics don’t work. There are no earnings or cash flows so there is a great deal of guesswork involved. The Discovery Investment Scoreboard (DiS) is designed to take the guesswork out of evaluating these companies. We can rank any one of the companies we mentioned today—it doesn’t even have to be a nano cap.

We might look at the management of a company and you might say it’s average. I might say it’s excellent. At the end of the day, who’s right? Nobody really knows. There are still a lot of open questions. We’re aiming to quantify those opinions. The real bonus for the end users is the crowd score. Investors can see how their opinions rank relative to the crowd. Since I’ve been using the system, it has raised many questions about what I’m seeing that the crowd is not or vice versa. We think it has potential to shine a lot of sunlight on accurate valuations for junior companies.

TGR: Have either of you adopted a New Year’s investment resolution?

MB: In 2012, we hope to make DiS available to everyone who wants to analyze these companies. It’s going to be by subscription but we’re actually looking now for people who want to help us build the database. We’re planning to kickoff the system on Jan. 22 at the Cambridge House International Resource Conference in Vancouver. We haven’t priced it yet, but it will be affordable for the individual user. We’re going to have versions for institutional users that will be more detailed and quite a bit more powerful.

TGR: Jeepers. You might just put some analysts out of business.

MB: Chris and I actually sat with two analysts and two investor relations representatives in China and they loved it. We travel to Denver next week to conduct a focus group on the usage of the DiS.

CB: Once we explained the rationale and the background to them, it became a little bit addictive, because companies start popping up in your head and you think, “Gee, I wonder what the crowd thinks about this company or that company?” The whole idea of finding out what I’m missing or what I know that the crowd doesn’t is key. I think that’s what has a lot of people excited right now.

TGR: Thanks to both of you.

Dr. Michael Berry served as a professor of investments at the Colgate Darden Graduate School of Business Administration at the University of Virginia from 1982-1990, during which time he published a book, Managing Investments: A Case Approach. He has managed small- and mid-cap value portfolios for Heartland Advisors and Kemper Scudder. His publication, Morning Notes, analyzes emerging geopolitical, technological and economic trends. He travels the world with his son, Chris, looking for discovery opportunities for his readers.

Chris Berry, with a lifelong interest in geopolitics and the financial issues that emerge from these relationships, founded House Mountain Partners in 2010. The firm focuses on the evolving geopolitical relationship between emerging and developed economies, the commodity space and junior mining and resource stocks positioned to benefit from this phenomenon. Widely quoted in the press and a frequent speaker at conferences throughout the world, Berry holds a Master of Business Administration in finance with an international focus from Fordham University and a Bachelor of Arts in international studies from The Virginia Military Institute.

Frank Holmes, chief executive and chief investment officer at U.S. Global Investors, will focus on the upside of massive Chinese modernization and growth. He is the recipient of both Mining Fund Manager of the Year Award from Mining Journal and International Citizen of the Year Award from the World Affairs Council of America and has a long-term investor’s view of international geopolitics.

Author and Commentator Gordon Chang literally wrote the book on why investors should be wary of China’s growth. His book The Coming Collapse of China has attracted attention from the likes of the LA Times and Asia Times and many other publications in between. He has made appearances on Fox News and regularly contributes to Business Insider, Barron’s, National Review and Forbes magazines. When he lived and worked in China and Hong Kong for almost two decades, most recently in Shanghai as counsel to the American law firm Paul Weiss, he saw the ghost cities and environmental challenges up close.

“The debate is a direct response to attendees who need to know if China is on a course to grow, slow or blow,” said Nicole Evans, president of the Cambridge House International Conference Division. The Gold Report called these two experts to find out the numbers behind why they have such different predictions about how this enigmatic country will fare in the coming years.

Frank Holmes: This veteran investment advisor based his positive prognosis for China and its Eastern neighbors on a combination of tacit knowledge learned firsthand through travel and observation of geopolitical conditions along with explicit knowledge of history and the markets.

He studies S-curve patterns, modeled on economist Simon Kuznets’ 20-year long cycles. For example, the world’s population has grown from 1 billion in the 1800s to 7 billion today, which has drastically affected commodity consumption and infrastructure buildout. “Nowhere is this more evident than in the emerging markets, such as China,” Holmes said.

“When governments have invested in infrastructure, there has been a powerful impact on gross domestic product (GDP) numbers.” For example, he pointed to the 1950s, when Eisenhower signed the Federal Aid Highway Act, allowing commerce to expand across the nation, with restaurants including Dairy Queen and McDonald’s experiencing tremendous growth over the next several decades. “Paved roads from coast to coast helped sustain a more than tenfold increase in U.S. GDP,” Holmes said.

“Whereas the U.S. connected 160 million people with nearly 47,000 miles of freeways, by 2020 China will connect 700 million people across 250 cities, spanning more than 47,000 miles of interstate and 18,000 miles of rail,” Holmes explained.

Holmes estimated that over the next 25 years, about $41 trillion will be spent on global infrastructure—$6 trillion has been approved for the 2011 through 2013 timeframe with China projected to spend half of that $6 trillion. He believes these investments will result in rising GDP per capita and trigger a consumption economy.

“Once China connects its super cities, it will enable more Chinese to travel around the country, resulting in a completely different consumption pattern. You will see train stations with 50-story condominiums along with U.S. restaurants that have already been expanding in China, including McDonald’s, Dairy Queen and Starbucks. Major hotel chains, such as Wyndham, Starwood and Hilton, along with luxury goods businesses including Cartier, Hermes and Gucci will compete for market share. Infrastructure will change the face of the economy in China just the way it did in the U.S.,” said Holmes.

“We are big believers that government policies are precursors to change, so our investment team continuously tracks the fiscal and monetary policies of the world’s largest countries in terms of economic stature and population. The G-7 (industrialized) countries are 15% of the world’s population but 50% of the world’s GDP and growing only about 1%. Western countries seem to be focused on cutting back infrastructure spending and raising taxes to pay for entitlements. At the same time, E-7 (emerging) countries comprise 50% of the world’s population with 20% of the world’s GDP. However, these countries are growing at 7% to 8% and include a rising middle class of some 60 million people out of a total 2.2 billion people. But, 60 million people making $30,000 a year is very significant. Think about the movie “Slumdog Millionaire”—this is what is happening throughout Asia. That is why companies such as Gap and GM and KFC are focusing on expanding in China where its residents love American products and pack the stores in Beijing.”

Holmes also saw important policy changes in the works that could improve China’s economic outlook. “Over the past 10 years, we have seen a slow migration of more property rights being given to people in China. The largest transfer of real estate in the history of mankind took place in China seven years ago when more than $500 billion of real estate value was basically transferred to farmers. That was followed by condo building. Additionally, to attract public companies, Shanghai adopted the Hong Kong Stock Exchange listing and bankruptcy systems, which are based on common law. This is significant because if you look at all the countries that have had financial problems over time, no common law system has ever gone bankrupt. Civil law has. China is slowly adopting a rule of law system.”

Not all of the changes have been smooth. “One of the biggest things that China has been wrestling with is the fear of inflation,” Holmes said. “The government raised the minimum wage and that resulted in a big spike in food inflation. Then it had to deal with real estate inflation in Shanghai and the cities along the ocean. It required banks to keep more reserves, up to 20% in some cases, to avoid the problems now occurring in European banks. A tax on speculative real estate slowed the economy and it showed up in the psychology of the stock market.

“The spike is slowly reversing and rates are falling. Because there is so much less borrowing generally in China than in the rest of the world, prices rebound much faster,” Holmes said. “Only 25% of homes have mortgages so the impact of bankruptcies is much smaller. Also, I don’t think they’re going to print money the way they did in 2008. The Chinese government will move slowly to make sure the country doesn’t get hurt by Europe’s slowdown.”

Based on money supply, debt levels and the weakness of the dollar, Holmes predicted economic activity in the emerging countries should double over the next five years. “It is going to be between 8% and 9% this year and it has another 10 years of growth ahead of it,” Holmes said. “Investors need to understand volatility and not be fearful of it. If you are trading futures where your leverage is 10 to 1 and you have a big correction, you can get wiped out. But, if you are a cash business, you understand when these markets go through these corrections. Solid companies paying dividends can be an attractive investment over the long term.”

Gordon Chang: This China-watcher recently wrote an article for Forbes that said what others considered positive November trade numbers—exports up 13.8%, imports up 22.1% year-over-year—was actually an indication of flat consumer demand once the commodities were factored out. His conclusion was that the government was taking advantage of low prices to stockpile things like soybeans, copper and iron ore while domestic demand remained stagnant. “Since September, we have seen essentially flatlining growth,” he said.

“The growth over the last three decades has been absolutely stunning, but that was then, and this is now,” Chang cautioned. “After 35 years of virtually uninterrupted growth, the Chinese economy hit an inflection point, probably in September of this year. I think we are going to see a long-term cycle down. There are a number of reasons for it, some of them short term, some of them long term. The reasons that created this growth either no longer exist or are disappearing fast. Deng Xiaoping’s policy of reform paired with the end of the Cold War and expansion of globalization triggered growth in the 1980s. However, under current leader Hu Jintao, China has seen the reversal of reform, with the government partially renationalizing the economy. Today, we are in the second part of a global downturn, which will be much worse than what started in 2008. A trade-dependent economy like China’s is going to have real problems. Additionally, China was aided by the demographic dividend, an extraordinary bulge in the Chinese workforce, which by most estimates will level off between 2013 and 2016, leaving a demographic tax where one worker supports two parents and four grandparents.”

Chang pointed to stagnant electricity consumption, flat car sales, plunging industrial orders and collapsing property prices. “For example, in October, we saw property prices collapse 30% in places like Shanghai and Beijing, and actually across the country. That has to eventually trigger a negative wealth effect.

“Domestic growth is vital for a sustainable economy,” Chang said. “Last year, domestic consumption comprised less than 34% of Chinese GDP and it has been dropping in recent years. That means China is not restructuring its economy because the problems go to the core of the political model. The government would have to let the Renminbi float, allow banks to offer market rates of interest to depositors and state enterprises, allow workers to bargain collectively to get higher wages and provide a better social safety net, especially in the health care area. These are things that Beijing didn’t do a half-decade ago when it was growing at 9.9% and they’re certainly not going to do so now in a very difficult environment.”

On the manufacturing side, Chang referred to the December HSBC/Purchasing Managers’ Index (PMI). “It showed an absolute, outright falloff in industrial orders domestically. I think that is a really important indication of the problems,” Chang explained. Technically, the Chinese economy went from expansion in October to contraction in November when it crossed the critical 50 line. Any number above 50 shows expansion; any number below 50 shows contraction.

The fact that China is reporting negative numbers is telling in itself, according to Chang, who said often government-issued statistics conflict with reports from other sources. Beijing reported 13.8% export growth in November. However, during that same period factories went bankrupt, factory owners fled because they couldn’t pay their debts and some of them took their own lives. Even more damning are container and freight statistics, including reports from mega-container shipper Cathay Pacific that showed November cargo shipments down 13.8%. “Exports to Europe have fallen off the cliff and the EU was China’s largest trading partner so something doesn’t add up,” he said.

For the final blow, Chang pointed to the actions of the Chinese government. “If China really does have robust, 8–9% growth as everybody says, why is the central government starting to stimulate the economy again? That just doesn’t make any sense. If we look at things like imports and exports, I think the economy is really in trouble.”

Chang warned of political consequences if the country is not growing at least close to a double-digit rate. “I don’t know if China can stand 3% growth—or the other very real possibility, contraction. The American government bases its legitimacy on the nature of its political system. The legitimacy of the Communist Party is primarily based on the continual delivery of prosperity. Already, the number of protests in China has increased dramatically from maybe 70,000 mass incidents a year in 2005, to as many as 280,000 last year. In addition to strikes, riots, insurrections and bombings, the standoff between villagers and the authorities in Guangdong province are threatening the future of the Communist Party.”

One solution is for the Chinese government to continue to spend millions on infrastructure to create growth as it did when it spent $1.1 trillion after the 2008 downturn. “This tactic is of limited usefulness the second time around,” Chang warned. “It may be able to play out the game for 18 months, maybe two years at the outside, but it’s pretty much done. Plus, the artificial stimulus also created a stock market bubble, inflation, ghost cities, banking weakness and property bubbles. Massive spending didn’t avoid problems, it just postponed them and made them bigger and more difficult to solve.”

Chang said that people in China are starting to see the reality of the problem. “There is a sense of pessimism. Starting in October, we saw large, unexplained transfers of money out of the country.”

The bright spot, according to Chang, is that while China will not be able to fuel a global recovery with a consumer-driven middle class, a Chinese meltdown won’t be a major blow to the U.S. either. “We have the world’s largest internal market; 70% of our GDP relates to consumption. Exports don’t really play that much of a role in the U.S. as it does in other major economies. So China can fall off the cliff in a sense, and it would have some negative effect but not very much. In fact, we might benefit from it.”

Chang’s conclusion? “People say the Chinese economy is the global engine of growth, but that’s not true. The engine has been the American consumer because we are taking every other country’s exports, and the Chinese, through predatory and mercantilist policies, have been grabbing growth from other countries. For the last 200 years, China has been a potential source of customers for other countries. Still, domestic demand isn’t that significant. China’s imports lately have been commodities and that is going to fall off because China’s exports of manufactured goods, to Europe and the U.S., are going to be stagnant or lower than they have been in the past. So China really reacts to the rest of the world. If the changes over the next couple of months are as dramatic as they’ve been for the past two, then we’re going to be looking at a very different China. The Chinese economy could fall into a big black hole with 1–2% growth or even contraction. Can the government turn it around as it has in the past? That’s the money question.”

Frank Holmes is CEO and chief investment officer at U.S. Global Investors Inc., which manages a diversified family of mutual funds and hedge funds specializing in natural resources, emerging markets and infrastructure. In 2006 Mining Journal, a leading publication for the global resources industry, chose Holmes as mining fund manager of the year. Holmes co-authored The Goldwatcher: Demystifying Gold Investing (2008). A regular contributor to investor-education websites and speaker at investment conferences, he writes articles for investment-focused publications and appears on television as a business commentator.

Gordon G. Chang is the author of Nuclear Showdown: North Korea Takes On the World. His first book is The Coming Collapse of China. He is a columnist at Forbes.com and The Daily and blogs at World Affairs Journal. He lived and worked in China and Hong Kong for almost two decades, most recently in Shanghai, as counsel to the American law firm Paul Weiss and earlier in Hong Kong as partner in the international law firm Baker & McKenzie. His writings on China and North Korea have appeared in The New York Times, The Wall Street Journal, the Far Eastern Economic Review, the International Herald Tribune, Commentary, The Weekly Standard, National Review, and Barron’s. He has given briefings at the National Intelligence Council, the Central Intelligence Agency, the State Department and the Pentagon. Chang has appeared before the House Committee on Foreign Affairs and the U.S.-China Economic and Security Review Commission. He has appeared on CNN, Fox News Channel, Fox Business Network, CNBC, MSNBC, PBS, the BBC, and Bloomberg Television. He has appeared on The Daily Show with Jon Stewart.

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The Gold Report: David, in August you predicted that the silver price could go as high as $75 an ounce (oz). It was recently at about $32/oz. Where is it along the path to $75/oz?
David Morgan: I don’t see the silver price going above the $50/oz level in 2011. In other words, the top is in for this year, and has been for some time. I do see silver’s price going above $50/oz in 2012. I forecast $65–75/oz silver by the end of 2012. I don’t foresee a big rush into price appreciation for gold or silver in the first quarter of 2012 (Q112), which is seasonal. Typically, there is a very strong boost to the price of metals in the first quarter of every year. However, this year I’m suspect because of what’s going on in the Eurozone and all the paper pushing between the central banks of the world. I’m reserved about what’s going to happen over the next three months.

TGR: What did you think of the recent move by central banks in the U.K. and Canada getting together to boost liquidity in the markets? It seemed to push up the gold price a bit.

DM: It was what I call “old school.” I’m showing my age, but we used to avidly watch the U.S. money supply. When there was a significant increase in the money supply, the gold price would reflect that because it is more dollars chasing a fixed amount of goods. It’s a clear indicator that papering over the problem is not a solution and gold is shouting that loudly. The increase in M1, M2 or M3 (not provided by the Fed anymore) is looked at, but not with the intensity it was in the 1970s.

TGR: In the November issue of Silver Investor, you report that China could become a significant holder of European debt. While any such move would devalue China’s significant holdings of U.S. Treasuries, it would provide leverage for China’s efforts to form a new global currency backed in part by gold. Could you expand upon that idea?

DM: China as a nation has become the creditor of last resort because it has money to recycle. The more debt that it owns, the more control it has over the debt. China would have a lot of leverage in any default negotiations. There was a conference about a gold-backed yuan about a decade ago. The idea about a gold-backed currency is probably going to take place at some point in the future. China has bought more gold all along than they publicly admit, but the amount is far too small at this point to do any real gold backing to their currency. The country continues to buy gold slowly and quietly. It’s hard to say when China would have enough to make a viable gold-backed currency out of the yuan. That’s where the negotiations would come into play.

TGR: Do you think it would take decades?

DM: It would take decades to accumulate enough to make a gold-backed yuan in the fashion China is acquiring gold now. However, if China dumped a significant amount of its money (U.S. debt) into gold at once it would drive up the price thousands of dollars an ounce overnight. Gold would go ballistic. On the other hand, China has the leverage of the debt. In other words, it says, “U.S., you owe us this much money, so what we’ll do is we’ll discount the debt. You send us this much gold and we’ll cancel out part of the U.S. debt we hold.” That is a lot of power. Remember, “The borrower is servant to the lender.”

TGR: You recently reprinted Ron Hera’s “23 Ways to Boost Silver Investment Profits.” It talks about risk versus growth.

DM: The best place to be in this market, after establishing a physical metals position, is on the mining side by balancing risk with growth. I like the midtiers because this is where the greatest growth is along with mitigated risk.

TGR: Hera also tells investors to take a 24- to 36-month time horizon.

DM: All markets move up and down, including the silver market. Investors have to take the long-term view of this market. There is still a major trend to the upside, but there’s going to be more volatility.

TGR: Hera tells investors to be greedy when others are fearful and be fearful when others are greedy.

DM: I was getting fearful while others were getting greedy when silver was around the $35/oz level on its way to $50/oz. I cautioned investors that if they had to buy silver at that level to only buy some because the market was temporarily overdone. I was getting a lot of blowback from even some of the better analysts for being too cautious. I called the top around $48/oz and I’m pleased with that call. In other words, looking from the perspective of this interview my call was a good one, yet you would not believe the flack I took from some in this business.

TGR: Hera also says, “No excuses.” If a company isn’t progressing, just get out.

DM: You have to hold every company’s feet to the fire. Ask what it plans to do next year and if it met its milestones last year. The idea is to strive to do everything it set out to, but if it can’t then it should report it honestly and move on.

I don’t really like the junior sector that much. There are a lot of companies that have gone by the wayside early in the junior mining cycle. There are still some good values out there, but it’s pretty tough to call these days.

TGR: He also advises that investors pay attention to value and don’t pay a premium to get on the bandwagon.

DM: I agree. For example, we did an update on Royal Gold Inc. (RGL:TSX; RGLD:NASDAQ) sometime ago that showed how valuable it was—even at an extended stock price. A well-known Wall Street stockbroker took the time to call me to say it was an over-the-top, great report. That stock has done extremely well while so many have not.

TGR: Hera also discussed the influence of inflation on real wealth. Given the hidden inflation in the market, he argues that to preserve or even grow wealth, investors have no choice but to seek higher gains of a minimum of 25% a year. What’s your perspective on it?

DM: Markets are volatile. They wax and they wane. The market is in a period of consolidation. Very few stocks are reflecting their true value. It’s a good time to gradually get into these stocks. They could go lower over the next few months, but they represent one of the best places to put money right now.

As far as what to expect in the future, let me just state that I agree with ShadowStats.com Editor John Williams’ prediction that we have 10% inflation. There will always be some dogs (stocks) that won’t move, but there should be some real gains in precious metals. If there’s truly 10% inflation, there could be 25% gains in a mining equity, which would be a 15% real gain versus the true inflation rate. Once the sector gets hot again, the gains could be huge.

Presently, stocks are undervalued, which means be greedy when everyone’s fearful. This is the time investors should be buying.

TGR: Some pundits are saying that the market’s going to go even lower before it heads higher. Do you believe that’s the case?

DM: I do, but to think that you can pick an exact bottom is an amateur’s game. A professional tries to get in and accumulate while the getting is good. I’m looking at December through perhaps as late as April.

TGR: If investors are trying to reach 25% returns per year, they’ve got to turn to the small-cap space.

DM: Not necessarily. First, to expect those returns every year is unreasonable. However, investors could make 17% a year just by holding a good company, like Royal Gold, and writing the options on it. The options writers win 85% of the time and the option buyers lose 85% of the time. An investor could rent a stock like that out to people that want to play the options game and smile all the way to the bank—even in a downtrending market.

TGR: Nonetheless, you have some speculative buys on a handful of small-cap silver plays.

DM: Of course. Nothing is more exciting than getting a speculation right. We had Western Copper before it was renamed Western Silver, and eventually bought out by Glamis. Glamis was eventually bought out by Goldcorp Inc. (G:TSX; GG:NYSE). When you get a 4,000% gain on something, you can’t help but smile.

We like some small caps. Silvermex Resources Inc. (SLX:TSX; GGCRF:OTC) is one that we’ve come back to. The stock did fairly well after our initial recommendation. Then we went into this financial situation that clobbered everything and Silvermex had to regroup. We sold it. We came back to it when it was very undervalued. I’ve done that on several companies.

TGR: Silvermex is down about 26% year-over-year right now. Is that just the market or is that fallout from the deal with Genco Resources Ltd.?

DM: It’s both. The Genco deal looks pretty good on paper, but the market is giving a different vote right now.

Sometimes persistence pays off in stocks, however. I’ll give you an example. We owned First Majestic Silver Corp. (FR:TSX; AG:NYSE; FMV:Fkft) for a very long time. We had it at $4/share, but it was under $4/share month after month. When that stock finally caught on it went like gangbusters. We could have missed a huge move in that stock if we weren’t persistent. Am I always right? No. Am I right on Silvermex? I don’t know yet. Does it look bad at this particular point in time? Yes, it probably does. But I know enough to know that there’s a strong probability that at some point the stock will catch up.

TGR: What’s your view of Silvermex’s management?

DM: It’s one of the better management teams out there. I know Mike Callahan, Silvermex’s president who was formerly an executive with Hecla Mining Co. (HL:NYSE). I also know Art Brown, who was also with Hecla. Silvermex has a strong board. They want to make this company viable. They have something to prove.

TGR: It’s trading at about $0.40/share right now. Is that a good entry point?

DM: We had it earlier than that, but it’s probably OK. Investors could slowly build positions between now and April to take advantage of any further market decrease.

TGR: You’ve done pretty well with some of the midtiers, too.

DM: Pretium Resources Inc. (PVG:TSX) stock is up 20% after it announced a much larger, higher-grade asset. We were into the stock at around CA$8/share. It’s well above CA$10/share, but it’s still undervalued. We love the management. Robert Quartermain has a proven track record. Investors see a stock move and they’re scared to buy it. That’s incorrect thinking. A lot of these stocks that make big moves make new high after new high. How else does a stock go from $5/share to $50/share?

TGR: Pretium is up about 45% so far in 2011. How much upside is left?

DM: I think there’s plenty left. Think about buying $1,000 worth of Coca-Cola stock in 1928. People worry about how much is left, but what if the stock goes up 500% or 5000%? You have to let the stock tell investors how much upside is potentially left. You don’t want to sell your winners. You want to sell your losers.

TGR: What other midtiers still have some upside?

DM: Tahoe Resources Inc. (THO:TSX) is a great company on my watch list with a lot of upside. It’s not very well known.

TGR: BMO Nesbitt Burns has a $26/share price target on Tahoe. It’s trading around $18/share now. Do you think that’s reasonable?

DM: I do, but I don’t like to use price targets because it’s a no-win situation. If it makes a target and it stops at that exact price, you’re a genius. If it’s under that or over that then you get nothing but flack. Do I think Tahoe is undervalued? Yes.

TGR: Tahoe is planning to produce about 316.9 million ounces of silver from its Escobal property in Guatemala over the next 18 years. Do you have any doubts that it will execute on that?

DM: There are always doubts in the mining industry. There’s jurisdictional risk in many South American countries. Am I confident that it’ll happen? No, not today. Investors should spread out geopolitically. It’s very important in today’s financial climate to expect the unexpected.

TGR: The company is run by Kevin McArthur, who was the president and chief executive of Glamis Gold, which was taken over by Goldcorp, and then headed Goldcorp. It’s hard to argue with that kind of track record.

DM: I’m not. You have to put a great deal of credence into that caliber of management. But the best management in the world in the wrong jurisdiction can have problems. Robert Quartermain is one of my favorite examples. He was involved in a project in Russia and got burned slightly.

TGR: Are there any other company stories you’d like to share with us?

DM: Prophecy Coal Corp. (PCY:TSX; PRPCF:OTCQX; 1P2:Fkft) is undervalued. Prophecy Coal was two companies. It’s a coal company, but it also had a platinum group metals company that was spun off. I still like the Prophecy Coal side.

It’s a long-term project with a lot of hurdles to overcome in the uncertain jurisdiction of Mongolia. However, I have been to Mongolia and met with some of the people heading up the project, which will be using the coal deposit to fuel a power plant. I got a pretty good feel for how serious they are. As a speculation, it’s one of the better ones.

TGR: Do you follow 49 North Resources Inc. (FNR:TSX.V) at all?

DM: Yes, it is on my watch list.

TGR: It’s a different kind of play. It’s a little like the Pinetree Capital model where it takes positions in companies involved in many different resources.

DM: What I like about that type of model is that it spreads risk out. These are run by professionals that know what they’re doing. That model is especially good for the retail investors who don’t have the time to understand what they’re buying. It’s a good way to play the market.

TGR: In a response to a readers’ inquiry about the frightening possibility of deflation, you replied, “I do see a deflationary scare and suggest you buy all the way through it—three to six months. These mining stocks are cheap, but could get cheaper. I do not see it as being as bad as 2008.” How bad do you see it getting?

DM: The mining equities market could drop another 10%. But it’s possible that the current market is as bad as it gets. I do not see the financial crisis of 2008 repeating in 2012. But something needs to be done that’s going to really strengthen the financial markets and confidence in the system on a global basis. If that isn’t done, I expect 2008 or worse to repeat at some point. But, again, I don’t think that will happen for a couple of years.

TGR: Thanks for taking the time to share with us.

David Morgan (Silver-Investor.com) is a widely recognized analyst in the precious metals industry and consults for hedge funds, high-net-worth investors, mining companies, depositories and bullion dealers. He is the publisher of The Morgan Report on precious metals, author of Get the Skinny on Silver Investing (Morgan James Publishing, 2009) and featured speaker at investment conferences in North America, Europe and Asia.