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December 08, 2008

China: Carpe Diem!
by Axel Merk

China has a unique opportunity and responsibility to shape not only its own future, but also that of the global economy. While China is by no means responsible for the plight the world faces, it has played an important role in allowing global imbalances to be built. If China decides to help prop up the world economic model that got us into trouble in the first place, we may face the same challenges again a few years down the road. Except then, China may not have $2 trillion in reserves to rescue its economy, and could face severe challenges. China will ultimately act in its own best interest, but prudent she must be. The time for China to act is now.

Because of the country's fiscal health, policy makers in China have far more flexibility to turn the global financial crisis into an opportunity than do their U.S. counterparts. Currently, U.S. policymakers mistakenly think they have all the flexibility in the world because of what is perceived to be an almighty Federal Reserve (Fed). In our assessment, the law of unintended consequences is likely to hit the U.S hard: debt monetization will cause inflation; economic growth will falter once the Fed tries to mop up all the liquidity it is throwing at the economy; and the wealth gap will increase further as the wealthy refinance their debt taking advantage of artificially low interest rates, whereas the middle class slides further into recession as they remain locked out from the credit markets. Policies to prevent the middle class from de-leveraging will backfire, causing not just economic misery, but the rise of populist politicians. While these policy mistakes are tragic in the U.S., similar mistakes in China could be catastrophic.

The greatest challenge of a negative feedback loop in an economic downturn is demand destruction. A depression is a state of mind - consumers and businesses are reducing their risk appetite and switch to survival mode no matter how low interest rates are. Banks are more interested in buying government bonds with capital injections received than in lending to the private sector. Uncertainty is a key contributor to demand destruction. U.S. policies are not as effective as policy makers would like them to be because for too long, there has been a lack of leadership to communicate how this crisis will be managed.

A U.S. Congress willing to give a $34 billion "bridge loan" to automakers knowing very well that the money will be spent within months while not placing car makers on a sound footing is a Congress building bridges to nowhere. Speaker of the House Nancy Pelosi said the loan would get the industry ready for the 21 st century; we are almost a decade into the new century - this effort is too little too late. Worse, even if there were a magic wand to heal the carmakers, zero percent financing on six-year loans extended during the credit bubble depresses demand for years to come. Similarly, the stimulus plans to be enacted in January are unlikely to be as effective as intended; foremost, the plans are expensive and should push up the cost of financing for government debt.

The U.S. Treasury has been at the forefront of the crisis, but any leadership taken was not properly communicated. The result is, again, that policies have mostly been expensive, but have failed to unlock credit markets. Too often have the Treasury's rules changed; the policies in place continue to discourage private sector participation in helping to recapitalize financial institutions. Lou Jiwei, chairman of China Investment Corp., the country's sovereign wealth fund, puts it bluntly: "Right now we don't have the courage to invest in financial institutions because we don't know what problems we will put ourselves into." He spoke ahead of U.S. Treasury Secretary Hank Paulson's visit to China and added, "My confidence should come from government policies. But if they are changing every week, how can you expect that to make me confident?"

The only leadership that seems to be emerging is from the Federal Reserve determined to print not just billions, but trillions of dollars to provide the backstop to all economic activity; at the same time the policies are an insult to any potential buyer of securities the Fed has targeted, as the intervention keeps yields artificially low. As China has been one of the premier buyers of these securities, namely Treasury bonds and agency securities, this is a clear message by the Fed that Chinese investments to finance U.S. deficits is no longer welcome; why else would the Fed depress the return for potential buyers during a time when unprecedented amounts of debt need to be raised? While we are provocative in our allegation, it is at best an unintended consequence, at worst highly deliberate. Intentional or not, it may coerce Asian buyers of U.S. debt to reduce their holdings to allow the U.S. dollar to weaken. The Fed may believe that it does not need the free market to set rates as it can use its own balance sheet to set economic policy; this ill-perceived view is also shared by economists that believe modern central banking is stronger than market forces.

China can learn from these mistakes, but has no time to lose. Demand destruction in China is working its way through the economy there as well. The window for Chinese policy makers to lift the spirit of workers is closing fast: the Chinese New Year is an opportunity for workers to reunite with their family and friends; during those days, the mood of the country will be set for the year. Right now, stagnating wages, job losses and the bleak U.S. economy will dominate the dinner table discussions. Consumer spending in China has continued to hold up year over year, but there is a seriously accelerating slowdown under way. Far more effective than a spending program on infrastructure is a program to lift the spirit of Chinese consumers.

Lifting the spirit of Chinese consumers is not done by providing access to credit, but by giving the country a vision. It is already abundantly clear that the toy industry is faltering; but the high tech industry in China is performing well under the circumstances. In its recent history, China has embraced change and must do so now. This is the opportunity to get the country ready for the next phase in its economic growth. To do so, rather than subsidizing industries that have little chance to survive, the country should focus on where its strengths are likely to be in the years to come. China has a tremendous opportunity as the outsourcing partner for goods and services at the higher end of the value chain. Toy production should be left to other Asian countries; China has to focus on technology and innovation. Similarly, while building roads and power plants may provide a buffer to an economic slowdown, policies are required to encourage Chinese entrepreneurs to take risks and invest. An infrastructure stimulus plan will favor state controlled enterprises; to turn the mood in the country, government policies have to provide the general population with a vision, not merely state owned enterprises.

Once a vision for the future is embraced, it will become apparent that it is in China's interest to allow the renminbi to appreciate. Since early 2007, the European Union surpassed the U.S. as China's primary export market. The close link between the renminbi and the dollar reinforces the public's perception that the fate of the Chinese economy is linked to that of the U.S.; China has to become more self confident - removing the shackles of the current exchange rate regime may provide an important catalyst to energize a spirit of change. While a stronger currency would hurt industries that mostly compete on price, such as the toy industry, it would substantially increase the domestic purchasing power. The future of China is a more balanced economy with a stronger domestic sector as well as an export sector that competes on value, not price. China does not want to face the challenges of Vietnam, which only competes on price, ending up with extraordinary inflation and, ultimately, unable to sell to the U.S. anyway because American consumers cannot afford their mortgages.

China is not powerful enough to prop up U.S. consumer spending; as a result, it is far more efficient for China to use its reserves to help transition the economy for the future rather than use its reserves to buy U.S. government securities to stimulate the U.S. economy. The Fed has decided to take China's place in buying U.S. debt; let the Fed pursue its dangerous experiment. In the meantime, China should position itself for the future as the road ahead will, without a doubt, be rough.

We manage the Merk Hard and Asian Currency Funds, no-load mutual funds seeking to protect against a decline in the dollar by investing in baskets of hard and Asian currencies, respectively. To learn more about the Funds, or to subscribe to our free newsletter, please visit www.merkfund.com.

Axel Merk
Axel Merk is Manager of the Merk Hard Currency Fund

The Merk Hard Currency Fund is a no-load mutual fund that invests in a basket of hard currencies from countries with strong monetary policies assembled to protect against the depreciation of the U.S. dollar relative to other currencies. The Fund may serve as a valuable diversification component as it seeks to protect against a decline in the dollar while potentially mitigating stock market, credit and interest risks - with the ease of investing in a mutual fund.

The Fund may be appropriate for you if you are pursuing a long-term goal with a hard currency component to your portfolio; are willing to tolerate the risks associated with investments in foreign currencies; or are looking for a way to potentially mitigate downside risk in or profit from a secular bear market. For more information on the Fund and to download a prospectus, please visit www.merkfund.com.

Investors should consider the investment objectives, risks and charges and expenses of the Merk Hard Currency Fund carefully before investing. This and other information is in the prospectus, a copy of which may be obtained by visiting the Funds website at www.merkfund.com or calling 866-MERK FUND. Please read the prospectus carefully before you invest.

The Fund primarily invests in foreign currencies and as such, changes in currency exchange rates will affect the value of what the Fund owns and the price of the Funds shares. Investing in foreign instruments bears a greater risk than investing in domestic instruments for reasons such as volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. The Fund is subject to interest rate risk which is the risk that debt securities in the Fund's portfolio will decline in value because of increases in market interest rates. As a non-diversified fund, the Fund will be subject to more investment risk and potential for volatility than a diversified fund because its portfolio may, at times, focus on a limited number of issuers. The Fund may also invest in derivative securities which can be volatile and involve various types and degrees of risk. For a more complete discussion of these and other Fund risks please refer to the Fund's prospectus. Foreside Fund Services, LLC, distributor.

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