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June 27, 2005

China: U.S. Dollar may not be Worth the Paper it is Printed on
by Axel Merk

The $18.5 billion bid by China's state-controlled Cnooc Ltd. to purchase the American energy company Unocal has created fear, anger and calls for intervention among U.S. politicians. As the U.S. trade deficit, currently around 6% of Gross Domestic Product (GDP), continues to climb, China has access to vast amounts of U.S. dollars that it has hoarded over the years. Until recently, Chinas has simply been buying U.S. Treasuries. In recent months, it has become clear that China is becoming a more active investor, showing interest in natural resources (timber, oil and gas assets) and U.S. enterprises (IBM's personal computer business and Maytag, among others).

China, already the world's largest importer of many raw materials, anticipates dramatically higher energy and natural resource requirements in the years ahead. The world's oil production capacity, according to some estimates, is approaching its peak and there will be increased global competition for natural resources. While China is securing capacity, the United States has not built additional oil refineries since the 1970s (nor have any nuclear reactors been built since).

In the meantime, the U.S. is consuming goods imported from China at a record pace. Because of the tremendous trade deficit, the Chinese are sitting on hundreds of billions of U.S. dollars. Now, as the Chinese want to use this money wisely, U.S. politicians cry foul. The Chinese must wonder whether the U.S. dollar is worth the paper it is printed on. It is acceptable to use dollars to buy consumer goods, but if they are put to use to invest in the future, red lights go off in Washington.

Warren Buffett has long argued that the U.S. trade deficit is akin to selling out U.S. assets to foreigners. His once abstract warnings are now becoming vividly clear: With a huge trade deficit, foreigners are going to own ever larger chunks of U.S. assets. And unlike Americans, who seem to derive great satisfaction from consuming goods frequently with a nearly insatiable appetite, the Chinese are investing in their energy needs of the future.

That is not to say that the Cnooc bid and others from China are not shocking. The culprit, however, is not the Chinese government, but the U.S. fiscal and monetary policies that foster an environment of exploding trade imbalances and abysmal domestic savings. We believe this policy puts long-term pressure on the dollar, especially as Asian countries realize that their dollar reserves will not be honored if they are used for something of value to them.

As far as this particular transaction is concerned, Cnooc is only interested in the Asian assets of Unocal and will spin-off the U.S. assets. U.S. calls to intervene are unlikely to be successful as it is difficult to argue that U.S. "national interests" are being jeopardized the way this offer is structured. What bugs many is that Cnooc is 70% state controlled and has access to financing at below market rate interest rates. According to Chevron, also interested in acquiring Unocal, this is unfair state intervention.

Politicians will fight over this transaction in the coming weeks and may be able to force China to open up their markets further, so that foreigners can take control of more Chinese owned firms. But much of the discussion will miss the point: China, having become a major player in the global market with deep pockets, will want to put its dollars to use. The Chinese have subsidized their currency to sell cheap goods to the U.S. In return, they have accumulated billions of dollars. Now they will find out whether these dollars are worth anything at all as they try to use them to secure their future natural resource needs. If disappointed, China and other Asian countries may accelerate their diversification out of the U.S. dollar and into a basket of hard currencies.

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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