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August 12, 2005

China's Basket of Currencies Impacts Trading Partners
by Axel Merk

As the weighting of the U.S. dollar is decreased in aligning the yuan to a basket of currencies, People's Bank of China governor Zhou Xiaochuan has confirmed that the euro, Japanese yen and Korean won are "natural" key currencies to help manage the yuan: "...a basket of currencies can [..] better absorb the impact generated by an unstable US dollar ..." Aside from the major trading partners using these currencies, any country with which China conducts more than $10 billion in annual trade is likely to be included; the Australian, Canadian and Singapore dollars were mentioned, as well as the Russian ruble, Thai baht, British pound and Malaysian ringgit. The central bank governor said: "When you look at currencies used in trade settlement, although some countries and regions prefer US dollar as the currency for trade settlement with China, this situation is changing gradually and trade settlement in local currencies are increasingly the choice of trading partners."

China has not given details about the weightings applied to any currency. In our recent analysis, "A Snowball in the Making: China's Basket of Currencies," we mentioned that we believe China will emphasize countries with which it has a trade surplus or with which it would like to do more trade. By managing its exchange rate with a trading partner, China has a tool to subsidize trade with that region. Aside from the euro-zone, the target market with a significant growth potential, Australia, Canada and Russia are worthwhile pointing out. As China is rebuffed in its efforts to purchase natural resources from the United States, it may well want to acquire natural resources in Canada and Australia. China's resource hungry economy is keen on securing future demand; the public got a glimpse of this at the recently failed attempt to acquire Unocal by the state-controlled Chinese energy conglomerate CNOOC. Separately, Russia with its very large natural resources is an increasingly important partner for China.

The reduced interest in U.S. dollars already has an influence on the markets. While analysts disagree on the weighing of the U.S. dollar in China's basket of currencies, it is certainly less than the 100% that was in place when the currency was pegged to the dollar with analysts estimating the dollar allocation to be between 30% and 70%. In our view not coincidentally, at a $13 billion U.S. government bond auction on August 8, foreign central banks and investors "surprised" the markets by their lack of interest. According to Bloomberg, these so-called primary dealers purchased 22 percent of the debt sold, the smallest percentage since June 2003.

Indeed, the lack of foreign interest may be a sign that international investors will eventually require higher interest rates as the U.S. dollar requires ever larger foreign investments to feed its current account deficit; while we caused headlines by quoting estimates of a current account deficit that may reach $900 billion in 2006, we have seen higher estimates by reputable economists since. Foreign investments in the U.S. are to a large extent through the purchases of U.S. debt. The Financial Times in an article on August 10, 2005, brings the rise in associated interest payments to the point: "By the end of the year - and for the first time since records began in the 1960s - the U.S. is likely to be paying more to service its debts than it receives in foreign income. As this happens America will find itself borrowing not just to fund current spending, but simply to service previous debts."

We warned only about a week ago that the U.S. is getting ever more sophisticated in financing its debt obligations, and that the way the U.S. refinances its obligations, is not so different from consumers financing their lifestyle by taking negative amortization mortgages out on their homes. It looks like the future is shaping up faster than we anticipated. Issuing debt to merely service your interest payments is a practice more commonly associated with third world countries, with inflation and hyperinflation.

We have been asked why we do not include the Japanese Yen in the basket of hard currencies the Merk Hard Currency Fund invests in. At this stage, we focus on currencies whose central banks have shown responsibility by not heavily intervening in the currency markets. Japan has made it very clear, both through statements and actions that they are not interested in having their currency rise (against the yuan or the U.S. dollar) and have their country fall back into deflation as a result. It may well be that Japan at some point may have to cave in and let its currency rise; however, that's a game for the speculator, as Japan alternatively may succeed in its efforts to destroy its currency. We see a similar risk in much of Asia, a region so desperate to sell to U.S. consumers that it may be willing to sacrifice its currency. For example, the only certainty about South Korea's monetary policy is that they are very nervous about the U.S. dollar. Singapore's monetary policy is not driven by money supply or interest rates, but very explicitly by targeting desired exchange rates. This may work during normal times and be in the interest of a small trading-oriented country such as Singapore, but it is difficult to predict how Singapore would react should currency markets become much more volatile. Instead of speculating how rather unpredictable countries may react as the dollar continues to fall out favor, we focus on currencies that enjoy benefits from the turmoil without carrying the same degree of political risks. The Merk Hard Currency fund focuses on currencies with central banks that have a track record in pursuing price stability; currencies that are very liquid and can cope with the additional inflows as China and other Asian countries are likely to build higher reserves in these. We treat gold as a hard currency. Unlike other similar products, we do not see the Merk Hard Currency Fund as a speculative tool, but as a long-term investment that seeks to profit from the potential decline in the dollar while at the same time diversifying one's portfolio.

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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