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April 19, 2005

Gold: Debt - Supersize Me
by John Ing

America faces "huge imbalances, disequilibria and risks". "If we can believe the numbers, personal savings in the United States have practically disappeared....and the nation is consuming more than it is producing". "Altogether, the circumstances seem as dangerous and intractable as I can remember, and I can. What really concerns me is that there seems to be so little willingness to understand or capacity to do much about it ... As a nation we are consuming and investing about six per cent more than we are producing. What holds it all together is a massive and growing flow of capital from abroad..." "It is more likely than not that it will be a financial crises rather than policy foresight that will force the change." "So I think we are skating on increasingly thin ice." Paul Volcker, former chairman of the Federal Reserve Board, February 11, 2005

Awash With Liquidity
Alan Greenspan's predecessor is right but is anyone listening? Today there is too much liquidity in the world pumped largely by America. Not only is America pursuing a lax policy, it has flooded the world with liquidity. In the 1980s, too much capital flooded into Japan's stock and property markets, eventually ending in a collapse. Speculative investment in telecommunications in the late 90s contributed to the dot-com bubble which also collapsed leaving too much capacity and a heavily indebted financial sector. And today, this liquidity has again spawned a series of asset-based bubbles poised to burst. This excess is sloshing around the global capital markets, as investors seeking higher returns take on increased risks since there is too much competition for too few deals.

As an example, in lemming-like fashion, the hedge funds have followed each other into the oil markets setting new highs despite slower demand this spring. There are other parallels as real estate crazed investors push new homes sales up the most in four years to record levels. The housing and oil boom are similar to the irrational exuberant stock market bubble of the late the nineties, when Greenspan kept interest rates low. The common denominator? Mr. Greenspan's rock-bottom interest rate policy.

The Debt Trap
The Americans have recklessly mortgaged their future. They are faced with little savings and a mountain of debt. Foreigners own $8.1 trillion in US financial assets or 74 percent of US GDP. And the government is currently running a $500 billion budget deficit and a whopping $700 billion current account deficit. The Americans import too much oil and too much capital. And not surprisingly, this deficit financing has led to a corruption of its financial icons.

A good part of US expenditures has also gone to pay for George Bush's "War on Terrorism", which has surpassed $500 million. Not only is the war expensive, but Bush has mired US policymakers and its troops in a quagmire similar to that of Lyndon Johnson's Vietnam debacle. The US appears determined to replicate the mistakes of the Vietnam War. Like before, Bush unseated the Talibans in Afghanistan, but the troops are still there. And then he went into Iraq and despite free elections, US troops are still in Iraq. Mr. Bush will discover, like former President Johnson, wars are like roach hotels, they are easy to get into but there is no way out. And, just when the Administration should be looking for an exit, the Bush forces appear to be opening a new front against Iran and Syria. Just where is this stepping stone strategy going to take the Americans and at what cost?

The Gusher of Liquidity
While America has flooded the world with liquidity, the risks of a burst bubble increases everyday, as conditions deteriorate on three fronts.

First, rising property prices poses risks to the financial markets, particularly since the Fed has taken the punch bowl away. We believe that monetary tightening is not only inevitable but needed against the backdrop of mounting inflation, record deficits and of course bubble-like oil and property markets. America's high consumption economy now requires almost $3 billion of capital inflows per day. Yet the Administration refuses to co-operate.

Second, not only has President Bush not vetoed anything, but in a so-called period of restraint, he proposes to expand Medicare by $23.5 trillion. It has become increasingly difficult to finance these deficits of historic proportion. Furthermore to make US securities more attractive to foreigners, the Fed has raised the federal fund rate seven times, yet real interest rates are negative and the "carry trade" still favours non-dollar securities. Real interest rates averaged three percent in the eighties and nineties, and are still too low by historic standards. And so, the Fed must increase rates even further, and therein lies the risk.

Third, because the US consumes much more than it produces and owes abroad much more than it owns, a near zero savings rate has forced them to borrow heavily to finance their deficits. The rapidly growing current account deficits is now approaching $700 billion or more than six percent of the entire American economy. The US current account deficit, the amount by which imports exceed exports, widened by thirteen percent in the fourth quarter, raising the current account for all 2004 to a record $665 billion, or 3.6 percent of gross domestic product another record. In March, the deficit recorded a record $61 billion of red ink. Yet, despite the three-year drop in the dollar, the US external balance continues to grow, meaning more dollars must be exchanged for other currencies to pay for purchases from abroad. Worst still the budgetary deficit continues to grow. It is impossible to finance the fifty percent increase in spending as a percentage of US gross domestic product with even larger deficits.

The US Dollar: Seismic Shock
The US has become the world's largest debtor and despite a "dead cat" bounce, the dollar has fallen more than 30 percent in the past three years. Rather than keep eighty percent or more of their reserves in dollars, the world's largest creditors, the Asian countries appear to have adopted a more diversified approach in line with their trade patterns, currency risks and political considerations. The US dollar was shaken by a seismic shock as Prime Minister Koizumi of Japan said they would consider diversifying their huge reserves away from the greenback. Japan has the largest build up of reserves at $840 billion with the majority in greenbacks but last month lost $110 billion due to the fall of the dollar. Over time it was inevitable that the Asians would lose their appetite for dollars. Asian central banks are stating the obvious - they have too much dollar-denominated assets. Even South Africa reduced its dollar exposure in the latest quarter.

And, the US is in no position to dictate or warn others about their finances. For example, in response to the US Senate's threat to impose economic sanctions should Beijing not unpeg the yuan, Foreign Ministry spokesperson Qin Gang cited the IMF's latest analysis that China's currency does not appear undervalued. He warned, "China has traded surpluses with the United States yet the country is experiencing a big trade deficit with many of its trading partners", adding that the United States should adjust its economic imbalance by looking at its own reserves.

Global realignment will require a huge inflow of foreign capital to finance America's debt. Without foreign investment, the Americans must look inward and there is neither the adequate savings nor political support for higher rates. The likelihood then is that the Fed must further devalue its currency, debase its debt and inflate its way out - ironically a recipe for even higher interest rates and higher prices.

Between 1985 and 1987, the greenback fell by 50 percent with inflation and bond yields soaring. In October 1987, the stock market crashed. Today, America's current account deficit is twice as big as it was then, so the coming fall in the dollar and fallout could be larger. It is our view that that the sustainability of subsidizing the Americans, propping up their asset markets and keeping the overextended American consumer afloat is at an end and that America's house of debt is ready to collapse. Gold is a good thing to have.

Gold is an Alternative Investment to The Dollar
Spurred by the UK government, the IMF is being asked to sell some of its huge gold reserves, to finance about $11 billion of Third World debt. The value of the IMF reserves today is approximately $45 billion. Any proposal must require the United State's approval, who has a thirteen percent voting stake which is an effective veto over any proposal. While the IMF has floated a number of trial balloons, ranging from the sale of anywhere from sixteen percent of its reserves to as high 55 percent, the proposals have been met with muted silence. We believe that IMF sales is a non-starter, due not only to the lack of American approval but also the fact that a great many of its constituents would actually bid for this gold. The Asian central banks for example have less than two percent of their reserves in gold and hold the world's largest foreign exchange reserves. Any gold sale by the IMF would be swamped with bids, further altering the landscape whereby the world of debtors owe the world's creditors even grander sums. Gold is an alternative investment to the dollar for these central banks.

Recommendations - Gold Stocks Get No Respect
Despite gold bullion trading within six percent of its sixteen year high, gold stocks have been disappointing performers. For the past nine months, gold stocks have been the Rodney Dangerfield of the stock market, getting NO RESPECT.

Part of the reason is that the gold producers themselves have become serial fundraisers, diluting themselves because underwriters were offering them loads of cash. Today, most of the gold industry is cashed up with no place to go. Cambior for example, raised $110 million in equity to finance the acquisition of a 55.3 percent stake in Poderosa in Peru. That deal fell apart but Cambior kept the money.

Another reason for the lagging performance of the gold stocks is the lack of discoveries. Drilling by Virginia Gold Mines at the Éléonore in Opineca region of Quebec is expanding and is one of the few exciting developing gold plays. Three drills continue to test two major zones. The White Knight Resources play was delayed last year but has begun an active drill program in the Cortez trend in Nevada. White Knight plans a three-hole program at Slaven Canyon, located about eighteen miles north of the Pipeline complex. Teck Cominco will drill Fye Canyon located eight miles southeast of the recently discovered Cortez Hills Pediment deposit. The mining industry is getting no respect because the dearth of exploration expenditures has resulted in few discoveries to replace depleting gold reserves and declining production. As such the senior producers found it easier to buy ounces on Bay Street than to spend the necessary money in the ground.

The industry is also faced with sagging gold production. Mines are getting deeper and costs are rising. The world's biggest gold producer, South Africa's gold production fell to just 342.7 tons last year, the lowest output in 74 years. Demand remains strong, but there have been few new companies formed. Today, the industry's cost of production is between $300- $350 per ounce. Reserves in the ground go for more than $200 an ounce. Industry costs for finding and development have been rising faster than the price of gold, causing an inflation of big projects such Pasqua, Pueblo Viejo and Boddington. While gobbling up reserves on Bay Street can work in the short term, at some time the industry will have to foot the bill to find and develop new deposits.

With the intermediate producers consolidating now that Goldcorp has been created, there is pressure on Meridian, Agnico-Eagle, Kinross, Glamis and the perennial bridesmaid IAMGold to merge. As such we continue to expect further consolidation in the intermediate category and given the lack of interest in the juniors, we also expect the smaller junior producers to be gobbled up by the intermediates. Eldorado Gold, Crystallex International and Bema Gold are likely merger candidates.

But what will cause gold stocks to perform better. Undoubtedly continued takeover activity would heat action in certain stocks. What will move stocks is the price of bullion. We believe that once gold breaks out of its tightly defined trading range and gaps through to our target of $510 an ounce, gold stocks will be much sought after. The seeds of gold's nonperformance ironically will provide the growth to gold stocks' next big second leg.

Companies

Bema Gold Corp
Bema's shares collapsed in part due to big writedowns and the delay in the start up of joint venture Refugio in Chile (Bema's share of production will drop by 25,000 ounces to 50,000 ounces this year). Nonetheless, the company reported production guidance of 300,000 ounces up from 230,000 ounces last year. Bema's results were hurt by South African Petrex and increased costs at Julietta. Offsetting the bad news was the expected upgrade in the resource estimate for Kupol due in part to infill drilling. A feasibility study is expected shortly and Bema will begin financing talks later this summer. While Bema has been able to add reserves at several of its operations, the inevitable hiccup has resulted in investor disenchantment. In addition, with the bulk of its reserves in Russia and high cost South Africa, the market places closer scrutiny on Kupol and the developments at Refugio and of course Cerro Casale. At Cerro Casale, the proposal to acquire Arizona Star appears to be a situation where the company is taking on more than it can chew. Nonetheless, Bema shares are attractive at current levels given the array of development-type opportunities.

Crystallex International Corporation
Crystallex reported huge write-downs but made substantial progress in advancing the Las Cristinas project in Venezuela. Management is confident that the Venezuelan government will award the long awaited final environmental land use permit before the end of May. The company had a number of meetings with the new environmental minister, Jacqueline Farias, and her staff. The granting of the permit will allow Crystallex's management to begin construction at an initial rate of 20,000 tonnes per day. The company anticipates expanding the project to 40,000 tonnes per day, which would average 500,000 ounces at an average total cash cost of less than $200 over the next twenty years. Crystallex has more than $130 million in cash and thus is able to finance Las Cristinas into production. To date detailed engineering has been completed and the company has begun a road into the project. With more than 12.8 million ounces, Las Cristinas is one of the largest undeveloped gold deposits in the world. We believe that the granting of the permit will prove to be the starting gun and expect corporate suitors. As such we continue to recommend purchase.

Eldorado Gold Corp.
Eldorado results were as expected including the charge to operations at its 100 percent owned mine in Sao Bento in Brazil. Eldorado's new 5 million ounce Kisladag mine in Turkey is on budget and will produce 164,000 ounces of gold next year, increasing to more 240,000 ounces a year after. Also in Turkey, Eldorado is going through the important environmental assessments at Efemcukuru, which is supposed to be an underground operation. Eldorado shares have lagged but with new production at Kisladag together with Sao Bento, Eldorado will at long last have its other mine. We continue to recommend purchase of this unhedged producer.

Newmont Mining Co.
Newmont is the world's largest gold company providing excellent leverage to a rising gold market. Newmont should produce 6.6 million ounces this year from five continents, down from 7 million ounces due to the delays at Boddington in Australia. The company has an excellent balance sheet together with core holdings in Nevada, Peru and Australia and a large land position. Newmont importantly has a no gold hedging philosophy. In addition, the company's royalty business provides $100 million of cash flow annually which covers Newmont's G&A. The royalty and equity portfolio can provide the basis for future acquisitions. Newmont shares have lagged due in part to the industry-wide difficulty in replacing reserves and production. Moreover, the company has problems in Indonesia and increased costs at Yanacoha in Peru. Nonetheless these problems are discounted in the stock price and we believe that Newmont's shares offer good value here and we recommend purchase.

Northgate Minerals Corporation
Northgate is a 300,000 ounce per year copper/gold producer whose Kemess South mine is in northcentral British Columbia. Kemess' results in the first part of this year will be weaker due in part to an expected decline in gold/copper grades and thus lower production is expected. Northgate has completed much of the work on nearby Kemess North, which is needed since Kemess South runs out of ore in 2009. Kemess North has more than 4.1 million ounces of gold and 1.5 billion pounds of copper and the development would extend the current mine life to 15 years. However given the expected lengthy permitting process together with dealing with the First Nation group, Northgate should look for an acquisition or merger candidate. Northgate has excellent open-pit experience and thus could be a good merger candidate. Consequently we continue to recommend the shares.

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John R. Ing
Maison Placements Canada
130 Adelaide St. West - Suite 906
Toronto, Ont. M5H 3P5
(416) 947-6040

Disclosures:
Rating Structure
Analysts at Maison use two main rating structures: a performance rating and a number rating system.
Performance Rating: Out perform: The target price is more than 25% over the most recent closing price. Market Perform: The target price is more than 15% but less than 25% of the most recent closing price. Under Perform: The target price is less than 15% over the most recent closing price.
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