Gold's record rally has been attributed to everything from worries about inflation, the dollar and the emergence of exchange-traded funds. One big factor many may have missed: huge buying from China.

Data cited Thursday by China's state-run Xinhua news agency showed that China imported 209.7 metric tons of gold in the first 10 months of the year, a fivefold increase compared with the same period last year.

That surpassed purchases made by ETFs and surprised analysts, who until now had no clear insight into the size of China's buying.

…

"Everybody in the gold market knew there was a surge in investment demand, but they didn't know it was China," said Jeff Christian, managing director at CPM Group.

China's import growth is a reminder of the country's huge but nascent purchasing power.

It comes as the government loosens its restrictions on gold purchases by financial institutions and individual investors. In August, the country began allowing more banks to import and export gold, opening up the gold market to the institutions and their clients.

Then this week, the Chinese securities regulator approved the country's first gold fund designed to invest in overseas-listed gold ETFs, a move analysts interpreted as another bullish sign for gold.

"The big picture is that China is continuing to relax the rules governing the domestic gold market," said Martin Murenbeeld, chief economist of DundeeWealth Inc., which oversees $69.9 billion in assets. "What we are seeing is the latent demand that has been there all the time and now can be exercised in the market because now the market is freed."

The World Gold Council estimates that China's gold demand could double in 10 years as more investors there embrace precious metals.

Until several years ago, China's gold market was strictly controlled by the central bank, which bought all the gold mined domestically. It then sold the metal to jewelry makers. The country, which is now the largest gold producer, remained largely self-sufficient in gold, with imports at a meager 31 metric tons in 2009, according to GFMS Ltd.

This year, fears of inflation have driven many Chinese investors to include gold in their portfolios as a store of value. At the Shanghai Gold Exchange, trading volume increased 43%, to 5,014.5 tons, in the first 10 months of 2010, exchange Chairman Shen Xiangrong said, according to Xinhua.

At a speech at the China Gold and Precious Metals Summit in Shanghai Thursday, Mr. Shen detailed the size of China's imports this year, Xinhua said. Those purchases were big enough to absorb all the gold that the International Monetary Fund had shed during that time period, which stood at 148.6 tons. It also dwarfed the SPDR Gold Shares, the world's largest gold-backed ETF, which added 159.48 tons of gold into its holdings in the same period.

China also is home to a booming gold-mining industry that keeps it as the world's largest gold producer. Wednesday, China's Ministry of Industry and Information Technology said the nation's gold production reached 277.017 metric tons in the January-to-October period, up 8.8% from the same period last year.

China's 2010 gold production is expected at about 350 metric tons, according to Standard Bank head of commodity strategy Walter de Wet.

So far this year, Chinese RMB has appreciated 3.1% against the US dollar. But it has depreciated against majority of other currencies (especially the currencies of the emerging market) on trade-weighted basis. 

Marty Feldstein forecast that with domestic inflation rising, China is likely to accelerate the pace of its currency appreciation so to achieve at least two goals: 1) contain domestic inflation through lower import prices of commodities; 2) increase real income of domestic consumers again through lower prices of foreign imported goods.

Link to the full text of Marty's piece.

According to WSJ, China's securities regulators are allowing mainland Chinese to invest in foreign exchange-traded gold funds for the first time, unleashing the full buying power of the world's second-biggest economy on funds that already own more gold than most central banks.

Robert Barro shares his thoughts on the Fed's QE2 operations on Economist.  This is by far the most damaging piece I've seen from a renowned macro-economist.  His main point is that raising interest rate on excess bank reserves will be equal to raising interest rate through the normal open-market operations, which is highly contractionary.  As Allan Meltzer argued many times before, if the Fed does that when the unemployment rate is still high, the Fed will face very strong opposition on the political front.

I am skeptical about Fed's exit strategy for another reason.  I think the Fed will never get the timing of exit right.  With so much excess reserves in the system, liquidity most likely will skyrocket through shadow banking system, which will coincide with a rapid pickup of money velocity. The Fed will have to raise interest rate quickly and sharply, otherwise, it risks a hyperinflation.

Now let's digest Barro's piece.  The highlights are mine.

A LOT has been written recently, pro and con, about the Fed’s new round of quantitative easing, dubbed QE2. But, frankly, much of the discussion on both sides lacks a coherent analytical framework for thinking about the key issues. I try here to provide such a framework.

The Fed, personified by its chairman, Ben Bernanke, is concerned about the weak economic recovery and, particularly, by the possibility of future deflation. To counter this tendency, the Fed plans a new round of monetary expansion. The main conclusions that I reach are:

• In the present environment, where short-term nominal interest rates are essentially zero, expansionary open-market operations involving Treasury bills would do nothing (a point with which the Fed concurs).

• Expansionary open-market operations featuring long-term Treasury bonds (QE2) might be expansionary. However, this operation is equivalent to the Treasury shortening the maturity of its outstanding debt. It is unclear why the Fed, rather than the Treasury, should be in the debt-maturity business.

The most important issue, of which the Fed is keenly aware, involves the exit strategy for avoiding inflation once the economy has improved and short-term nominal interest rates are no longer zero. The conventional exit strategy relies on contractionary open-market operations, but the worry is that this strategy would hold back an economic recovery. The Fed believes that paying higher interest rates on reserves gives it an added instrument that will help the economy recover more vigorously while avoiding inflation. I think this view is incorrect. I find that:

• In an exit strategy, raising interest rates on reserves to match rising interest rates on Treasury bills is equivalent to a contractionary open-market operation whereby the Fed cuts reserves along with its holdings of bills. Therefore, increasing interest rates on reserves is just as contractionary as the standard exit strategy.

• We can compare instead with an exit strategy whereby the Fed reduces the quantity of reserves and its holdings of long-term Treasury bonds. This operation is equivalent to the above strategy plus a lengthening of the maturity of the Treasury’s outstanding debt, something the Treasury can accomplish or avoid without help from the Fed.

As a background, the Fed has, since August 2008, expanded its balance sheet by around $1 trillion. Thus, the Fed has roughly $1 trillion more in assets (dominated by mortgage-backed securities, but that can be the topic of a different column). On the liability side of the Fed’s ledger, excess reserves that pay close to zero interest have expanded by about $1 trillion. Institutions are willing to hold this vast amount of non-interest-bearing claims because of the weak economy; in particular, the financial crisis dramatically increased the demand for low-risk assets, such as reserves held at the Fed. Because of this rise in demand, the dramatic expansion of the quantity of "money" has not yet been inflationary.

For institutions that can hold reserves at the Fed, excess reserves are essentially equivalent to Treasury bills. Therefore, interest rates paid on these two forms of assets have to be nearly the same; in the present environment, both rates are close to zero. If the Fed carries out a conventional expansionary open-market operation, whereby it buys more bills while creating more reserves, the private sector ends up with fewer bills and correspondingly more reserves. Since institutions regard these two claims as essentially the same, there are no effects on the economy; that is, no effects on the price level, real GDP, and so on.

If the Fed does QE2, then it essentially adds to the conventional open-market operation a sale of Treasury bills and a purchase of long-term Treasury bonds. Bills and bonds are not the same, as evidenced by the difference in yields—bills are paying 0.1% while ten-year bonds are paying almost 3%. The hope is that the smaller quantity of long-term Treasury bonds outstanding (outside of the Fed) will tend to raise their price or, equivalently, lower the long-term yield. This reduction in long-term rates might spur aggregate demand. This reasoning may be correct but, as already noted, it has to be the same as the Treasury changing the maturity structure of its debt; that is, funding with more short-term and less long-term debt.

The exit strategy comes into play when and if the economy has improved and, hence, institutions no longer have an enormous demand for low-risk excess reserves that pay zero interest. If the Fed kept the interest rate on reserves at near zero and had no contractionary open-market operations, the extra $1 trillion of reserves would become highly inflationary. To avoid the inflation, the standard policy would be contractionary open-market operations that reduce the quantity of "money".

The Fed thinks it can improve on the exit strategy by instead raising the interest rate paid on reserves. For example, if rates on Treasury bills rise to 2%, the Fed could pay around 2% on reserves to induce institutions to maintain the excess reserves of $1 trillion held at the Fed. However, at that point, it would still be true that open-market operations involving reserves and bills would not matter. That is, the Fed’s selling off $1 trillion of Treasury bills (if it had that much) in exchange for $1 trillion of reserves would have no effect. This reasoning implies that the exit strategy of raising the interest rate on reserves in tandem with the rise in interest rates on bills is equivalent to the standard contractionary open-market policy. That is, the effects on the real economy are the same.

In practice, the alternative to raising interest on reserves is not a massive sale of Treasury bills (which the Fed does not possess) but, rather, selling off a large portion of the assets accumulated since August 2008. After QE2, this would likely be mostly Treasury bonds but it could also be mortgage-backed securities. When compared to selling bills, the sale of bonds has the reverse of the effect discussed before—the extra bonds would likely require a reduction in price, corresponding to a higher long-term yield and, thereby, an added contractionary force. But, again, the Treasury could offset this effect by changing the maturity structure of its outstanding debt (by shifting toward bills and away from bonds).

My conclusion is that QE2 may be a short-term expansionary force, thereby lessening concerns about deflation. However, the Treasury can produce identical effects by changing the maturity structure of its outstanding debts. The downside of QE2 is that it intensifies the problems of an exit strategy aimed at avoiding the inflationary consequences of the Fed’s vast monetary expansion. The Fed is over-confident about its ability to manage the exit strategy; in particular, it is wrong to view increases in interest rates paid on reserves as a new and more effective instrument for accomplishing a painless exit.

Interview of Shan of TPG on private equity investing in China.  Shan echoes Jereme Grantham’s view that high growth does not equal high return or profitability.

Link to the interview at FT

This is rare. Only happens when there is great cause of concern.

Open Letter to Ben Bernanke

The following is the text of an open letter to Federal Reserve Chairman Ben Bernanke signed by several economists, along with investors and political strategists, most of them close to Republicans:

We believe the Federal Reserve’s large-scale asset purchase plan (so-called “quantitative easing”) should be reconsidered and discontinued.  We do not believe such a plan is necessary or advisable under current circumstances.  The planned asset purchases risk currency debasement and inflation, and we do not think they will achieve the Fed’s objective of promoting employment.

We subscribe to your statement in the Washington Post on November 4 that “the Federal Reserve cannot solve all the economy’s problems on its own.”  In this case, we think improvements in tax, spending and regulatory policies must take precedence in a national growth program, not further monetary stimulus.

We disagree with the view that inflation needs to be pushed higher, and worry that another round of asset purchases, with interest rates still near zero over a year into the recovery, will distort financial markets and greatly complicate future Fed efforts to normalize monetary policy.

The Fed’s purchase program has also met broad opposition from other central banks and we share their concerns that quantitative easing by the Fed is neither warranted nor helpful in addressing either U.S. or global economic problems.

Cliff Asness
AQR Capital

Michael J. Boskin
Stanford University
Former Chairman, President’s Council of Economic Advisors (George H.W. Bush Administration)

Richard X. Bove
Rochdale Securities

Charles W. Calomiris
Columbia University Graduate School of Business

Jim Chanos
Kynikos Associates

John F. Cogan
Stanford University
Former Associate Director, U.S. Office of Management and Budget (Reagan Administration)

Niall Ferguson
Harvard University
Author, The Ascent of Money: A Financial History of the World

Nicole Gelinas
Manhattan Institute & e21
Author, After the Fall: Saving Capitalism from Wall Street—and Washington

James Grant
Grant’s Interest Rate Observer

Kevin A. Hassett
American Enterprise Institute
Former Senior Economist, Board of Governors of the Federal Reserve

Roger Hertog
The Hertog Foundation

Gregory Hess
Claremont McKenna College

Douglas Holtz-Eakin
Former Director, Congressional Budget Office

Seth Klarman
Baupost Group

William Kristol
Editor, The Weekly Standard

David Malpass
GroPac
Former Deputy Assistant Treasury Secretary (Reagan Administration)

Ronald I. McKinnon
Stanford University

Dan Senor
Council on Foreign Relations
Co-Author, Start-Up Nation: The Story of Israel’s Economic Miracle

Amity Shales
Council on Foreign Relations
Author, The Forgotten Man: A New History of the Great Depression

Paul E. Singer
Elliott Associates

John B. Taylor
Stanford University
Former Undersecretary of Treasury for International Affairs (George W. Bush Administration)

Peter J. Wallison
American Enterprise Institute
Former Treasury and White House Counsel (Reagan Administration)

Geoffrey Wood
Cass Business School at City University London