"China also bought 590,000 tonnes of aluminium, 159,000 tonnes of zinc, 30 tonnes of indium and 5,000 tonnes of titanium, said Yu, who works in the National Development and Reform Commission's industry department." Now that metals prices have rebounded, though, will the stockpiling continue, even at high prices? Or was it a case of bargain shopping at everyday low prices?

There are several components of demand. There's real economic demand (you need the stuff to make other stuff). There is investment demand (you're buying it in order to make a profit from what you think the price trend is. There is also pure speculation, and it's possible that some middle-men were flat-out speculating by buying alongside China's State Reserve Bureau (sort of like the banks and brokers in the U.S. buying Treasuries ahead of the Fed late last year to improve Q4 earnings).

But if you're trying to figure out the ultimate direction of certain base metals prices (or commodity prices in general) you have to also consider the currency in which they're priced. Or, as my colleague Dan Amoss writes, "You also want to consider what Ben Bernanke and Tim Geithner will do to debase the dollar in the coming years. If you're a foreign creditor facing with this constant portfolio decision, which has higher marginal utility? Is it 1.) US$2.32 or, 2.) one pound of copper?"

Dan is referring to a pretty handy economic concept. Marginal utility is the economist's attempt to quantify how much satisfaction or benefit you get out of each additional good or service you buy. You have probably heard the term "diminishing marginal utility" more often.

An easy way to understand this is that while one cheeseburger may satisfy your appetite (and your craving for animal fat), four cheeseburgers gobbled down in a row are neither useful nor terribly good for you. They might even be bad (although as an American, we are reluctant to concede this point).

In Dan's scenario, U.S. dollar holders will ask themselves if each additional dollar owned is more useful. Given the fact that the U.S. monetary authorities are making so many dollars, it's pretty clear that each additional dollar added to supply makes each existing dollar less useful. It is not very satisfying to see a methodical reduction in the purchasing power of your savings.

If Dan is right, then stockpiling real assets (even during a relatively weak economy) makes more sense that stockpiling U.S. liabilities. Or, as Dan says, "The Chinese will probably go with #2, especially because copper (and oil, and iron ore) can be stored and used in infrastructure projects to keep the population somewhat placated with infrastructure jobs," says Dan.

He adds that you should look for the Chinese to stockpile resources on the dips in commodity prices, while selling/divesting of U.S. Treasuries into the rallies that come with 'safe-haven' buying. That sounds right to us. But the only catch to the plan is if Treasuries fail to rally on safe haven buying.

On that score, the Treasury market seemed to survive last week's big auction without a huge spike in yields. If the economic news remains neither bullish nor exceptionally bearish, then we reckon Treasuries could rally (prices up, yields down), providing a discrete exit opportunity for certain large investors.

Incidentally, we still haven't seen much in the Australian press about the long-term consequences of government deficits. That's probably because most people are accepting the government's case that Australia's borrowing (and its deficits) will be temporary. We're not as sure. And besides, there are some serious questions about how structural deficits affect a country's currency, its credit markets, and its interest rates.

Those are just some of the questions we hope to take up at our upcoming debt symposium/summit, which will precede the first Australian screening of I.O.U.S.A. We've even picked a date, booked a venue, and secured a cracking panel of experts to train their eye on Australia's very own addiction to debt. Stay tuned for your official invitation!

Meanwhile, did you see that China has astonishingly and rather conveniently discovered some 3 billion metric tonnes of hematite and magnetite iron ore? It's apparently true, and probably comes in pretty handy during the current stagnated annual price contract discussions with Aussie iron ore producers BHP Billiton and Rio Tinto.

As you know, China is the world's largest steel maker and thus the largest importer of iron ore. Chinese geologists claim they have found Asia's largest iron ore deposit ever in Benxi city, which is in the northwest province of Liaoning. The good news is that the deposit is said to be about 2.5 miles long and 1.8 miles wide and could, officials say, have a mine life of 50 years-if a mine is built.

The bad news is that the resource (not a reserve because it's not know if it can be produced economically) is buried around a mile underground. That's a long way down, or a long way to lift iron up, if you prefer, and if you're strong (which China is).

Contrast that with the Pilbara, where the stuff seems to lying around waiting to be found in the hundreds of millions of tonnes by any Tom, Dick, or Kerry. That's right. Iron Ore Holdings, owned by Kerry Stokes, told the ASX yesterday it was increasing by 50% its estimate of its mineral resource at Iron Valley in Western Australia.

This deposit is only 97 metres below ground. It's surrounded by big projects by BHP, Rio, and Fortescue. And the company says it reckons its sitting on a 132 million tonne resource-which is up from the 88 million tonnes it believed it had just three months ago.

Proving up a resource into a reserve-and seeing your share price benefit because of it-is the name of the game for the iron ore juniors. Despite the big Chinese find, we reckon the Iron Valley story is where the Big Picture meets the Little Juniors (or where the rubber meets the road, if you prefer).

At the right prices, stockpiling commodities makes sense to people who will need them later anyway and already have too many U.S. dollars. And if prices aren't right...if..in fact...commodity prices decline (either because of slow economic growth or a halt in stockpiling) then commodity stocks probably fall a bit too...which makes those very stocks-especially the smaller ones that need capital and JV partners-the next logical candidates for acquisition or accumulation.

Dan Denning
for The Daily Reckoning Australia

• Australian Iron Ore Shares on China’s Menu
• India Beats China to Walk Away With 200 Tonnes of IMF Gold
• Have the Chinese Stopped Industrial Stockpiling of Raw Materials?
• China Performs a Kind of Financial Alchemy
• Chinese Steel Price to Rise in Wake of Coal and Iron Price Hike

A smattering of articles in recent weeks has highlighted the stockpiling of metals by the China State Reserves Bureau. The Bureau scarfed up 329,000 tonnes of copper in February and 375,000 tonnes in March. This buying has partly fuelled copper's 47% rise year-to-date (it's tied with lead for the biggest gain so far) and its 70% rise from a low of around $2,800 in December of 2008.

Couple this with additional stockpiling of metals like aluminium, nickel, zinc, and tin, and you could make a case that China is trying to back its currency with metal. After all, that would be consistent with the call in March by People's Bank of China Governor Zhou Xiaochuan for a global reserve currency that was not the U.S. dollar. Also, a currency backed by a basket of commodities would certainly have more tangible value than a currency backed by a basket case of basket case currencies (yen, dollar, euro, Yuan).

But the story is probably simpler that a great global currency end game. Copper prices fell by 70% from their July 2008 high to their December lows. Trading depreciating U.S. dollars for copper at rock-bottom prices is a great trade. It's especially great for a nation that plans to electrify itself (which takes a lot of copper) and be a world-leading producer in hybrid cars (which also takes a lot of copper...and a lot of rare earth metals, by the way).

So is China laying the foundation for a commodity currency backed by stockpiled metals and minerals? Probably not. It's just stockpiling minerals and metals while prices are low. And to the extent that the move has anything to do with a currency, it's not China's currency. It's the U.S. dollar.

The Chinese economic planners realise they have made themselves strategically vulnerable to dollar devaluation by owning so much long-term U.S. Treasury debt. The U.S. government is loading up on debt. It intends to pay it back with printed money. This classic devaluation punishes long-term bond holders whose principal is thrashed by inflation.

Besides, since Chinese companies (State-owned and otherwise) keep getting rebuffed trying to take equity stakes in foreign resource producers, it's better to take the Jim Rogers approach and just by the stuff directly and not bother with Wayne Swan and FIRB.

Does any of this benefit Aussie resource producers? Well, yes. Chinese stockpiling of metals has lead to a seven percent rise in aluminium prices in the last month and a nearly twenty percent gain in much maligned zinc prices. As we showed in a Diggers and Drillers e-mail update two weeks ago, Aussie base metals producers have surfed the Chinese liquidity surge into commodities to double digit share-price gains.

Liquidity surfers beware!

The trade only makes sense for would-be stockpilers if prices on the Comex and the London Metals Exchange remain attractive (rock bottom). If speculators try to climb on board the stockpiling bandwagon, it's going to make for a really volatile trading market. Copper for three-month delivery lost 3.6% in London trading on the LME. And on the Shanghai futures exchange it fell even further, down 5% in yesterday's session.

My my my. Let's think about this, shall we?

This situation isn't exactly the same as the across-the-board rally in all asset classes that began in 2003 after Alan Greenspan cut U.S. short-term rates to 1% and left them there for awhile. But it is absolutely the same in one particular aspect: U.S. monetary and fiscal policy is fuelling inflation in certain asset classes, and probably not the asset classed policy makers intended.

In this case, the Fed's quantitative easing policy is designed to drive-down borrowing costs and free up credit. What's happening, though, is that U.S. creditors are abandoning the long-end of the yield curve of the bond market and flooding the short-end (when they aren't bidding up commodities). Fewer creditors want to lend the U.S. government money for 30-years. More are willing to do it for 90 days, even if yields are low, just for the sake of having a liquid, near-cash investment in a still dodgy financial landscape.

You can see this vividly by looking at two-year charts showing the yields on 90-day T-Bills and 30-year Treasury bonds. Check them out below. Bloomberg reports that according to data from the U.S. Treasury Department, China bought $5.6 billion in bills in February and sold $964 million in longer-term notes. Its preferences are clearly changing. You'd expect the 90-day T-bill to again approach zero, and 30-year yields to rise. And in fact, that's exactly what the chart shows.

90-Day T-Bill Rates Again Approach Zero

30-Year Rates Bounce as U.S. Creditors Factor in Inflation

These two charts are bad news for Uncle Sam and probably good news for Uncle Kevin. For the U.S., the shift in borrowing to shorter-term notes and bills makes future borrowing needs extremely interest rate sensitive. Every try rolling over a $1 trillion in debt when interest rates have doubled? And remember, future borrowing needs are massive, with the Congressional Budget Office predicting a deficit of $1.4 trillion next year and nearly $10 trillion by 2019.

If creditors aren't willing to fund U.S. deficits, then the Fed will. And that means printing money. This has two effects. One, it drives up interest rates on longer-term bonds even more (making long-term financing expensive) and it accelerates the flight out of U.S. debt into tangible assets.

Either way, funding U.S. deficits with borrowing-whether its long- or short-term-is the prelude to dollar devaluation. The only way that money gets paid back is through money printing. There is a remote possibility that new taxes could cover the interest expense on U.S. debt. And in case you missed it last Friday, the U.S. Environmental Protection Agency officially classified carbon-dioxide and several other so-called greenhouse gasses as threats to public health.

This reclassification gives the EPA authority to regulate threats to public health under the U.S. Clean Air Act. More likely is the passage of a bill in the U.S. Congress to institute a "cap-and-trade" system on carbon dioxide in which carbon dioxide "polluters" could bid for permits that allow them to emit a certain amount of CO2.

The folks in the Obama administration reckon a "cap-and-trade" regime on CO2 could generate anywhere from $500 billion to $1 trillion in new government "revenues." And the best thing of all is that it won't look like a tax increase. It's a new regulation that imposes upon business the real cost of producing CO2 emissions.

If you think for a minute that those costs won't be passed on to consumers, though, you are obviously brain dead and not reading this at the moment (RIP). Consumers will bear the brunt of a cap-and-trade system with higher energy costs. And that's if the higher costs don't put energy producers out of business altogether. After all, it's not hard to imagine the government imposing a "cap-and-trade" system that raises production costs, but simultaneously capping retail electricity rates (howling voters freezing in their sub-prime prisons).

Do these people really hate coal that much?

You can see that all across the world, the effort to prop up asset values with more inflation is having a widening circle of negative unintended consequences. To keep all that borrowing from being immediately inflationary, governments are grubbing like addicts for new sources of "revenue" that don't arouse the ire of the population. And they don't seem to care if they wreck the economy in the process.

Which brings us to Uncle Kev. Australia's future borrowing needs look small compared to Team America's. Right now, the Aussie government reckons that the deficits as a percentage of GDP will be around 2% in the upcoming budget year and 3% in the year following. That doesn't sound so bad, does it?

In the U.S., the CBO projects the 2009 Obama budget will produce a deficit 13.1% of U.S. GDP. Even under an optimistic scenario, the ratio only declines to 9.6% by 2010. The trouble with deficits is that they become part of the public debt. And the public debt as a percentage of GDP is already at 74% in the U.S. and climbing.

Granted, it's been much higher in other countries (like Japan) and not led to a collapse deficit financing. But each country's case is particular. And what we'd say here is that the long road to national debtor status begins with running annual deficits out of "necessity." The real trouble with short-term deficits is that they add up, year after year, into long term debts.

Speaking just before Reserve Bank Governor Glenn Stevens confessed that Australia was in a recession, Kevin Rudd-in that tortured parlance that he has mastered-said, "The truth is this - the global economic recession makes it inevitable that we'll have a recession in Australia which means that, as we frame the budget, we're going to have to make even stronger our economic stimulus strategy because unemployment will rise even further."

What on earth does that mean?

We think it means that Rudd is already laying the ground work for further transfer payments to Australians which he is going to call "stimulus" and which he is going to claim will help the country avoid recession. But that was the goal the first time around in December, and it didn't seem to work then. So why try again?

Undoubtedly, the people in Canberra who are eager to borrow on your behalf and funnel the money to favoured constituencies will say that the "stimulus" made things less worse (as if a $900 cash payout makes up for the risk of losing your job). They will keep on stimulating until the Prime Minister's poll numbers fall, at which point China will probably be blamed for something to distract the public's attention. Or perhaps the issue will be immigration. Who knows?

Mind you, we're not saying the Liberals look any better on this issue. Across the world, moron politicians on the Right and the Left are trying to spend their way out of a recession that was caused by too much spending. Only an idiot could embrace and defend that strategy. But then, we are talking about politicians here.

The danger here for Aussie investors is that increased government borrowing to finance transfer payments and backstop the commercial property sector will force up interest rates. Higher interest rates are bad for household borrowing, corporate borrowing, and anyone who has a lot of debt to service (which includes a lot of Aussie households).

The secret to any good lie, we remember reading somewhere, is that the number of people who find out the truth is smaller than the number of people who heard the lie once and believed it. Most people are lazy. We hear a good lie once and even if we don't believe it, it sticks in our head. Say it enough and it begins to pass for truth, even if it's absurd.

Australians keep getting told that government stimulus is the way to soften the effects of recession until the recovery takes hold (an event which keeps getting further and further away on the horizon). But this is a lie. The stimulus doesn't solve any of the problems that face the economy. It just keeps people busy and distracted for awhile, while annual deficits and a rising debt (which must be financed by foreigners) become a fact of life in Australia.

The only upside to continued world-wide government ham-fistedness is that the monetary and fiscal insanity heighten the appeal of real assets. This represents tangible wealth for which there is a world-wide market. That's why in the April edition of Diggers and Drillers we resume our look for smashed-down base metals stocks that have exposure to commodity price gains by way of proven reserves of various base and precious metals. It's the best trade of the year so far. Just ask the Chinese.

Dan Denning
for The Daily Reckoning Australia

• China Has Stopped Stockpiling Metals
• Geithner Reassures China that America Takes Financial Obligations Seriously
• Australia’s Currency and its Economy Will Benefit from China’s Stimulus Package
• Chinese Foreign Mining Acquisition Equal to All of 2007
• Everyone is Busily Debasing Their Currency

First, the big fish. "With iron ore prices rising explosively," says China's National Development Reform Commission (NDRC), "many domestic firms are very enthusiastic about investing in overseas mines, which needs strengthened macro guidance from the country."

Macro guidance is about what you'd expect from a nation that has methodically and with stunning success, pulled itself from centrally planned poverty to centrally planned prosperity (at least for some). But what does 'macro guidance' mean? GPS? RFID?

Today's Australian has all the intriguing details on China's Grand Strategy towards Australia in a story titled, "Beijing takes over BHP raid plans." The comments from the NDRC are a fascinating take on how at least some Chinese officials think capitalism works. "Globally, iron ore mines that are of high quality and easy to exploit are basically in the hands of major multinational companies. Our firms need to pay a high cost to mine iron ore resources abroad. Their exploitation risks and costs are increasing."

Is it really 'exploitation' to pay the market price for natural resources? Or is that just the language of socialism? Perhaps a crash course on free market economics is in order for the NDRC.

Not to sound too condescending (this coming from someone who uses the royal We), but you have to wonder if there is some wishful thinking going on in Beijing. Or maybe, after having lost money in Blackstone and Bear Stearns, state backed firms are wary of buying equity chunks in public companies. Maybe they want a different arrangement.

Either way, it is clear the Chinese have woken up to the fact that the century is theirs for the taking. But there seems to be some confusion about what rules the century is going to operate under: will it be mostly free market rules...or other rules. The market price for the resources China wants is rising. So it would prefer to not pay the market price.

By the way, we reckon free markets are headed for a bit of a bear market. Globalisation, in the bastard form we find it (where trade isn't really free and currencies are manipulated regularly) has produced US$114 oil, massive inflation, the worst credit crisis since 1929, food riots, and a growing popular backlash. Expect more direct government intervention and regulation in financial markets and, perhaps, resource markets. That should play right into China's hands, actually.

This latest line of probing rhetoric coming from China is not exactly a new line of attack. After all, the resources are there for the taking on the public markets. There's no need to attack at all. But it does feel like an attempt to flush out Australia's politicians and get them more involved in China's plans for Australian resources. The government is already involved, of course, with the Takeovers panel quashing the bid by Shougang Steel and APAC resources to take a 40% stake in iron ore up-and-comer Mt. Gibson (ASX:MGX).

Let's put this whole affair in the context of steel and GDP. We found the chart below yesterday while preparing for a radio interview with a Canadian business show. The host wanted to know how steel companies could afford to pay a 300% increase in coking coal prices and a 75% increase in iron ore prices. We asked him to picture the chart below.

Steel and GDP, Marching Hand in Hand

Source: Mining and commodities exports, Angelia Grant,
John Hawkins and Lachlan Shaw, 2006

The chart shows that world steel production leapt ahead of GDP growth during the two big periods of Asian industrialisation of the last 50 years, in Japan and Korea. With China now industrialising, and coming off a much lower base in steel production, a period of growth in steel production that exceeded world GDP would be quite the spectacle. It would also mean China's consumption of base metals is just now hitting high gear.

From an Australian perspective, what's so flabbergasting about the chart is that both Korea and Japan have been devoted customers of the black coal from the Bowen Basin that is so well suited for coking. They've also been tied up for years as customers of Rio Tinto and BHP for the iron ore that comes from the Pilbara. Now you add China to the queue.

Despite its surge to the top in terms of global steel production, China's individual steel firms are still smaller, at least according to the latest figures from the International Iron and Steel Institute, than Japan and Korea. Nippon Steel, Posco, and JFE are all bigger producers than Baosteel. Keep in mind, however, that as recently as 2002, China was a net steel importer. It's now a net exporter.

Source: International Iron and Steel Institute

You could argue that Japanese and Korean steel production might decline as those economies age and become more service oriented. Yet major industries in both countries, including ship building and heavy equipment, are massive users of steel. And as of 2005, Japan ranked behind the EU as the world's second largest exporter of steel.

More likely than declining steel production by Japan and Korea is that they will compete for market share with Chinese producers. And the producers in all three countries don't seem to have batted an eyelash at higher input prices. That may be because they'll simply pass those higher prices right on customers. Steel prices are up by about 10% this year already.

But if you're wondering why steel producers don't seem panicked by rising coal and ore prices, there's probably a simpler explanation: there's a bull market in steel. When you combine the industrialisation going on in India and China with the massive commercial, residential, and industrial build-out in the Middle East (rebar prices are up 65% in the UAE this year), you get a pretty bullish case for steel producers. Consumption is rising at an enormous rate.

Australia ranks 22nd in terms of global steel production. Despite having an abundance of the two main inputs (coal and ore), the country, alas, has only 20 million people. Its demand for steel is low, which is why no single Aussie firm dominates the global steel-making stage. And so Asian steel producers have essentially outsourced their raw material requirements to the Pilbara, the Bowen Basin, and the Hunter Valley.

If you want to keep tabs on this three way competition for Aussie resources, watch the battle for infrastructure project at Geraldton. This projects brings rail and port access together to open up the lower-grade iron ores in the Mid West.

One project, put together by Yilgarn and Midwest (ASX:MIS), is embroiled in all sorts of intrigue. But with Sinosteel as the main JV partner of Midwest, this can be viewed as the Chinese project. The other proposal is backed by Murchison Metals (ASX:MMX) and Mitsubishi. It's the Japanese project. Korea is not represented, as far as we know.

To what lengths will Rio Tinto (LON: RIO) go to fend off the BHP takeover offer? Rio shares were up in London overnight by 6% on rumours that BHP would raise its share offer to 4-1 (currently 3.4 for 1) or ad some cash into the pot.

Rio and BHP keep quarreling over whose assets are better. With crude oil futures in New York cresting US$114, BHP is playing up its oil and gas assets. Rio managing director Tom Albanese is having none of it. He presented production figures from Rio's first quarter poured a cold latte all over BHP's oil story.
"I've seen numbers that would indicate to me that BHP Billiton's oil business is about 60th ranked in the world in terms of size...I would certainly rather be the leading player in the aluminium sector than the 60th ranked company in the oil and gas sector."

That's a nice quote. But it's a bit disingenuous isn't it? Size doesn't matter so much in terms of production. It's what you're getting for what you make. Just ask the coal producers on the East Coast. They're actually producing less coal for export this year due to infrastructure bottlenecks and flooding. But with higher contract prices, export earnings will go up on declining production volumes. That's not exactly how you'd draw it up. But you'd take it, wouldn't you?

Rio is even talking up its zircon assets in an effort to bolster its defences. The company revealed it found a big deposit of zircon-rich material in Victoria in East Gippsland. We laughed at this because we joked around the office yesterday about rising zircon prices. Mineral sands are intriguing, not least because James Packer and his lot have recently sold off their position in Iluka (ASX:ILU).

We are not so much interested in zircon as we are in rutile, titanium, tantalum, and lithium. We've been digging through the juniors in our research at the Australian Small Cap Investigator and have found the pickings slim, although there are a few plums there. Rio rightfully calls itself a world class explorer. But we doubt its zircon assets are going to fend off a persistent BHP.

The real bombshell from Rio's announcements yesterday is that it will sign a deal with Saudi Arabian Mining Company to build a giant aluminium complex in the Kingdom. The complex will include the whole aluminium chain, a power generation facility, an alumina refinery, and an aluminium smelter.

As we argued in a recent newsletter, aluminium is the most energy-intensive of the metals. Its production is migrating from cheap energy-challenged areas (China and South Africa) to energy-abundant areas (the Gulf States). The Saudi smelter will produce 617,000 tonnes of the metal each year, making it one of the world's largest. It will cost US$7.5 billion to build.

Rio didn't say how much it would get of that US$7.5 billion. But between Rio, Worley Parsons (ASX:WOR), Leighton (ASX:LEI), and a host of other Aussie mining services and infrastructure companies, the move by the Saudis into minerals and metals production should be good news for Aussie firms. Our preferred play on aluminium continues to be bauxite, the ore from which alumina is made, which later is smelted into metal.

The votes are running 20-1 in favour of more technical analysis. Ask, and ye shall receive, only it will probably be over at Money Morning. We want to make a home for Gabriel Andre's analysis of global indices, Aussie indices, and individual shares. But after careful thought, we believe that kind of approach is more suited to our sister e-letter, Money Morning.

The DR will stick with its skeptical end-of-the-worldism while Gabriel and Al Robinson over at Money Morning track money flows, moving averages, and the technicals (which are often described as the 'language of the market'. Watch this space for further details and feel free to write in with your suggestions to dr@dailyreckoning.com.au

How do you become a Decamillionaire? Easy! Move to Zimbabwe. Maybe it should be called a "Zimmillionaire." Reader Luke in WA recently came into possession of a paper currency note from Robert Mugabe's fiefdom. It had no watermarks and an expiration date. Luke placed it next to a gold coin to show DR readers the difference between real money and government fraud. Thanks Luke!

Dan Denning
The Daily Reckoning Australia

• Chinese Steel Price to Rise in Wake of Coal and Iron Price Hike
• Red Bear Rising: Russia’s Resource Based Geopolitical Strategy
• Chinese Foreign Mining Acquisition Equal to All of 2007
• The Future of the Australian Resource Market, Two Ways the Boom Could End
• BHP Billiton (ASX: BHP) to Report Second Half Results Today