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Planes, Trains & Rickshaws

Is China in a bubble? Not by a long way says this "big-picture" view...

Is CHINA in a BUBBLE? Not according to Gianni Kovacevic, corporate development strategist and principal of Kovacevic Consultants.

Here he tells the Gold Report why China will continue to be the primary driver of fundamental demand for copper and other hard resources, as hundreds of millions of people join the largest migration in human history...

The Gold Report: We noticed that you were one of the gold sponsors at the recent Mines and Money Show in Hong Kong. Talk to us about that.

Gianni Kovacevic: About six months ago, I signed up for that sponsorship. I decided back then that I wouldn't just arrive in Hong Kong. I wanted to take the train across China and get a real first-hand feel. I've been to Asia before and I've been to most of the countries in Asia, but I wanted to go across the landscape and take a look. Sort of like the 1987 movie Planes, Trains and Automobiles; I just added rickshaws to the mix.

I already had a really good sense of what's going on, but from visiting the eastern seaboard of China and talking to people from all walks of life, I got a sense of their daily lives, their quality of life, and what they are looking forward to.

TGR: Do you still see China as a big player in the mining markets?

Gianni Kovacevic: There are people who will tell you that China is building the bridge to nowhere, or the road to nowhere. Let's look back at history. History teaches us everything. Ever since Moses left Egypt, the situation has been, "if you build it they will come." We've seen this happen time and time again.

In France, in the 1800s, 20% of the people lived in the cities, 80% lived rurally. That flipped. In America, it flipped during the 20th century, after the biggest road to nowhere project that took place to this date. That was the 46,000 miles of interstate highways that were built in the US after the Second World War, and we all know what happened there.

China is building an impressive amount of infrastructure, but it's required. They have what I call a youth brain drain from rural China. These villages are losing their youth. They all want to have a piece of the action. Information moves so fast. They know it's out there. They want to get it and they're getting it. You go to the shopping malls in China and people are walking out one after the next with a television or an air conditioning unit. These status symbols that we take for granted, they're buying for the first time. The infrastructure that still needs to get built is mind-boggling.

TGR: A lot of people seem to think that there's a China bubble. It seems you don't agree?

Gianni Kovacevic: They keep saying this year after year. There perhaps could be some overbuilding. In the Pudong area of Shanghai; some would say it is overdeveloped. It's for the most part full now. That's what sophisticated "in the know" and "in the building" people are telling me. They know.

I met with managing directors of banks and they tell it the way it is. They say it worked. There may be some vacancy, but there's certainly a sufficient amount of occupancy.

Another very common, very well-publicized story in the media is the injection of capital. In one of the talks in Hong Kong, one of the bankers gave a very good presentation on this exact question. Within that presentation, it stated that corporations in China have taken just over 23 trillion Remnimbi (USD$3.5 trillion), in loans. The interesting thing is they still have not spent over 50% of it. It's still sitting in cash. So if you haven't spent the money, how can that be a bubble?

TGR: There's been some monetary tightening in China. Do you see that continuing to happen?

Gianni Kovacevic: I would suggest that they know what they're doing and how they're going to do it. They have these long plans, 5-year and 10-year plans. Which is exactly why, in the teeth of the crisis that took place in the last 18 months, they were out deploying hundreds of billions of Dollars to get long-term supplies of all the commodities they don't have at home. They understand pretty well where they're going.

They have people coming into the eastern seaboard by the tens of millions. The train ride I took from Beijing to Shanghai, just over 1,600 kilometers, travels between 200 and 137 kilometers an hour. Parallel to this railroad track, they're building a new railroad that is going to travel a little more than 300 kilometers an hour. It's coming with new stations in the big cities. It's elevated on concrete stilts for a good portion of the distance.

When you have the biggest migration of human beings in the history of the world taking place by the tens of millions, there's not enough space. The train ride I took was only 1,600 kilometers, which would be like a train ride from Boston to Atlanta. Imagine moving the entire population of the United States, 250 million or 300 million people, to a strip of land that size. Tell me the amount of infrastructure that's going to be required. That's happening and has happened over the past 20 years and will continue.

TGR: So is the opportunity, in terms of playing this Chinese growth, infrastructure or consumer products?

Gianni Kovacevic: When you look at the very basic buildings blocks of an economy, you have steel, concrete, copper and oil. You're going to have the most leverage out of those commodities that they don't have enough of (i.e., copper, oil, steel and the things that are used to create steel). You can't grow an economy without those things. Even in the darkest day of the recession, they were out deploying hundreds of billions of Dollars.

Take copper, for example. Stockpiles increased over the past year from 250,000 tons to over 500,000 tons. For the first time, the price climbed with it. This is because we're playing by new rules. If you look at the old rulebook, you're going to get it wrong. You cannot do that.

TGR: So, you think China is going to be the principal driver of the demand for copper?

Gianni Kovacevic: Yes, I do, because it's a never-ending loop. The way we generate, transmit and utilize electricity is where the vast majority of the world's copper is being used. For more than 100 years, we've been globally deficient in electrical generation. So that continues.

China will have its own initiatives, whether it's going to be from cleaner coal or nuclear power or some kind of green energy, wind, or what have you. They're going to create more electricity because they have to. They have to transmit more electricity because of this massive migration, equivalent to the population of America moving to an area of a couple thousand kilometers. Those people are going to continue to utilize electricity.

Let me give you some examples – status symbols. You have to have an air conditioning unit now to have status in China. You don't sweat; you live in comfort. That unit itself has about 10 to 15 pounds of copper between all the tubing, all the windings, and all the wires. It's the most energy-intensive product that one can buy for one's home here or there. Old communities have had to fortify their electrical systems. New communities need to have more ability to generate and transmit electricity because people keep utilizing more electricity with this product.

The Chinese, again, I stress the 300 million people who have buying power, are just like us in the developed West. We don't have two or three electric gizmos in the household. You might have 20 or 30. It takes hundreds of thousands of tons of copper per year just to satisfy the building blocks of those air conditioning units. Then the second part of it is providing the electricity. Look at Moscow. During two or three month of the summer, everybody's got air conditioning on. You have to fortify the whole electrical grid for those two or three months when they all turn on in order not to crash it the overall system. Remember Brazil last year? The Eastern Seaboard a few years ago? Governments don't have a choice. They are going to have to prepare for more usage, and there will be a lot of copper demand.

TGR: What other resources are good plays, given this idea that China is still going to be the driver?

Gianni Kovacevic: Demand for other resources is inevitable. Oil is an example. We look at China as the world's largest market for automobiles. Just this week, the China Association of Automobile Manufacturers reported that sales reached 1.74 million units in March, up 56% over March 2009, or 20.43 million units on an annualized basis. As well, Q1 vehicle sales were at 4.61 million units, or 18.7 million on an annualized basis – 37% higher than total 2009 sales. The US market had reliable sales of 14 to 17 million units between 1995 and 2007, so one can see that China is at American boom-time levels already, 10 to 15 years ahead of most experts' forecasts. That happened last year, in part because of the decimation of the US automobile market, which fell to about 10 million units.

Can the 300 million people in China with spending power maintain a reliable purchasing pattern similar to that in the US before the financial crisis? Absolutely, which, in my opinion, debunks the bubble theory for cars and many, many other categories in China. It's going to keep growing as those who have not participated in basic progress obtain their first basic items. That's extremely bullish for oil. The biggest status symbol for someone in China is to have a car. Bicycles are not that prevalent anymore, particularly in the big cities where people are driving cars. And they're driving fine cars.

Here's another commodity that's really interesting. If copper is the life blood of the economy, I call molybdenum the glue of the economy. It holds the whole economy together. Again, you cannot grow as an economy without molybdenum. It's what we use to strengthen steel. It's put in steel to resist heat. It takes sulfur out of diesel fuel. It's being used in all those different products where specialty steel is used.

The question right now is, where's that threshold and where's the future for molybdenum? A pipeline project is a good example. If you fortify a pipeline with around 0.75% of molybdenum, each kilometer of large diameter pipeline will need about 1,000 pounds of molybdenum. At $17 or $18 a pound, it costs you $17,000 a kilometer to fortify that pipeline for long-term performance. If molybdenum goes to $30 a pound or $40, it would cost, say $30,000 a kilometer to fortify that pipeline for long-term performance. Is this going to prevent you from using it at a few million Dollars per kilometer? Of course not. In almost every single application of molybdenum, the price almost does not matter. You're going to pay for it and you're going to use it. However, there could be an oversupply in four, five or six years.

The question for investors is what to do in the next 18 months? The next 24 months? I would say there's a considerable profit to be made, or potential profit to be made, within the molybdenum space, but it's a very difficult thing to invest in, though.

You mentioned that we should take advantage of this molybdenum opportunity for the next 18 to 24 months. Then you said immediately afterwards, it's hard to take advantage of it. So what does an investor do?

Gianni Kovacevic: Well, on February 22nd of this year, the London Metals Exchange (LME) began offering contracts for both cobalt and molybdenum. That is something that has given an alternative market to people who have excess molybdenum. It would have been nice for the moly market to have had that when it crashed from $30 to $8 in a couple of weeks during the crisis. It's also given a little more transparency to a truer supply and demand situation. How an investor profits from this is extremely difficult. There are four or five good companies in the junior space that, unfortunately, have been decimated through dilution, but they're very valid opportunities.

TGR: Thank you for your time.

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