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Too Hot to Handle

The world's biggest investors are too big to Buy Gold without sending the price far higher...

MAJOR INVESTMENT funds now dominate the global economy.

   Their appearance has been sudden, spreading over just a few recent years. And this rapid growth in sovereign wealth funds and petro-dollar investment – both government controlled – plus hedge funds and private equity groups poses risks for the world economy almost as large as the size of these funds themselves.

The prospect of major financial tsunamis, overwhelming the real economy, is a genuine threat posed by these monsters of capital. How big are they and just how big is the danger? Asset bubbles, excessive lending, market distortions, and bank failures are all possible consequences, as we are seeing right now in both the US and Europe and also much further afield.

For all of their benefits, the rise of these funds poses awful risks to the global financial system, the first of which is upon us now in the "Credit Crunch" unfolding on a daily basis. The threats break down into two groups, right in line with the two groups themselves: nationally dominated funds, and the private profit-seeking group.

The non-governmental hedge funds and private equity buccaneers are there for profit. They provoke price changes as a way of profiting, and they will change positions as fast as they can if profits threaten to dissipate.

These private funds can be a source of heavy and persistent volatility in currencies and markets, should it suit them.

Governmental bodies, on the other hand, move carefully and slowly so as to protect the longer term benefits of their investments. But when they move, they are large enough to change investment currents and dominant trends.

Evidence of their influence is seen in real estate values in developed countries, which have increased by $30,000 billion between 2000 and 2005, far outstripping economic growth. This partly reflected property purchases by petro-dollar investors, but it was also a side effect of lower interest rates caused by investment in government securities – especially in the United States – by Middle Eastern and Asian investors, as well as by private investors. Now they, alongside European investors, are suffering the pain of the present credit crunch associated with real estate, but they are unlikely to go bust.

The size and leverage of hedge funds – plus their nepotistic relationship with their banking creators – threatened the sort of contagion we saw in July when the sub-prime crisis exploded. (Please note that these funds are outside the banking system, but usually under its control.) So for as long as we continue to see an on-going "Credit Crunch", we will see damage to the hedge funds, fed through the entire banking system as they are interrelated through syndication and markets.

This crisis is by no means over. We are now seeing the bankruptcy of the Dublin-based Rhinebridge, a "structured investment vehicle", and also one of its investors in Germany, the IKB Deutsche Industriebank. It has lost about half its value and is unlikely to repay all its debt.

Their fall can be attributed to the dramatic growth in high-yield debt, plus lax lending covenants to satiate demand from private equity groups. Such easy lending of itself increases credit risk.

All told, oil investors, Asian central banks, and hedge and private equity funds collectively held $8,400 billion in assets at the end of 2006. Those assets had tripled since 2000, and they are now equivalent to 40% of the size of the world's pension funds and a similar proportion of global mutual funds. Altogether, they represent 5% of the world's $167,000 billion in financial assets.

Thanks to Dollar deficits, rapidly rising oil prices, plus massively growing Dollar surpluses in the hands of mainly Asian and oil-producing nations, their growth rate has been meteoric. Between 2000 and 2006, the assets held by Asian central banks grew by 20% a year, four times as quickly as the world's pension funds. At the current growth rate, the assets of the four groups will exceed $20,000 billion in five years' time...some 70% of the size of the world's pension funds.

Biggest of the four is the petro-dollar reserve funds, which has grown rapidly after a tripling in the oil price since 2002. They now hold some $3,800 billion in foreign financial assets. At a minimum pace of growth on an oil price less than half the present rate, each petro-dollar fund would continue to grow rapidly over the next five years. Using the base of $50 oil, an extra $1 billion a day will pile up in the financial markets by 2012. Take that higher to the $80 level and it rises to $1.6 billion, at least, per day.

Central banks, mainly those of China and Japan, are the next most significant player, with $3,100 billion held in foreign reserve assets at the end of last year. Most of this money has found its way into US Treasury bonds, helping keep Western-world interest rates artificially low.

The central banks of China, South Korea, and Singapore have announced their plans to shift a collective $480 billion into more diversified assets. Clearly they will aim to keep the buying power of the Dollar high, so that they don't face losses in their reserves, but they hold so much this is impossible to do with a declining Dollar.

Hedge funds are less significant, but they have still grown from less than $500 billion in 2000 to $1,500 billion today. Together with the leverage they typically employ, hedge funds could have $12,000 billion of financial firepower by 2012. These funds have the potential to make the recent credit crunch look tame. Their interests are specific, bottom-line oriented, and they respect no foreign domain in which they are invested.

If the global major central banks put a foot wrong in this present delicate situation, the quake that sets off the tsunami of capital flows we have repeatedly warned of will happen.

These four groups can no longer be ignored or thought of as a blessing to stimulate long-term growth in smaller emerging nations, except where they are tied into securing future resources for the developing East. (That effectively passes ownership of their precious resources to foreigners in exchange for some infrastructural developments.)

We live in an integrated global economy, where the web of banking has already shown that what happens in one nation spreads across the oceans in a heartbeat. So small nations receiving these massive inflows of capital, could see them withdrawn, not for local reasons, but thanks to forces lying outside the nation.

In short, brace yourself for more Capital Controls such as those we are now seeing in India as it seeks to protect its Rupee against inflows of capital.

Expect higher interest rates in these nations as inflation takes off as a result of the inflows. But more aggressively, expect Capital Controls to prevent this "hot money" from draining capital from these emerging countries and also expect Capital Controls from even the largest nations on earth to prevent foreigners as well as locals from controlling the well-being of their economies by withdrawing major amounts of capital from them.

We live in a financially dangerous world now, with the warning lights flashing brighter and brighter.

While the Gold Market is just too small at the moment, and will be until several noughts are added to the Dollar Gold Price, it cannot provide any protection for these monsters of money. Hence it is a place to protect yourself, if you are an individual or smaller institution.

And even though the Gold Market cannot provide a haven for such massive amounts of cash, the dangers posed by these monsters will ensure that the Gold Price will rise to much greater heights when any of these funds quake in crisis and send out financial tsunamis, as confidence in the system buckles yet again.

JULIAN PHILLIPS – one half of the highly respected team at – began his career in the financial markets back in 1970, when he left the British Army after serving as an Officer in the Light Infantry in Malaya, Mauritius, and Belfast.

First he worked in Timber Management and then joined the London Stock Exchange, qualifying as a member and specializing from the beginning in currencies, gold and the "Dollar Premium". On moving to South Africa, Julian was appointed a macro-economist for the Electricity Supply Commission – guiding currency decisions on the multi-billion foreign Loan Portfolio – before joining Chase Manhattan and the UK Merchant Bank, Hill Samuel, in Johannesburg.

There he specialized in gold, before moving to Capetown, where he established the Fund Management department of the Board of Executors. Julian returned to the "Gold World" over two years ago, contributing his exceptional experience and insights to Global Watch: The Gold Forecaster.

Legal Notice/Disclaimer: This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment. Gold Forecaster/Julian D.W. Phillips have based this document on information obtained from sources they believe to be reliable but which it has not independently verified; they make no guarantee, representation or warranty and accepts no responsibility or liability as to its accuracy or completeness. Expressions of opinion are those of Gold Forecaster/Julian D.W. Phillips only and are subject to change without notice. They assume no warranty, liability or guarantee for the current relevance, correctness or completeness of any information provided within this report and will not be held liable for the consequence of reliance upon any opinion or statement contained herein or any omission. Furthermore, they assume no liability for any direct or indirect loss or damage or, in particular, for lost profit, which you may incur as a result of the use and existence of the information, provided within this report.

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