Wednesday, September 09, 2009

China Syndrome

China Signals Loss of Confidence, Will Move Away From Dollar

The warnings have come in stages, but they have been consistent and clear.

In March, Chinese Premiere Wen Jiabao, worried about his nation's massive commitment to US dollars and Treasuries, sent a warning to the US and shook world markets.

"We have lent a huge amount of money to the US, so of course we are concerned about the safety of our assets. To be honest, I am definitely a little worried,” Mr. Wen said at a news conference. He called on the US to, "Maintain its credibility, honor its commitments, and guarantee the security of Chinese assets."

With about $2 trillion invested in the US, China is the world’s largest holder of American government debt. That gives it significant reason for concern.

The US has been printing and borrowing like mad, while setting interest rates near zero. These actions are worrisome to any large holder of US dollars, like China, which surely fears large losses.

With American consumers tapped out and buying much less from overseas, Chinese exports to the US have dropped considerably. That has limited US dollars from flowing into Chinese coffers. It's also left them with less money to buy additional US Treasuries.

However, it hardly matters; the Chinese are finally crying "uncle." China has been seeking ways to limit any further exposure to US dollars for quite some time.

Premiere Wen indicated that China would not be rash in making changes to its massive stockpile of foreign reserves because of the worldwide implications sudden moves could portend.

Wen also noted that China would look out for its own interests, but would "at the same time also take international financial stability into consideration, because the two are inter-related."

That same month, China’s central bank proposed replacing the US dollar as the international reserve currency with a new global system controlled by the International Monetary Fund.

Further, it also condemned the current credit-based system: China’s central bank governor said the goal would be to create a new reserve currency, “That is disconnected from individual nations and is able to remain stable in the long run, thus removing the inherent deficiencies caused by using credit-based national currencies.”

This was further indication of China's concerns about the Fed simply printing money—backed by nothing—and the resulting hyperinflation that will eventually follow. It was also a condemnation of fiat currencies in general.

Then, in June, the head of the economic department at China's policy research office said he believed the dollar is poised for a fall. He said that buying land in the US is a better option than US Treasuries. He also urged his government to redirect a huge portion of its foreign exchange assets to buy energy and natural resource assets.

'Should we buy gold or US Treasuries?' Li Lianzhong asked. 'The US is printing dollars on a massive scale, and in view of that trend, according to the laws of economics, there is no doubt that the dollar will fall. So gold should be a better choice.'"

China, already possessing the largest gold stockpile in the world, will soon have doubled its gold reserves in the space of six years.

And at a June summit, Brazil, Russia, India and China (the BRIC nations) said they are considering buying each other’s bonds and swapping currencies to lessen dependence on the US dollar. Russia’s top economic advisor reiterated his intention to push for the creation of a “supranational currency” to challenge the US dollar and encouraged China and the other Shanghai group members to use each other’s currencies for trade.

And now the Chinese government has given its clearest signal yet that they have lost confidence and are moving away from the dollar.

Cheng Siwei, a former vice-chairman of the Standing Committee, said point blank that the Chinese central bank was about to actively diversify new reserve assets away from the US dollar and into currencies like the Yen and the Euro, and even gold.

“We hope there will be a change in monetary policy as soon as they have positive growth again,” he said at the Ambrosetti Workshop, a policy gathering on Lake Como.

“If they keep printing money to buy bonds it will lead to inflation, and after a year or two the dollar will fall hard. Most of our foreign reserves are in US bonds and this is very difficult to change, so we will diversify incremental reserves into euros, yen, and other currencies,” he said.

“Gold is definitely an alternative, but when we buy, the price goes up. We have to do it carefully so as not to stimulate the markets,” he added.

Depending on the degree that the Chinese sell dollars and buy gold, Yen or Euros, there can only be further downward pressure on the US dollar.

That makes the China/US relationship a unique and critical one. If China were to dump all their US investments (known as the financial nuclear option) it would devalue their investment and crush the dollar.

Pulling all of its money out of US treasuries would mean that Americans would pay more for goods. But that’s not all.

It would also cause interest rates to spike; mortgage rates to spike; inflation to spike; the dollar to go through the floor; and the stock market to go into chaos.

Essentially, we would be in very big trouble. But the Chinese would also suffer great losses. So they will be cautious and move incrementally.

But it means the US government can no longer count on China to finance its continued deficit spending. In other words, the jig is up

The Fed will now begin printing even more money—out of nothing, of course—because it has no other recourse. Our government has obligations and liabilities that it simply cannot meet in any other way for many years to come.

Regardless of what the Chinese do, the dollar is already falling, currency inflation is spiking, and interest rates will eventually follow.

You can count on significant tax increases, as well as cuts in benefits and services.

Siwei’s comments also suggest that China has become the driving force in the gold market and can be counted on to buy whenever there is a price dip, putting a floor under any correction.

That should signal bullishness for gold and bearishness for the US Dollar.

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