China inoculates itself against dollar collapse

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China inoculates itself against dollar collapse

From the Asia Times.

March 18, 2009
DOLLAR CRISIS IN THE MAKING, Part
3
China inoculates itself against dollar
collapse
By W Joseph Stroupe
This article concludes a
three-part report.

PART 1: Before the
stampede

PART 2: The not-so-safe
haven

There is mounting evidence that China's central bank is
undertaking the process of divesting itself of longer-dated US Treasuries in
favor of shorter-dated ones.

There is also mounting evidence that
China's increasingly energetic new campaign of capitalizing on the global crisis
by making resource buys across the globe may be (1) helping its central bank to
decrease exposure to the dollar, while (2) simultaneously positioning China to
make much greater profit on its investment

of its reserves into hard assets whose prices are now greatly
beaten down, while (3) also affording it greatly increased control of strategic
resources and the geopolitical clout that goes with it. This is turning out to
be a win-win-win situation for China as it capitalizes upon the important
opportunities afforded it by the present global crisis.

The exact size
and the precise composition of China's huge forex
reserves, the exact degree of China's exposure to the dollar and its viable
options, if any, in decreasing that exposure are matters of intense interest,
because China's policies in this regard could have gargantuan implications for
the US and the global financial systems and for the dollar.

One of the
foremost experts who continues to research and track these matters is the highly
respected Brad W Setser, a Fellow for Geoeconomics at the prestigious Council on
Foreign Relations in New York. His work is providing significantly deeper
insight into the size and composition of China's reserves and is affording the
world a better view of that country's options in managing its reserves going
forward and what the implications of those options might be.

Another
expert whose ongoing work is also adding very important, deeper insight into
such matters is the highly respected Rachel Ziemba, lead analyst on China and
the oil exporting economies at the prestigious RGE Monitor, founded by Nouriel
Roubini.

Drawing on the work of these two experts, let's examine the
matter of the likely size and composition of China's forex reserves and its investment
options

going forward, and the probable implications of those options for the dollar.

The first issue is to determine the actual size of China's foreign
exchange

reserves. Its central bank officially confirms the current figure of about
US$1.95 trillion. However, Setser's work reveals that China's actual reserves
are significantly higher and may actually be as high as $2.4 trillion, according
to his latest figures [1]. About $2.2 trillion of this total figure is easily
identifiable, according to Setser, with the remaining $200 billion being his
estimate of the amount currently held in China's state banks.

As for the
issue of the composition of these reserves and its total exposure to the dollar,
the most recent Treasury International Capital (TIC) report by the US Treasury
has China's holdings of Treasuries at $696 billion as of the end of 2008.
However, Setser's research indicates China's total holdings of US Treasuries is
likely to be more than that figure, since some of the purchases of Treasuries by
the UK and Hong Kong should actually be attributed to China's central bank.
China also holds US government-sponsored agency debt
(Fannie Mae and Freddie Mac paper) and corporate
bonds
,
but the recent TIC reports indicate its central bank has been steadily divesting
itself of these assets in favor of short-dated Treasuries.

As for
China's purchases of Treasuries over the most recent three months (October -
December of 2008), note this statement from Setser:

And over the past three months, almost all the growth in China's
Treasury portfolio has come from its rapidly growing holdings of short-term
bills not from purchases of longer-term notes.

Setser goes on to make the point that China's central bank is
unquestionably divesting itself of the comparatively less-safe assets such as
agency debt in favor of very short-dated Treasuries. The best estimates of the
total exposure of China's central bank to dollar-denominated assets of all kinds
is about 70%, or somewhere between $1.5 trillion and $1.7 trillion depending
upon whether you use the $2.2 trillion figure or the $2.4 trillion figure for
the total sum of China's reserves.

That uncomfortably high level of
exposure to the dollar is what has been causing concern to flare in China most
recently. A much more desirable figure, from China's standpoint, of its total
exposure to the dollar would be 50% or less of its total reserves. A reserve
composition of 50% dollars to 50% everything else is much safer because an
excessive decline in the value of the dollar would tend to be offset by
corresponding increases against the dollar in the value of the non-dollar assets
comprising the rest of the reserves.

In order to get to that more
desirable composition fairly quickly over the next several months, China would
have to somehow divest itself of as much as $450 billion of its existing
dollar-denominated assets, not purchase a significant amount of new
dollar-denominated assets, and accomplish all this without triggering a global
dollar panic. That's a very tall order indeed - but it is not by any means
impossible. How so?

If we stand back to look at Setser's work from a
distance, we see what appears to be a clear strategy on China's part that is
potentially very compelling. The country has its official reserves, which it
acknowledges now total about $1.95 trillion, and it also has its unofficial or
secret reserves, which Setser estimates at about $450 billion at present.

Coincidentally (or perhaps not merely coincidentally) the secret
reserves total about the same sum that China needs to divest itself of in order
to reach the desired composition of its reserves noted in the previous paragraph
- about $450 billion. At this point, recall the intriguing and potentially very
important statement quoted earlier (see DOLLAR CRISIS
IN THE MAKING, Part 2
), a statement made by Fang Shangpu, deputy director of
the State Administration of Foreign Exchange and reported by the Xinhua News
Agency on February 18, 2009:

Fang Shangpu, deputy director of the State Administration of Foreign
Exchange, noted Wednesday that the report released by the US Treasury of the
amount of government
bonds

held by China included not only the investment from the reserves, but also
from other financial institutions. It might be a hint that Chinese government is
not holding as much US government bonds.

[Italics added]

China is managing its foreign exchange reserves with a
long-term and strategic view, Fang told a press briefing. "Whether China is to
purchase, and to buy how much of the US government bonds will be decided
according to China's need," Fang said. "We will make judgment based on the
principle of ensuring safety and the value of the reserves," Fang
said.

Is Fang Shangpu hinting that China has intentionally, as a deliberate
strategy, divided its reserves into two general holdings, official and secret,
and that SAFE (the State Administration of Foreign Exchange) has ensured that
the composition of the official (government) holdings of the $1.95 trillion is
such that its exposure to the dollar is not the roughly 70% assumed in the West,
but rather something much closer to the desired target of 50%, while the secret
reserves hold predominantly dollar-denominated assets?

If this is the
case, then China could employ a number of schemes to clandestinely further
reduce its total exposure to the dollar, using its secret reserves, all the
while maintaining safety for the official reserves. Note Fang Shangpu's recent
statement to the Wall Street Journal regarding how carefully, and with what
foresight, China manages its reserve holdings:

"Since the subprime crisis evolved into the international financial
crisis in September last year, we have executed the central authorities' plans
to cope with the international financial crisis and launched the emergency
response mechanism. We have closely followed developments, made timely
adjustments to risk management, taken decisive and forward-looking measures to
evaluate and remove risks ... "

Chinese officials have been painfully aware, for several years now, of the
increasing risks of too great an exposure to the dollar. It simply isn't
believable that their level of prudence and foresight in this regard was so low
as to allow them to fail to formulate and execute strategies designed to limit
that exposure to safer levels than is presently assumed in the West. But if
China has indeed prudently and deliberately structured its official reserves
(now totaling $1.95 trillion) to be much less exposed to the dollar than is
assumed in the West, while off-loading the riskier, dollar-denominated assets
into its secret reserves, how might it propose to use those secret reserves to
further decrease its exposure to the dollar?

Conversion into
resource reserves

Enter China's resource buys. Several Chinese
experts have been saying that China needs to spend a significant portion of its
dollar-denominated reserves on hard assets, thereby further reducing its
exposure to the dollar. It certainly appears that China is embarking upon just
such a strategy.

According to research by Rachel Ziemba of RGE Monitor,
in the first two months of 2009 alone China has already confirmed suchdeals for
hard assets worth a total of over $50 billion [2]. Clearly, China is just now
opening its global strategy of pursuing such resource buys at a time when the
prices of hard assets are extremely attractive and many more such buys are in
the offing. This is made evident by the recent February 23, 2009 report by China
Daily which stated the following:   

As part of the National Energy Administration's three-year plan for
the oil and gas industry, the government is considering setting up a fund to
support firms in their pursuit of foreign mergers and acquisitions, the report
said.

Fang Shangpu, deputy director of SAFE, the State Administration of
Foreign
Exchange

, said earlier this week that more measures will be introduced
to support firms seeking to expand overseas.

Veteran analyst Han
Xiaoping said the time is now ripe for China to convert some of its capital
reserves into resource reserves
, as global oil
prices

have fallen 70% since last year, to about $40 a barrel. [Italics added]

"We shouldn't miss this opportunity to use our foreign exchange reserves
to build up our oil stocks,"
he said.

Jiang Jiemin, chairman of PetroChina, said recently: "The low
share prices of some global resource companies provide us with some fresh
opportunities."

RGE Monitor's Ziemba says the resource buys are a smart move now because
they decrease the role of increasingly uncertain financial assets such as
Treasuries, which now carry little profit appeal and diminishing appeal as safe
stores of wealth, and increase the role of hard assets, which now carry an ever
greater profit potential and a mounting appeal as safe stores of wealth: "For
China, these
investments
seem to be a relatively efficient way to use its financial resources given the
likely long-term appreciation of resource prices and uncertainty about financial
assets."

Ziemba, in response to questions e-mailed to her, also alerts
us to watch for forthcoming details about the currencies
employed in China's resource buys. If these deals are being transacted largely
in dollars, then she notes that there will likely be no negative near-term
effect upon the dollar's role as the world's reserve currency. But if they are
arranged outside of the dollar, it might well serve to undermine the dollar's
international role to some extent.

However, it should be noted that
almost no matter what currencies these resource buys are being transacted in,
there does exist a potential negative impact for the dollar itself further down
this path. How so?

Obviously, with China's uncomfortably large present
exposure to the dollar, it is in its interests to concentrate on converting much
of the dollar-denominated portion of its secret reserves into resources
reserves. In other words, China will undoubtedly spend dollars, whether directly
or indirectly, to fund its resource buys. But it must do so in a largely opaque
manner that leaves little, if any trace in official data such as the US
Treasury's TIC report. It will also be likely to be a net buyer of Treasuries,
though nowhere near its 2008 pace, or else refrain from selling significant
amounts of Treasuries, while it clandestinely reduces its exposure to the
dollar. Otherwise, its actions could spark a dollar panic.

Increased
buying of Treasuries by US citizens and investors,
and by various foreign investors other than China, as the global crisis rapidly
deepens and increases risk aversion, may likely take significant pressure off of
China to soak up the huge issuance of new sovereign US debt
now getting underway. That will help to provide breathing room for China to
address its problem of reducing exposure to the dollar.

Whether China
will approach the problem with a scheme of swaps amongst its various
state-controlled entities and wealthy private Chinese investors, or by some
other nearly opaque means, probably cannot be determined with any certainty at
present. But it has undoubtedly worked out the problem of clandestinely
converting significant sums of its dollar-denominated financial assets into hard
assets without dumping Treasuries and triggering a dollar panic.

It is
most unlikely, therefore, that its actions in this regard will be sufficiently
proved before it has already succeeded in accomplishing its goals. Furthermore,
since resource prices are now very attractive, China will certainly expand and
accelerate its resource buys while prices remain attractive, converting
ever-larger sums of its dollar-denominated reserves into resource reserves.

If China averaged a conversion of only $35 billion per month from
dollars into resources, it could convert the entire $450 billion in little more
than 12 months' time. Hence, I predict that the next eight to 15 months will
provide China with sufficient time to bring its total exposure to the dollar
much more in line with its strategic goals.

What about the problem of
dealing with any ongoing accumulation of dollars? A number of analysts note that
China's trade surplus is worsening even in the global slowdown because, while
China's exports are falling, its imports are falling much faster. However,
Chinese officials have made clear that they will use their reserve holdings to
bolster imports, and that measure should alleviate China's need to accumulate
large sums of dollars and other currencies in order to keep the yuan stable.

China is extremely unlikely, therefore, to accumulate dollars at
anywhere near the rate at which it did in 2008. China is also funding its
domestic stimulus package designed to spur domestic consumption. All these
measures denote a much wiser use of its huge reserves and a steadily decreasing
focus on the dollar. All in all, China looks set to weather the storm quite well
in spite of some significant hardships along the way.

Summarizing the
escalating risks of a dollar crisis

The bubble in US Treasuries is
getting increasingly massive and unstable with each week that passes. Deepening
global risk aversion is keeping investors lined up, so far, to buy Treasuries -
especially short-dated ones. And the deepening economic crisis in the US is
moving its own citizens to join in the buying spree.

If the Treasuries
bubble persists for much longer, and especially if it continues to mount, the
massive and dangerous distortions in the global financial system and the
Treasuries-induced strangulation of its credit markets will only become more
severe, likely leading to a meltdown somewhere in the emerging markets, one of
whose effects will almost certainly spread to engulf the severely weakened
Western European and US financial sectors and plunge particularly the US
economy

into a deep depression, with potent negative effects upon the dollar.

Such an eventuality will tend to force global investors to evaluate the
safe-haven appeal of the dollar based much more on the fundamentals of the US
economy, and that will portend a stampede out of the dollar and a potentially
chaotic bursting of the massive Treasuries bubble. Hence, even if the US finds
buyers for its huge sums of new sovereign debt now beginning to flood the
markets, the picture does not look good for the dollar beyond the short term.

Obviously, if the US reaches the point where it fails to find sufficient
buyers for its new flood of Treasuries, that will also become a perilous
situation for the dollar and for the huge Treasuries bubble, which will almost
certainly burst as global investors seek better stores of wealth in hard assets,
following the lead of China's central bank.

Either way, the US is
engaged in the implementation of extremely risky and potent inflationary,
dollar-debasing policies, making a loss of global confidence in the dollar in
the short to medium term a virtual certainty. Even if the massive spending does
restore economic growth, the US economy is likely to remain very weak for some
time. That will make it extremely difficult for the US Federal Reserve to
tighten monetary policy to fight off the inevitable and potent inflation that
will result from today's shortsighted policies.

When the Fed attempts to
tighten, the US economy will likely be plunged into a second-round recession or
depression, with obviously awful effects upon the dollar. But if the Fed fails
to tighten sufficiently and quickly, runaway inflation will ravage the currency
anyway.

Prudent, forward-looking Chinese officials have clearly assessed
the entire situation as one demanding careful but swift action to ensure that
its huge reserves are not imperiled by what has obviously become an untenable
global rush into an unstable and perilous dollar bubble.

Hence, China's
central bank is enacting with a sense of urgency prudent measures, both explicit
and clandestine, to significantly decrease exposure to the dollar. If the
details of such measures should become sufficiently public and should attract
undue global attention before China accomplishes its goals, a dollar panic might
be triggered.

This risk, though perhaps not major, does exist
nonetheless, and it is significantly increasing as China undertakes new measures
that might attract undue and unwanted global attention. However, it is also
likely that China will enjoy cover and gain breathing space to enact its prudent
measures while much of the rest of the world continues to rush into the bubble.

Notes
1. See "China's Record Demand for Treasuries in
2008", by Brad Setser, The Council on Foreign Relations.
2. See "China's
Resource Buys" by Rachel Ziemba, RGE Monitor.

W Joseph Stroupe
is a strategic forecasting expert and editor of Global Events Magazine online at
www.globaleventsmagazine.com

(Copyright 2009 Global Events Magazine,
All Rights Reserved.)

 

JAG's picture
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Re: China inoculates itself against dollar collapse

Thanks Cat, great read and timely info.

Jeff 

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Re: China inoculates itself against dollar collapse

I like Brad Setzer's work, but this article doesn't reflect the massive devauation of the dollar that just transpired yesterday.  Treasuries get paid off in dollars, China just took a massive beating. 

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Re: China inoculates itself against dollar collapse
cat233 wrote:

Hence, China's central bank is enacting with a sense of urgency prudent measures, both explicit and clandestine, to significantly decrease exposure to the dollar. If the details of such measures should become sufficiently public and should attract undue global attention before China accomplishes its goals, a dollar panic might be triggered.

Excellent article - Most of us are buying gold and the Chinese are buying multinational companies...Either way we are all moving away from the US$.

The shift from long to very short term bonds seems like a clear "exit strategy" - Funny to think that an entire nation is also preparing for a SHTF scenario. Specially since most other countries are just flailing.

I read that Australia is already trying to stop the Chinalco takeover. I think the Australians see the writing on the wall and don't want to have too many of their companies under Chinese control.

Anyway, thanks again for a great article.

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Re: China inoculates itself against dollar collapse
plantguy90 wrote:

I like Brad Setzer's work, but this article doesn't reflect the massive devauation of the dollar that just transpired yesterday.  Treasuries get paid off in dollars, China just took a massive beating. 

About US$ 80bn loss since yesterday at 2 PM, when the Fed revealed it's intentions. It was exactly what the Chinese were trying to avoid... They must be really upset. I'm curious to see their reaction, and wondering if they will accelerate their shift from the US$.

Feels like China and the US are playing chicken.

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Re: China inoculates itself against dollar collapse
reistr wrote:

Feels like China and the US are playing chicken.

I agree. I have come to understand that China's military is primarily defensive, in that they lack the ability to bring war to another place on the globe due to the lack of logistical infrastructure like massive troop, tank, etc. movers.

That said, do you feel that this game of chicken is one of America trying to remain the imperialistic overlord to the world it used to be, and are convinced China can't do anything about it due to a lack of military might? It feels like there is a new cold war brewing, only this time with China rather than the Soviets. How smart can that possibly be for us?

Let's assume worst case scnario for a moment. China reacts with emotion and pulls 100% of it's holdings as soon as they are able to. In the process, they partially destroy those holdings, but they are biting off their nose to spite their face in this scenario. Would the result be the Fed dumping trillions more into TBills (2 - 3 trillion will cover the China investment and any other fallout)? This further devalues the dollar, but makes the existing debt easier to pay off too. So, we essentially inflate the debt away and destroy much of the value of the dollar in the process. Is this the worst case scenario, or am I missing something? If this is what happens, it seems hard to believe China would be willing to go to war over this, as the war would be as expensive as the value of the assets they would be trying to protect.

Ultimately, it seems clear that China is not going to be putting additional dollars into new debt, although they may roll the existing debt as it comes due if we play nice. Maybe the powers that be figure that if they aren't buying new debt, we don't have much use for them?

Great thread Cat.

Rog

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Re: China inoculates itself against dollar collapse

Excellent post, Cat.  This part stands out to me:

Quote:

It simply isn't
believable that their level of prudence and foresight in this regard was so low
as to allow them to fail to formulate and execute strategies designed to limit
that exposure to safer levels than is presently assumed in the West.

I couldn't agree more.  China isn't stupid.  It's silly to assume they've just been sitting on their hands watching the U.S. make bad decision after bad decision.  Like any other smart investor, they have been taking steps to protect their assets.

The next few weeks should be very interesting indeed.

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Re: China inoculates itself against dollar collapse

I also dont forsee see the return of the Amrican consumer, especially back its glory days level of consumption.  Sticking around to help the debtor nation recover makes less and less sense.   

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Re: China inoculates itself against dollar collapse

just one question what did hillary promise to give the chinese to get them to play nice?

i think in financial terms it is called collateral. our dollars are based on the full faith and credit of the u.s. which i believe in contract law is "good consideration" something intangible as opposed to "valuable consideration" which is something tangible like gold or the secrets of state.

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Re: China inoculates itself against dollar collapse
R_Eddy wrote:
reistr wrote:

Feels like China and the US are playing chicken.

I agree. I have come to understand that China's military is primarily defensive, in that they lack the ability to bring war to another place on the globe due to the lack of logistical infrastructure like massive troop, tank, etc. movers.

That said, do you feel that this game of chicken is one of America trying to remain the imperialistic overlord to the world it used to be, and are convinced China can't do anything about it due to a lack of military might? It feels like there is a new cold war brewing, only this time with China rather than the Soviets. How smart can that possibly be for us?

I don't think that things would take a military turn. It looks like China is "pushing" the U.S., using it's dollars as leverage, to be economically responsible - There is an implied threat of dumping the dollars if they feel it will become devalued. The move from long to short term bonds is an example of such threat, the message being "we will be able to sell quickly if we need to".

On the other hand, as you said, if China starts openly dumping dollars a run is guaranteed, and China will have huge losses. The U.S is counting on this to put pressure on China to not only keep their bonds, but buy even more (Hillary's trip to china).

For now they have a kind of M.A.D. (mutually assured destruction) economic policy happening, that keeps both countries threading VERY carefully. 

So for now China keeps setting itself up to divest of their dollars, and the U.S. will keep printing... But for how long will they put up with the U.S. printing money? Eventually there will be a tipping point, in terms of cost-benefit.

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Re: China inoculates itself against dollar collapse

reistr -

Countries have gone to war over far less, but I seriously doubt anything like that would happen between the US and China. 

Would both countries suffer immensely if we just keep printing and eventually China dumps the dollar?  - You bet.

That event would not threaten the sovereignty of either country so the likelihood of going hot over it is very, very slim.

And in the final analysis, only one of the two countries can directly threaten the sovereignty and hold at risk what the other country values. 

I'll leave it up to the readers to figure that part out................

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Re: China inoculates itself against dollar collapse

The question, Dogs, is if the US is commiting financial suicide then what will China, Europe, and Russia do? Yes, the US has the overwhelming nuclear capability, but what if other major players decide to protect their own interests? That is, at what point will US actions be perceived as so destabilizing that others need to circle their own wagons... The US is dependent on imports of fuel and raw materials... How will this game play out?

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Re: China inoculates itself against dollar collapse

One thing I am wondering is why is the Fed. announcing this two weeks prior to the G 20 meeting?  One would hope that this is a strategic move on the part of the Fed.  The question is for what?  I am not sure what we get by playing our hand one week after China's comments and two weeks prior to the G 20 meeting.

I have not had much time to read post today, so sorry if this has been posted it came across  Reuters today -

"U.N. PANEL SAYS WORLD SHOULD DITCH DOLLAR."

"A U.N. panel will next week recommend that the world ditch the dollar as its reserve currency in favor of a shared basket of currencies, a member of the panel said on Wednesday, adding to pressure on the dollar," the story noted. "Currency specialist Avinash Persaud, a member of the panel of experts, told a Reuters Funds Summit in Luxembourg that the proposal was to create something like the old Ecu, or European currency unit, that was a hard-traded, weighted basket. Persaud, chairman of consultants Intelligence Capital and a former currency chief at JPMorgan, said the recommendation would be one of a number delivered to the United Nations on March 25 by the U.N. Commission of Experts on International Financial Reform. 'It is a good moment to move to a shared reserve currency,' he said."

Pieces are coming together, just not sure what the end of the puzzle looks like......

 

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