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Yes Virginia, The Chinese CAN Dump The Dollar

by Aaron Krowne

I’m surprised how persistently I see the dubious assertion that the Chinese “can’t move away from the dollar because they own so many of them”. A related argument is that they are “stuck in dollars because of the trade deficit”. They certainly can move away from the dollar, though, by continuing to do what they are already doing.  This will bring them to a point where they will be positioned to transition away from the dollar, possibly rapidly.  Here is what I mean.

Assume China has $2 trillion in total dollar reserves. By “dollar reserves” I mean mostly Treasury securities (Treasuries) and to a lesser extent Agency securities (Fannie and Freddie) and cash dollars. However, for the purposes of this discussion, they will be considered one and the same, and can just be called “Treasuries”.

At the same time many observers are closely watching the US-China trade balance, and China’s purchases of Treasuries, we know the Chinese are buying gold and every sort of natural resource they can get their hands on around the globe. Some of this is public, but probably not all (maybe not even a majority). Yet, those pointing to China’s holdings and accumulation of dollars rarely mention it.

This can be considered “cashing out” of the dollar, in a sense. As for the current level, I’d be surprised if they’ve even “cashed out” $500 billion worth of their dollar holdings–or about a quarter of the total assumed here.

So, that’s a mere minority of their total dollar holdings, China-US “status quo” trumpeters say. The impression I get is that these people think it’s basically pointless for China to be buying hard assets.  Yet, this minority share of their total portfolio doesn’t imply that the Chinese are a huge support for the dollar going forward.

That’s because what they are buying — precious metals and natural resources — are inherently valuable, regardless of what happens to the dollar. That is the key part — no one is considering what happens if the dollar’s value changes radically… downward. Yet that is exactly the situation one would want to prepare for in the long term, if one expected a major global “portfolio rebalancing” away from a dominant reserve currency like the dollar.

To see why this matters, let’s imagine the Chinese reach $750 billion in hard assets, valued in today’s dollars.

Then imagine that at this point, they decide they have plenty, and are tired of propping up the dollar, so they “pull the plug” in one of a myriad of ways (probably a statement saying they will simply cease buying Treasuries would be enough, but it could also involve some outright selling in unexpected, large quantities).

A 50% fall in the dollar wouldn’t be out of the question in such event. Horrible for the Chinese, right? They hold so many dollars…

But look what happens to their “portfolio”… the $750 billion in hard assets becomes worth $1.5 trillion, and the Treasuries (while they have the same nominal value) shrink in buying power on a relative basis from $1.25 trillion to $625 billion.  The overall portfolio is now nominally valued at $3.75 trillion.  That sure doesn’t seem so bad for the Chinese.

Using a more meaningful comparison, imagine that gold starts out at $1000/oz, and the entire $750 billion in hard assets is in gold.  Then the Chinese hoard is valued at 2 billion gold oz equivalent before the devaluation.  After devaluation, it would (if purely in dollars) be valued at only 1 billion oz.  But since they were wise enough to “cash out” $750 bln  into gold prior to devaluation, they end up with 750 mln oz of gold + $1.25 trillion, worth 625 mln oz of gold, for 1.35 bln oz gold equivalent value.

You see where this is going.  The Chinese can easily capture a large portion of the “value” of their present dollar holdings through devaluation by moving them into hard assets … arguably even if the (dollar) value of the hard assets a priori is a minority of the total portfolio.

One a deeper level, there is no realistic way to move all of the dollar portfolio into hard assets.  Commodities and precious metals markets are simply too small (that even goes for currency markets… nothing comes close to the dollar paper market for depth).  There is a maximum practical amount that can be “cashed out” before the dollar starts plummetting and its real value approaches zero.  Put another way,  it’s impossible to buy 2 billion ounces of gold with the $2 trillion in dollars we started with.  China’s challenge, then is to buy as much as they can before the devaluation process gets along too far.

Given that, I think they are doing amazingly well.   Most commodities are not even back to 2008 peak levels (gold and silver are a weak point, at new highs since then).  But the dollar value “lost” from their holdings can be seen simply as a hidden premium to converting their stash to hard assets.   In truth, they will be doing immeasurably better than any nation dumb enough to still hold primarily dollars in its Forex account when this moment comes.

I’m not claiming the Chinese are actually at the tipping point now. But it is obviously the direction in which they are going. Should this trend continue (and there is no reason to believe it will not), a point will come in the near future at which the Chinese benefit more from ditching the dollar (letting it collapse) than propping it up.

The current impact on the market is likely muted — intentionally — by the manner in which the Chinese are going about their hard assets deals. Many are taking the form of long-term contracts where dollars are pledged in exchange for resources (such as oil), as they are output. The impact of such a deal is not felt immediately on the dollar or commodity market, yet the Chinese can basically “earmark” portions of their dollar portfolio as “allocated to hard assets” every time they do such a deal. As a result, in the future, the commodity will be marginally more scarce, and the dollar marginally less desired, which suits China fine from their perspective.

Mining and agricultural deals are similar, as future supply is bought up in the present, at a fixed dollar price. Should the dollar fall, China has both secured a portion of production the commodity involved in the deal, and they don’t care a whit what the dollars are worth which they previously used to purchase the producing property.

It is also rumored that Chinese agents are going to the commodities exchanges, using their Treasuries as collateral to control commodities contracts. This indirectly secures ownership of the commodity, without having to actually sell Treasuries.

The above analysis leaves one thing unaccounted for: the value of the Yuan, and the ongoing US-China trade deficit. Should the Chinese ditch the dollar with gusto, they will need to let the Yuan float (or at least readjust its value upwards). This will remedy the US-China trade deficit, as well as quell inflation in China. Most analysts point out that China stubbornly is not revaluing the Yuan (some even argue it isn’t undervalued, a claim the Big Mac Index belies).

That is true… now.   But should China be in recognition of the “tipping point” I am describing, such a point would naturally be a good one to start revaluing the Yuan. Then the infamous Chinese stubbornness against letting the Yuan rise would magically change. Perhaps that stubbornness is precisely because they are waiting for this point — the Chinese authorities are not stupid; they know the Yuan is fundamentally valued too low.

Seem unlikely? Then I will close by pointing out that virtually every major world power has announced its arrival on the global scene with a strong currency, not a weak one. And many influential Western analysts and power brokers, not to mention the Chinese, have made no secret of the fact that they expect China to truly “arrive” soon.

Perhaps, then, it is all planned out.

There Are 10 Responses So Far. »

  1. The flaw here is is that you keep saying “the Chinese”. The actions you are talking about are all “the Chinese government”. And if they give up on the dollar, they will destroy all of their export based business. The thing to watch to decide when “the Chinese” will abandon the dollar is when the value of their internal consumption starts to get big relative to their export business. That is when they can walk away from the dollar. And really, the Chinese government isn’t doing a very good job of pursuing this path. They may think they are, but the gigantic distortion of the value of their currency has forced the economy to gear up for export and empty the pockets of their domestic populace. They’ll have to be lucky to get from here to there without serious pain.

  2. philip:

    As I pointed out, the path towards a dollar devaluation only makes sense if they (Chinese government) are willing to accept a Yuan rise.

    While exporters might not like that, I cannot see how it can be denied, in the long run. As you yourself say, the peg of the Yuan has created a gigantic distortion. Despite transitional pain, I cannot see how alleviating that distortion is a bad idea. And it will be good for the Chinese people in the long run (a strong currency always is… as long as it is not propped up at an abnormally high level).

  3. There is one detail you didn’t mention in this article- Timing.

    When will China dump the US Dollar?

    When China can do so and cause the least pain, if any, to itself.

    Consider this-

    China wanted Hong Kong returned to it and had one of two choices to reclaim it.
    1. Invade.
    2. Wait for its guaranteed return.

    China chose to wait, and in doing so allowed Hong Kong to become even more valuable after a fifty year wait than if China chose to invade. By patiently waiting, China spent zero Renminbi on soldiers, tanks, planes, etc and eventually gained the valuable businesses, factories, banks, airport, and stock exchange located in Hong Kong.

    China is fully aware of what would happen if the US Dollar were to crash and burn, the whole world would go to hell in a hand basket overnight along with China’s export market. Even though China does more exporting to South America and Europe than the US, if the US Dollar, the world’s reserve currency, falls, everything else falls with it.

    So what can China do? Wait it out like it waited out to reclaim Hong Kong. While waiting for the day (or year, or decade) that the dollar is eventually replaced with some new reserve currency, China sits in the catbird seat using its US Dollar holdings to buy up oil fields around d the world, mines around the world, farmland and food around the world, and anything else China may want or need.
    China can play the waiting game with its US Dollar holdings, exchanging them for everything the Chinese people want or need, but do so under the radar so as not to crash he dollar’s value, all the while making itself stronger by buying vital resources it needs.

    It has been said that the rich plan for four generations while the poor plan for Saturday night.
    The Chinese plan for decades and centuries, how much planning is the US doing?

  4. How about this. Lets consider China 50 years ago. That was 1961. I don’t think China had the option to invade Hong Kong back in 1961, 1971 or even 1981. So really, they only had one choice, to wait.

  5. [...] http://blog.ml-implode.com/2011/01/yes-virginia-the-chinese-can-dump-the-dollar/ [...]

  6. [...] Yes Virginia, The Chinese CAN Dump The Dollar (Hat Tip: Jean Stoner) [...]

  7. [...] He’s back. Aaron Krowne, writing over at ML-Implode has posted another great article of concern for all Americans. Particularly for those with some skin in the game, such as a family and home to protect from ILLEGAL bank foreclosure. See his complete article here. [...]

  8. [...] ZeroHedge piece that just came out necessitates a nice follow-on to my recent article about China’s ability to “dump” the [...]

  9. U.S. was just downgraded and yield on treasuries went down. think about that for a second buddy. this would make NO sense in any other credit situaution except for one major thing. the FED creates a fake market for u.s. treasuries by printing funny money. this debt is NOT and NEVER going to be paid back it is going to be inflated away through a mathematic equation of rolling over debt continuously.
    (there are limits to this behavior but these limits have zilch to do with the chinese and everything to do with domestic employment cost of food and civil unrest)

    it DOESNT MATTER IF CHINA BUYS STUFF WITH THEIR RESERVES SO LONG AS THOSE DOLLARS DON’T EVENTUALLY COME BACK TO THE U.S.

    the idea that international demand for dollars plays neutral for inflation in the united states is called EXPORTING INFLATION.

    if those chinese treasuries were sold to purchase U.S. goods and to buy u.s. property and investments, than you’d have a hyperinflationary scenario in the u.s.

    this is why there are limits on capital inflows of u.s. dollars as well as foreign currencies.

    it really wouldn’t matter if the treasury market crashed. the FED will still buy treasuries by PRINTING MONEY AND INFLATING AWAY REAL INTEREST RATES.

    yes THE FED PRINTS MONEY AND CAN PROP UP DEMAND OF THE TREASURY REGARDLESS OF A CRASH OF OUTSIDE BUYERS OF TREASURIES.

  10. Great article. By melting down the dollar the Chinese government can use a gold backed Yuan and become the world reserve currency. Remember their political philosophy is communism, they will sacrifice short term exporting of goods to insure this. Its really a brilliant plan as they don’t care about the US economy and they eliminate their greatest rival at their own game, all without firing a single shot!!!!

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