China's Greatest Trade Ever

There has been a considerable uproar over a story in the overseas version of the Chinese newspaper The People’s Daily. The story suggested the Chinese are very unhappy with the low value of the U.S. dollar. The most quoted line from the story is:

The United States has plundered global wealth by exploiting the dollar's dominance, and the world urgently needs other currencies to take its place.

Clearly the Chinese have a beef with the greenback and the way the U.S. has treated it.

However, the Chinese anger seems misplaced, they are massive holders of U.S. dollars and dollar denominated assets, why would they want to trash the dollar? Doing so would only hurt their dollar positions.

I spent a good portion of yesterday pondering this exact question, and then, over a bowl of cookie dough ice cream it came to me….the Chinese have figured out the greatest trade EVER!

If the Chinese decide to transfer their dollars into another dollar denominated asset, besides U.S. Treasury debt, they have a few choices. Several of these options include: U.S. equities, private equity stakes, agricultural commodities, oil and gold.

If they choose gold they have a significant advantage. Since gold roughly trades inversely to the U.S. dollar, the Chinese could buy gold with some of their dollar reserves and use the rest of the dollar reserves to keep a cap on a rising dollar. In this way they create the exact scenario that would cause the price of gold to rise, i.e., increased investment demand and a weak dollar. With this trade they could convert a depreciating asset into an appreciating asset and have some control over the appreciation. The Chinese government is one of the only sovereigns that have the resources to have a significant impact on both these markets.

Chinese dollar holdings are estimated to be more than $1 trillion. Using this figure as the estimated “dollar portfolio” we can get a little perspective on China's ability to influence the gold market.

According to the World Gold Council, as of June 2008, the total amount of gold held in reserve was $894 billion or 29,813 tons. Immediately it is clear to see that, if it wanted to, China could buy all the gold in the world. Of course, that is all but impossible since the gold reserves are held by central banks and are not for sale.

A more realistic (and mathematically simple) scenario may be that China wants to spend $89 billion of its $1 trillion on gold, using the World Gold Council statistics that would buy China about 2900 tons. The following chart shows tonnage statistics for the last two years.

Gold Supply and Demand

In Tons

In tons	2006	2007
Supply
Mine Production	2485	2475
Central Bank Gold Sales	370	501
Total Gold Supply	3573	3496
Demand
Jewelry	2284	2400
Bar and Coin Investment	424	445
Total Demand	3405	3518

Source: World Gold Council

It is clear from the table that if China spent less than 10% of its dollar reserves to buy gold, they would overwhelm the market. They would be able to buy all the mine production and all the gold the central banks wanted to sell. They would also double the total demand for gold.

Of course I have no proof that the Chinese are doing this or are even contemplating buying gold with their dollars. But if I was running the dollar reserve portfolio and my bosses were talking tough about the dollar, I would look for alternative investments.

Disclosure: I am long GLD and DGP

Comments

[bluesmoke:]

Agreed. What's more, it's logical from the standpoint of basic diversification. The real question then would be - could the price of gold really be manipulated in the future by the same extent it seems to be today? I don't think so.

2008 Oct 30 09:49 AM

[NOWHEREMAN:]

I hate to have to tell you this but China's reserves are about $1 .8 Trillion; these have already declined with the appreciation of their currency from above 8 to below 7; the Chinese currency has closely followed the $ through its rally so it has appreciated another 20% against against most other currencies which has dampened their exports somewhat and Since Gold is traded in dollars as are most commodity trades, using dollars to buy gold isn't a feasible way to get out of the dollar.

Now if the Chinese were to buy the Euro with their Dollars, thereby weakening the $$, then buying gold as it depreciates. It might help their trade as well as enabling diversification. This is my opinion.

GO Barack Hussein Obama. Carl Marx would be proud of you.

2008 Oct 30 10:08 AM

[bcncv:]

Trying to divine China's currency policy from a newspaper article is like trying to divine US tax policy from Joe the Plumber. It just doesn't work.

2008 Oct 30 11:17 AM

[dieuwer:]

Why should the Chinese telegraph what they are up to? Seems silly.
What I do think is that the Chinese are masters is disinformation and spreading confusion.

2008 Oct 30 11:18 AM

[huangthomas:]

Nice intellectual exercise, but I don't believe any central banks should be involved in market manipulation. China accumulate US$ denominated debt instrument, because China has to lend us money to buy their products. This happened to Japan, South Korea, Taiwan........

2008 Oct 30 11:59 AM

[Rokjok777:]

PaulTaut displays his ignorance when he misspells Marx's name. The idea that Obama is a Marxist is a joke. Compared to Comrade Bush, who is in the process of nationalizing the financial industry (and soon autos & airlines too!), Obama is a lightweight commie!
And maybe we could use something different, anyhow. What we're doing now, whether you call it "capitalism" or just "socialism for billionaires" ain't working. I call it FASCISM: the unholy alignment of government, military, and industry that devours the people they are supposed to represent & protect.

2008 Oct 30 12:05 PM

[Urbane Gori...:]

There have been many prior metal manipulations... Can't recall the details, but wasn't there a big silver manipulation back in the 70's or 80's? And there is the 'Mr. Copper' fraud. Interesting how the same old names keep popping up:
----------------------...

Merrill sued in copper scam
May 20, 1999: 1:33 p.m. ET

U.S. officials say broker had role in Sumitomo scheme to fix copper prices

NEW YORK (CNNfn) - U.S. commodity market officials filed suit against Merrill Lynch & Co. Thursday, alleging the brokerage helped Japan's Sumitomo Corp. in its effort to fix copper prices more than three years ago.

----------------------...

I have stated before and will again. I suspect that the economic downturn is a result of China stockpiling commodities such as coal, iron and copper. I believe that they were/are trying to push the price of these products down. It could be that they lost control of the situation and may have accidentally engineered our world recession.

Actually, I'm not much of a conspiracy theorist, I just don't see these types of market manipulations as being that hard to pull off.

jegan ;-)

2008 Oct 30 12:40 PM

[bjd:]

Good read. Something I've been pondering for a while now. Keep in mind that China is rapidly growing its domestic gold mining production with little to show for net exports. My guess is that China will gradually gobble up all of its domestic gold production using its dollar reserves. Combine that with a gradual shift in diversifying some its reserves from US$ into Euros or other strong currencies.

Also keep in mind, if China is worried about the dollar and wants to do something about it, all they need to do to "break even" (i.e. not lose the net value of its reserves) is to shift only 50% of its reserves out of the US$.

2008 Oct 30 12:49 PM

[bjd:]

Brian K.

One more thing, I thought your article is well within the line of thinking of a good article I read earlier this year on the Kitco website. Here's a link...

www.kitco.com/ind/Dill...

In the article, he makes some predictions about gold prices under various scenarios, one of which is a move by China to diversify just 5% of its dollar reserves. That scenario alone was estimated to drive gold prices up to around $1,400.

FYI- I"m long DGP/GLD/gold coins/and Toqueville Gold Fund.

2008 Oct 30 01:01 PM

[Mark Anthony:]

Read this, you MUST be SHOCKED:
seekingalpha.com/artic...

Speculation: Is China behind the $2.29T naked shorting of US T-Bonds? It's T for Trillions!!!

2008 Oct 30 02:24 PM

[NOWHEREMAN:]

Karl vs Carl, a Marx by any other name, Das Kapital.

I don't claim to know the entire Communist Manifesto but I do know that the goal is to eliminate the class split between Owners and Workers. In this case, both small and large business owners, exceeding a certain scale, will be taxed more so that those below a certain scale can be taxed less. You can call it whatever you want.

Robin Hood stealing from the rich to give to the poor was a way of redistributing the wealth. It lasted until King Richard returned to power and the poor were taxed again.
The definition of stealing: the act of taking something unlawfully.

Obama wants to change tax law to accomplish his ends. I would benefit, but just because I would benefit doesn't make it the right thing to do.

You work hard your entire life and then someone comes along goes says you were foolish to do so. I don't like the very idea of a "hand out".

Now if Taxing the Rich involved transferring it to create new jobs to employ more workers, I would cheer him on.

2008 Oct 30 04:42 PM

[Larry House:]

I would rather own most anything other than US $ debt. We may have gotten the last laugh on the Chinese. They bought worthless paper!

2008 Oct 30 05:27 PM

[nmelendez:]

It doesn't matter whether or not the dollar goes up or down, the chinese will make out like bandits. If it stays up they will just keep buying cheap gold. If it goes down their currency value will increase and they buy by printing more yuan, making the yuan "King Yuan". They are in a no lose situation.

2008 Oct 30 08:05 PM

[montyman:]

Based on historical patterns, I would say that the Chinese will end up being duped by the Americans. I have no financial training, but it seems to me that the past few decades have been nothing more but a form of neo-colonialism. The Asians do all the work and ship goodies to Western consumers in exchange for paper that can be made worthless at the stroke of a pen.

The Americans will keep playing this game until it collapses, and then the Americans will simply renege on their debt. The Asian economies will be wiped out. As for the Americans, who would also be in economic trouble after such a move, all they have to do is start a program of rebuilding factories, infrastructure, etc. and not only would there be jobs for every American, but Americans would regain all the physical plant they need to continue economic dominance (remember that in the 1950's Americans were not only the biggest consumers but they were AT THE SAME TIME also the biggest producers). They will come out of all this smelling like roses! If there is competition for natural resources because of this then the Americans can call on their powerful military to ensure supply.

People like Peter Schiff say that the Asians will rebel against the West and become consumers themselves, but I question whether the Asian world can ever be "Western-style consumers". There are cultural issues that suggest that only the West can be the West.

2008 Oct 31 11:12 PM

[FWallace:]

montyman....

great analysis indeed, love it...

2008 Nov 01 09:34 PM

[OctoberFaith:]

Previously, the Chinese wouldn't weaken the dollar because they would destroy their export market to the US. With the US consumer slowing down, it becomes more realistic for them to at least weaken the dollar a bit; but not to utterly destroy it.

Neither does it make sense for them to corner the market in gold--certainly not to the extent where it would allow the US to wipe its balance sheet clean by dumping its own gold reserves and/or leasing proven reserves on Federal lands.

I've said it before, and I'll say it again "A clean balance sheet in exchange for some pretty rocks". It isn't going to happen, not unless the Chinese get some hick with a C average running the country. I mean, a major power with an imbecile like that at the helm? It... will... never... umm... nevermind

roflmao. ah man. funny shit. istar i like you.

to bad china aint a trading partner anymore.

2008 Nov 02 05:20 AM

[OctoberFaith:]

I would rather own most anything other than US $ debt. We may have gotten the last laugh on the Chinese. They bought worthless paper!

chinese stole the strength of the currency anyways?

2008 Nov 02 05:22 AM

[OctoberFaith:]

Chinese debts were already forgiven

2008 Nov 02 05:35 AM