China's Investing in a New Currency... And It Ain't the Dollar

Let’s talk about China.

China is the US’s largest creditor. All told, the People’s Republic has $700+ billion in US Treasuries. However, if you account for other dollar denominated investments, China is believed to have 70% of its $1.7 trillion in foreign reserves sitting in green backs.

That’s an unbelievable amount of money invested in the US dollar. Needless to say, the Chinese are not too happy about our Central Bank’s decision to print TRILLIONS of dollars propping up the US financial system.

Indeed, the initial rumblings of what will eventually turn into outright conflict (either economic or war) have already begun. China’s Premier Wen Jiabao recently commented, "We have lent a huge amount of money to the US…Of course we are concerned about the safety of our assets. To be honest, I am definitely a little worried."

Other, former Chinese officials have been less polite in their public statements. Yu Yongding, a former Chinese central bank adviser, recently referred to the US Federal Reserve “as the world’s biggest junk investor… ridden with rubbish assets,” and to Chairman Ben Bernanke as “helicopter Ben.”

The situation has gotten intense enough that Secretary of the State Hillary Clinton flew to Asia to plead with China and other US creditor nations to continue buying US Treasuries. “By continuing to support American Treasury instruments the Chinese are recognizing our interconnection. We are truly going to rise or fall together," Clinton said at the US embassy there.

In simple terms, China owns a TON of dollar denominated assets. And the Fed is doing everything it can to devalue the dollar. Thus China has a few options:

1. Openly sell the dollar, thereby destroying the value of its reserves and inviting open war with the US.
2. Quietly shift away from the dollar without openly attracting attention or threatening the US publicly.
   

The Chinese government, particularly its Premier, has been floating option #1 in the media, discussing the potential for dropping the dollar standard along with Russia and Brazil.

However, this boils down to nothing more than grandstanding. The Chinese are not idiots. And they know that dropping the dollar standard would destroy a HUGE portion of their foreign reserves, since everyone and their mother would follow suit.

Indeed, abandoning the dollar for another currency (say the yen or euro) would serve no benefit from an economic standpoint. It would crush China’s Treasury denominated reserves as the dollar plunged. It would also be akin to trading one problematic investment for another: no major world currency is backed by gold or any asset of real value.

No, to my way of thinking, the Chinese are merely posturing with these statements, trying to draw attention away from the fact that they’re already begun pursuing option #2 (diversifying away from the dollar in private). Indeed, China has already begun moving into a new currency, one that is neither fiat nor flawed. And they did it in their usual manner: under the radar with great focus and determination.

That new currency is natural resources.

Throughout 2009, China has been buying up natural resources, commodities, and other real assets at a break-taking pace: copper imports hit a record 329,000 tons in February, only to be eclipsed by a new record of 375,000 tons in March.

The copper story is just the latest and most obvious display of China’s new currency binge. The Chinese have been buying up mines, metal ore (57 million tons of iron in April alone), and other resources for years now. The headlines were right under the world’s collective nose, but no one was thinking “diversification away from the dollar.” Instead they were thinking, “purchases needed to fuel economic growth.”

Truly, it wasn’t until the world noticed that China was still buying commodities in record amounts even after its economy took a hit that the media began to connect the dots.

Here’s a few dots to consider…

• Feb.10, 2009: China buys Oz Minerals, the world’s second largest zinc miner for $1.7 billion
  
• Feb. 12, 2009: China buys $20 billion worth of Rio Tinto, one of the three largest iron ore producers, giving it the potential to raise its stake to 19%.
  
• Feb. 24. 2009: China buys 16% of Fortescue Metals an Australian iron ore company.
  
• April 1, 2009 China buys $46 million worth of Terramin Australia’s lead and zinc supplies in Algeria.
  
• April 15, 2009: China buy 51% of Ontario’s Liberty Mines: a nickel producer.
  

One should also consider that these are merely the transactions that are publicly displayed. The Chinese government has proved adept at buying assets below the radar via foreign holding companies and other complicated business structures. Informal accounts posit that China has in fact scooped up even more natural resources and mines via these methods today.

The reasoning here is simple. Unlike paper currencies, natural resources and commodities cannot be reproduced ad infinitum by central banks. Thus they are inflation proof. In addition, natural resources actually offer a direct benefit to China’s economy whereas an investment in a foreign currency (the dollar or otherwise) is merely a means of parking cash for a return.

Finally, and most notably, natural resources allow the Chinese to diversify away from the dollar without damaging their current dollar holdings: or their relationship with the US: if word got out that the Chinese were dumping Treasuries, the Treasury market would implode, destroying the value of China’s current investment.

Make no mistake, the Chinese have already begun diversifying away from the dollar. They just haven’t advertised the fact openly. Chinese students openly laughed at our Treasury Secretary Tim Geithner when he gave a talk there promising that “Chinese assets were safe” in the dollar. If Chinese STUDENTS can figure the Fed’s moves out, what do you think the Chinese GOVERNMENT is doing?

I think we both know the answer to that.

Comments

[Larry House:]

Graham, your piece is well done, as always, but this is old stuff. We have seen this happening for months now. The question for commodities is how long will they continue to buy? When China stops/slows down purchases, commodities could correct in dramatic fashion.

Jun 16 11:37 AM

[Bull Run:]

GS; I agree, but the question who will be next..I think Xstrata, King of Coal.. The Chinese have been buying up alot of excess coal lately..Thermal (Up 100%) and coking coal(Up 400%). Xstrata has some big refi's coming up in a couple years, and may very well be the next Chinese target..

Jun 16 12:14 PM

[Donald Ingram:]

Agreed. The Chinese do plan with careful, deliberate, consideration of all possible outcomes to the goal in mind. This is a bit vexing to the Western mind that is used to planning not all that far into the future. Where as the Chinese use generational goals, like "where do I want my great grandchildren to be?" This has always been one of the great strengths of China. Patience in all things.

Jun 16 12:23 PM

[Dave Wrixon:]

" It would also be akin to trading one problematic investment for another: no major world currency is backed by gold or any asset of real value."

This statement is meaningless. If we were all Apes nothing would hold any value other food, and even that could not be effectively stored. So even Gold would be pretty worthless.

However, we are not Apes, we have organization and systems and the value lies therein. On gross, the sum of all that organization and system making is called the economy, and it is therein the value lies. Each regional segment of the global economy is regulated and controlled by Sovereign Government, who in turn take their cut of everything. To facilitate this extortion known as taxation, they created currency, and that currency has value because it can be exchanged with in the economy for Goods and Services. The power of Governments is defined by the tax base of the economies which they control, and they maintain the value of their taxation by keeping strict control over the supply of money. At least they should and indeed they must, otherwise their economy drops to bits and their power evaporates. Just occasionally some Government's lose control of this basic fact. Generally, they belong to countries of little consequence, with huge problems and ideas above their status, but once in a while dominate empires simply lose sight of the source of their power and influence. This point in history is one such time. What happens thereafter is rather messy and unpleasant, so I will just leave you to work out the details.

Jun 16 01:04 PM

[odin:]

Commodities, like anything else, are not a perpetually rising asset. Contrary to popular belief, the supply of many commodities is not about to run out in our generation. Owning mining assets in other countries is subject to a great deal of risk (including appropriation).

China has a population which has given up current consumption for quite a while, and there is potential to cash in those savings. China is wise to acquire and develop resources to satisfy that demand and develop internal employment. However, buying assets willy-nilly in shady areas under shady regimes is not wise either.

Commodities only have value to the degree they are inputs in production. In the near-term, who is China producing for? Global trade will decline, the balance of payments will normalize one way or another.

Jun 16 01:24 PM

[TimT:]

Let's look at all the facts before making a judgement. Yes the Chinese are deliberate, contemplative, and have a long term perspective --they are a remarkable people. But they also have selfish motives just like everyone else. Moreover, they were lobbied for a long time by the developed economies who trade with them to float their currency. Their response was to let their currency trade in a tight range set by them--no real market mechanism there. If they want to play in the world of free market economies then they need to play by free market rules. They didn't float their currency so screw 'em. We devalue our currency and they lose--game over.

Jun 16 02:17 PM

[nun:]

"The Chinese are not idiots."

Really? Then why did they put 70% into a single asset?

Jun 16 03:08 PM

[Jade Bearer:]

"Really? Then why did they put 70% into a single asset? "
Because Euro is even worse.

Jun 16 04:12 PM

[Carl Spackler:]

Interesting position - China trading the dollar for real assets. Only flaw is currency control. China bought U.S. Treasuries in order to keep their currency from rising too much versus the dollar. How is the Yuan going to stay cheap versus the dollar if they are using dollars to buy Australian mines, Chilean copper, etc... If they were doing this, they would be buying U.S. mines and U.S. suppliers. To some degree, they may be diversifying a little into commodities, but it is not a wholesale move. If they did, the Yuan would appreciate too much and their exports would plunge.

Jun 16 04:53 PM

[thiazole:]

I think there is an obvious solution to this problem. Use the dollars to buy up US goods like housing/property/compa... That would simultaneously prop up the dollar (by helping the US economy) while giving China an way out of the dollar. The Chinese government isn't averse to "govnerment controlled business". Create government REITs. Take advantage of the current rent to property value ratio.

Jun 16 05:11 PM

[ken3602:]

because it was working fine then. They are now shifting their position trying not to tank dollar as much as they can.

Bernanke and Geithner are too dumb to see how they triggered this slow but fatal shift. Japan is nervous because they are rather on a losing side, and some misunderstand it as dollar's strength. I lose my word on them...


On Jun 16 03:08 PM nun wrote:

> "The Chinese are not idiots."
>
> Really? Then why did they put 70% into a single asset?

Jun 16 05:44 PM

[Mad Hedge F...:]

Nice discussion. I couldn’t help but laugh when I saw my old colleague from Morgan Stanley, Stephen Roche, on CNBC today. The current chairman of Morgan Stanley Asia (MS) is bearish on the economy and sees no chance of a “V” shaped recovery, just a very weak one at best. There are no “green shoots”, they’re still underground. “The consumer is toast”, he averred, and he expects consumer spending to plummet from a record 72% of GDP to 67% in five years. Because a massive external deficit has to be funded by foreigners, the outlook for the dollar is “down, down, down.” There won’t be a crash, just a gradual decent, as we have seen for the last 38 years. China isn’t going to bail us out. The US has only 4.5% of the global population, but accounts for $10 trillion of consumer spending. China and India together have 40% of the population, but only spend $2 trillion. This disparity is 50:1. Steve was an early BRIC fan, like me, and since China is so overbought short term, India is his first pick. You want to buy countries that have to build infrastructure and a middle class, and China has already done that. India’s recent election of a more pro business government is the trigger. I aggressively pushed India at the beginning of the year (www.madhedgefundtrader...), and it has doubled since then. The humorous thing about all of this is that Steve has been spouting the same perma bear line for the US for 15 years. The in-house joke at MS was that he was sent to China because his bearish sentiments were scaring the firm’s conservative US institutional investors. Given the performance of the BRIC’s since then, it is Steve having the last laugh.

Jun 16 06:48 PM

[Big K:]

Come on guys, nobody takes the Geithner and Bernanke clowns seriously anymore. They have burned up all their dry powder and are out of scams. The gallows floor is now open beneath us. Look out below!

If the Chinese are stupid enough to keep their money with Tim "Madoff" Geithner and Ben "Ponzi" Bernanke, we are happy to take them to the cleaners too. Afterall, it is the American way.

Jun 16 11:37 PM

[TeresaE:]

China is buying natural resources with the profits our corporations and government have gifted them.

Let us look at the price of gas and realize that China is adding more cars to the road daily than we are. Thus the increase in prices even as our consumption falls.

So, they will be manufacturing a huge percentage of everything we need to survive. Foods, construction, clothing, pharmaceuticals and over the counter medicines too.

And they will own the natural resources too, right out from under "Western" nations.

All before Washington enacts some screwed up Energy plan that will gift China the rest of our manufacturing capabilities (other than the two government motor companies-which will be using Chinese made parts in their POS cars).

How can ANYONE not see what is happening?

China once vowed to destroy the US without a shot being fired.

They are succeeding. Sadly, the pundits, government and CEOs are encouraging our demise.

Just wait until China decides to quit discounting their exports (through currency manipulation) and we are hit with the bills.

Doomed comes to mind.

Jun 17 09:23 AM

[TeresaE:]

Because the cash that we paid for their manufacturing was all in USD.

That is the reason for the 70%, it was already in dollars and no loss in value if new assets were bought with dollars.

The Chinese are not idiots, nor are they Western. The GOVERNMENT owns everything, including the "private" companies.

We are the only idiots in the room, we gifted China our greatness (thanks Bill, WalMart already thanked you with huge donations to your library and other charities), now we have discounted our assets so they can use our dollars to buy our future out from under us.


On Jun 16 03:08 PM nun wrote:

> "The Chinese are not idiots."
>
> Really? Then why did they put 70% into a single asset?

Jun 17 09:27 AM

[bbowen7:]

An excellent piece - perhaps not original, but very clearly stated. It is enough to move my thinking 10 degrees.

Jun 17 01:36 PM

[TinyTim:]

good article reiterating several similar pieces.

Ther Chinese are rebalancing their portfolio, and like Warren Buffett, whatever they do moves markets. Buying commodities is one of the more innocuous things they can do wrt impact on USD.
They're making a huge gamble that the zero rate of return on these assets will be greater than the real rate on Treasuries, minus dollar devaluation.
At this point, their exports to the US are so low, they are promoting domestic consumption and infrastructure projects.

Jun 17 03:29 PM

[Mark Anthony:]

I agree with the author's observations. I also want to add that China's strategy was helped greatly by currency speculators. That's why so few people recognize it even as China's global commodity buying binge is happening right under every one's nose:

seekingalpha.com/artic...

Jun 19 01:36 AM

[adamnb:]

China has for some years now been the market maker in commodities. If so, what sense does it make for China to keep buying, when prices on commodities have risen more than 100 % from it low. It makes a lot more sense for China to ease off, let prices retreat, and resume purchases at far more attractive prices. I strongly suspect that is the phase we're now entering.


On Jun 16 11:37 AM Larry House wrote:

> Graham, your piece is well done, as always, but this is old stuff.
> We have seen this happening for months now. The question for commodities
> is how long will they continue to buy? When China stops/slows down
> purchases, commodities could correct in dramatic fashion.

Jun 19 01:55 AM

[adamnb:]

I don't think it took any great strategy for the Chinese to buy natural resources. The Chinese strategy made great sense when commodity prices crashed, simply buying at fire sales. The real question is does it make sense now, with China being the main driver of commodity prices. With oil above 70 p/b, in the midst of recession, I can't figure out why China is not hitting on natural gas, where prices are still deeply depressed. One would expect that to be its next move, but it's no where apparent.

Jun 19 02:09 AM