Yuan May Hold Key To Chinese Territorial Expansion

Includes: CNY, CYB, FXCH, GLD, IAU
by: Steven Cochran

China's recent declaration of an "air defense zone" over the Japanese-held Senkoku Islands in the East China Sea has become the latest flashpoint in the expansionist policy in the West Pacific that it has pursued for decades. China has already won a victory of sorts by getting the world to treat the islands as "disputed territory," since Japan has been the only nation to occupy them, claiming them in 1895. China never contested Japanese ownership until 1971, when possible petroleum reserves were discovered there. China has gone so far as to alter old Chinese maps that show the islands as Japanese.

This is the standard procedure China has used to expand its territory since 1949. It makes small, incremental incursions, no single one egregious enough to go to war over, until it has achieved its territorial goals. China claims 80% of the South China Sea. If allowed to enforce those claims, they will control shipping routes through which over half the world's merchant tonnage and one-third of the world's oil tonnage passes.

China seized the Paracel islands from Vietnam in 1974, killing over 70 Vietnamese soldiers, then attacked Vietnam's possessions in the Spratlys in 1988, killing 60 Vietnamese sailors. China has recently built a town on Woody Island in the Paracels it named Sansha City, installing a civilian government it claims has authority over all the Paracel and Spratly Islands. Chinese patrol craft based there chase out any foreign fishing boats.

China has been only slightly less aggressive in its seizures of islands off the Philippine coast. Chinese coast guard vessels now patrol Scarborough Shoal , and have erected barriers to prevent Philippine fishing boats from anchoring there. A spokeswoman for China's Foreign Ministry told Reuters,

"The Scarborough Shoal is indisputably part of China's territory, and China will ensure that its sovereignty over this area is not being violated."

China's goal is not only energy self-sufficiency, but remote naval bases for its expanding navy, so that it isn't hemmed in by Japan and Taiwan.

As many analysts note, nothing China does is spontaneous. Every action on the international stage has been planned years before. Therefore, it knows it needs to convince the U.S. to continue allowing Chinese expansion in the South China Sea. Since the PLA Navy has no chance of bullying the U.S. Pacific Fleet as it does its smaller neighbors, any pressure will have to be economic. This means reducing the international power of the dollar, while building the yuan into the new reserve currency.

One way to enhance the yuan is to open currency bourses in major trading hubs, such as Singapore and London. This is exactly what China has done. This facilitates international trade in commodities using yuan instead of dollars. This makes it easier for China sign up its major sources of raw materials, such as Australia, to bilateral agreements to denominate trade in yuan. Agreeing to trade with China in yuan cuts the dollar out as a middle step, therefore reducing demand for dollars. Since China is the world's leading consumer of base metals (as well as many other commodities,) convincing trading partners to ditch the dollar is not a very hard sell.

China is also the largest oil importer in the world. Since oil is also traded in dollars, it provides major demand and support for the dollar. To combat that, the Shanghai Futures Exchange is planning to offer crude oil futures denominated in yuan, and using the medium sour crude that China favors as the benchmark. There are some oil-producing nations that would be happy to reduce the importance of the petrodollar, and may sign on.

China is both the #1 producer and at the same time the #1 importer of gold. Again, these commodities are traded in dollars, forcing the Chinese to buy dollars. To reduce its vulnerability to U.S. debt, China is looking to expand its central bank gold reserves. To that end, it has financed the purchase of many foreign gold and base metal mines in Asia, Africa and Latin America. The Chinese government has bankrolled $4 billion in loans to Chinese companies in two years just on gold mine acquisitions, mostly in Australia (which whom it has a yuan trading agreement.) The gold produced in these mines goes straight to China, and never sees the open market. With enough gold production under its control, China can move the focus of the gold trade to Hong Kong or Shanghai, and dictate that gold contracts be denominated in yuan.

Since government bank reserve figures are a state secret, no one knows how much gold the Peoples Bank of China is storing, but domestic demand cannot account for all the gold flowing into the country. It is surmised that the Chinese government is using gold to replace U.S. Treasury debt in its central bank reserves, and recent pronouncements by top officials that "It is no longer in China's favor to accumulate foreign-exchange reserves" signal a reduction in both foreign bond and dollar purchases.

This will weaken the dollar and strengthen the yuan. The ultimate goal is to be formally included as a reserve currency by the IMF. To qualify, the yuan has to be fully-convertible. Last week's announcement of allowing market forces more say in the yuan's value by expanding its allowed trading range, moves it another step towards that goal. One trader noted,

"Once convertibility is achieved, reserve managers will flock to the yuan as an additional reserve currency. Its position will take market share away from other, overweight reserve currencies, most notably the U.S. dollar."

China's efforts are starting to bear fruit. The yuan replaced the euro as the second-largest international trade currency last month, but is still used in less than 9% of all global transactions. (The dollar stands at 81%.) The Chairman of China's central bank isn't standing still, announcing that he is going to "pull out all stops to deepen financial sector reforms"in its goal to make the yuan "basically convertible" in two years.

When that happens, the world will have a partially gold-backed reserve currency independent of the dollar, and a China with no compelling reason to buy or support dollars or U.S. debt. The U.S. will be far less likely to oppose Chinese expansion into the Southwest Pacific, as it will not want to provoke China into boycotting U.S. Treasury bond sales.

How can investors position themselves in preparation? Once the yuan becomes convertible, it is expected that the Chinese will reveal the extent of their gold reserves. It will then be in China's interest to support gold, as it will constitute part of the yuan's backing as a reserve currency. The revelation will probably get investors in the West noticing how much international trade is being conducted in yuan. They will also notice just how much gold production China controls, and that it is not reaching the open market.

This should prove supportive for gold, not only for the spotlight these moves will focus on the precious metal, but also because the dollar will weaken from reduced demand. Even if, in the future, gold has its price set in yuan, American investors will still be buying in dollars.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.