Sunday, April 26, 2009

China's Stealth Abandonment of the Dollar Has Begun (Part One)

Written by Justice Litle, Editorial Director, Taipan Publishing Group

China wants to get shed of its excess dollar reserves – and to eventually see the dollar replaced as the world’s reserve currency – but in its deep ambition China must tread carefully. The great game has begun...

If you owe your bank manager a thousand pounds, you are at his mercy. If you owe him a million pounds, he is at your mercy.”– Yu Yongding, influential Chinese economist, citing John Maynard Keynes

A quick note relating to Friday’s Taipan Daily, “
The Last Western Country Where Banker isn’t a Cussword.”

TD reader from down under Roger K. writes, There is another western country where banks are also doing well, that is Australia. The banks here have similar stringent regulation and conservative management... and Australia is a western country and we speak english - well sort of...

Good on ya Roger. (An Aussie expression, for those unaware.) I should have thought to include Australia in my mental checklist of Western countries.

When I took a semester at Macquarie Uni in Sydney (back in the late 1990s), there was a lively debate taking place as to whether Australia should consider itself a part of the West or a part of Asia. Perhaps I subconsciously resolved the question in favor of the latter. As it so happens, the Australian dollar is one of the six currencies represented in the
Ultra Resource Index CD*, so all’s well that ends well.

China is well aware of its little “problem” – that is to say, the problem of what to do with $1.3 trillion worth of U.S. dollar reserves. (China’s total reserves are pegged at just under $2 trillion. Roughly two-thirds of that sits in dollar-denominated assets.)

Nor is it an easy problem to solve. In many respects the United States has China over a barrel. There is no way China can credibly threaten to dump its dollar holdings over the side en masse, as such would be an act of financial self-destruction. This “gotcha” situation gives Uncle Sam a certain degree of freedom to be as abusive as he likes when it comes to the printing press.

TEH : I have read many of such analysis regarding China "outburst" on USD. But, China is NOT sitting still and you could see China is 'up to something' big. I m still following closely the "Sun Tze" art of war applied in China at the moment ... a very interesting way of economic-war.

But hold on, that’s not quite accurate. If things get desperate enough in Beijing, the mandarins can, in fact, threaten America with a full-scale dollar blowout. They can put the gun to their own heads, so to speak, and in so doing put it to Uncle Sam’s head too. (For more along this line, see the March 20 Taipan Daily essay, “

China, the Fed and Financial MADness revisited.”)

Of course, that action is only palatable as a last-ditch resort. Playing the madman requires a certain air of desperation, a certain loss of face at home... and no doubt the mandarins would prefer avoiding that indignity if they can.

Something has to be done about the dollar situation regardless. And as we try to handicap the moves, we have to remember that China is very comfortable playing the long game. While U.S. politicians are content to play checkers, in other words, China prefers to play chess. Or, to make the analogy more apt, perhaps China prefers to play “Go” – an ancient game involving the placement of black and white stones that is, in its own way, even more subtle and complex than chess.

Change at the Periphery

The first tactical concept China seems to be embracing is “change at the periphery.” If you cannot challenge your opponent bluntly and head on, then you do so obliquely and from the side. You undertake a series of quiet, subtle maneuvers – perhaps so subtle that your opponent does not notice them at first – and slowly build strength in that fashion.

This process of change at the periphery is related to a powerful concept from the theory of evolution known as “punctuated equilibrium.” I gave a talk on this subject (as it relates to markets) in New Orleans in 2006.

A key thrust of the punctuated equilibrium idea is that, despite what many assume, the center does not actually evolve or change. Instead, the center remains relatively stable, while interesting things happen out on the fringes (the periphery). These fringe-area happenings are mostly inconsequential... little bubbles of experimentation that come and go.

But then, given enough time, something happens. One of those fringe happenings out on the edge catches on. Something new and powerful takes place at the periphery. This new model or idea or experiment or whatever it is – the precise technical term doesn’t matter – begins to catch on.

The source of peripheral change then begins to compound in force and impact, reaching a stage where it grows and expands rapidly. And then, seemingly out of nowhere, the dominance of the old center is challenged.

As mentioned before, the old center does not actually change or evolve. Instead it is challenged and eventually dominated – perhaps dominated out of existence – by a new center that quietly grew in the shadows, out on the fringes, while few were paying attention.

TEH : This is a very interesting concept, which certainly came from a scientific-brain. Nevertheless, I fully enjoyed and do believe such evolvements are possible.

One Shovel at a Time

This roadmap of “change at the periphery” is the path China must take to free itself from the heavy yoke of excess dollar reserves. The mountain is too big to be moved all at once. And so, instead, China must figure out how to move the mountain quietly and in stages... one shovelful of earth at a time.

At the same time, China is obviously thinking of power on the geopolitical stage. It is not just enough to get shed of overwhelming greenback exposure – that is only half the goal.
The other half of the goal is finding ways to accelerate the twilight of the dollar as the world’s reserve currency, in such a manner that Beijing’s power can wax as Washington’s wanes, without disturbing the existing order of things so much as to bring the current system crashing down on everyone’s head. This, too, is a delicate business.

And so China must start small, and proceed with caution. But there is a time factor here too... the longer Beijing waits to carry out a strategic plan of action, the greater the risk that large stores of Chinese wealth could evaporate through the ongoing process of dollar debasement. There is no element of leisure here. In many ways time is of the essence, and this requires certain movements to be perhaps a little less subtle and a little more blunt than the mandarins would ideally prefer.

So that’s the setup... tomorrow I will tell you about the three key “peripheral actions” China has recently undertaken, and show you how these actions could have dramatic impact on our trading and investing strategies in the years ahead.

China's Stealth Abandonment of the Dollar Has Begun (Part Two)

Written by Justice Litle, Editorial Director, Taipan Publishing Group

In part two of our "stealth abandonment of the dollar" series, Justice explains the three peripheral actions China has taken to accelerate the greenback's demise.

In part one of this two-part series we talked about China’s not-so-little “problem”: a paper mountain of U.S. dollar reserves in excess of $1.3 trillion (out of some $1.9 trillion total). We also laid out China’s two-part goal of 1) getting shed of U.S. dollar exposure and 2) hastening the end of the greenback’s reign.

It should be emphasized, again, that China is thinking longer term here. In the West we are more used to short-term thinking on the part of our leaders. This is, in part, due to a flaw in the system of representative democracy. Politicians are always thinking of the next election – never more than a few years away – and hardly if ever beyond that. This leads to a constant stream of easy promises, a tendency to put off hard choices, and an almost stubborn refusal to think clearly and soberly about the future.

From the “long game” perspective, the near-term ups and downs of the dollar don’t matter as much. To get a sense of China’s perspective, it might make sense to look at charts of the US Dollar Index from a weekly or monthly perspective, rather than a daily one.

But with that said, the game is definitely afoot. Here are the three “peripheral actions” (
see part one) China is taking to bring about the dollar’s demise, each bigger than the last.

Peripheral Action #1: Speaking to Those With Ears to Hear

China’s recent rhetoric on the dollar has been a curious mix of strength and weakness, boldness and timidity.

On the one hand, a key Chinese official, central bank governor
Zhou Xiaochuan, stated flat out in recent weeks that the dollar should be replaced as the world’s reserve currency. On the other hand, when pressed on the matter, China waved off concerns of fiat currency regime change, calling the statement simply a matter of “academic opinion” put forth in essay form for discussion.

Chinese Premier Wen Jiabao has also appeared alternately hard and soft. “We have lent a huge amount of money to the U.S.,” Mr. Wen said in March. “Of course we are concerned about the safety of our assets. To be honest, I am definitely a little worried.”

There are mixed signals here. At times China has seemed to hold the whip hand, and at other times China has played the role of anxious creditor subject to the whims of its massive debtor client.

I suspect the mix of tones is deliberate. By sounding sometimes strong and sometimes weak, China is presenting a sort of Rorschach ink blot – a muddled
message that biased listeners can resolve to their liking. Those who want to believe China is strong on the dollar question have evidence to support that idea. So, too, do those who believe the opposite.

Meanwhile, the very fact that a conversation is being held is a subtle victory. One might say a whisper campaign against the dollar has begun, and China (with a touch of help from Russia) has begun probing for ways to keep the conversation going... and perhaps even gradually turn up the volume.

This is how a delicate campaign begins, especially when the ultimate idea (replacing the dollar as world reserve currency) is so bold. You test the waters at first... get people thinking... use subtle channels to get your message to those with ears to hear, being careful not to pressure those for whom it’s still too early to hear.

As the stakes get higher, this low-level background chatter should increase. By the time there is widespread and serious talk of “what to do about the dollar,” if China’s mission is accomplished, it will feel like the subject is not new or taboo, but had already been on the table for quite some time. And those who heard China’s message early on will be prepared.

TEH : A brilliant game plan, if that is what China has in mind.

Peripheral Action #2: Quietly Circulating the Yuan

China's second course of action is more substantial. But because the details are a little too complex for the average layman to grasp, the media has all but ignored the implications.

Here is the gist from Bloomberg, as reported some three weeks ago:

China’s leaders... are making it easier for trading partners and consumers to do business in yuan.

The People’s Bank of China has agreed to provide 650 billion yuan ($95 billion) to Argentina, Belarus, Hong Kong, Indonesia, Malaysia and South Korea through so-called currency swaps. More such arrangements are being planned so importers can avoid paying for Chinese goods with dollars, the central bank said. In Hong Kong, which has pegged the currency to its U.S. counterpart since 1983, stores from Park’n Shop supermarkets to jewelers accept yuan.

The Chinese yuan is not yet what’s known as a “convertible” currency. In other words, the yuan is not yet freely tradable on the open market. Currency traders can’t buy or sell yuan in the same manner as dollars, Swiss francs or euros.

TEH : I have shared with JL recently about what I read regarding China moves to use the 'currency swaps' and making yuan 'more tradable'. This is only to point why I thinking that China is really up to something 'big'. US is aware of it but ... it is a clash of strategies now. We shall see China's next move. Also, China has been very 'quiet' in UN and such ... but recently China DARE to voice out their 'displeasure'. Time is here for China to dominate ... the crisis becoming an opportunity for China to grow ... into economy power house.

Over time, this status will change. Beijing has long placed trading restrictions on the yuan as a measure of protection for the home market. But now, through various “currency swap” agreements, China is looking to end the role of the U.S. dollar as transactionary middleman in various trading partner transactions.

Part of the role of a world reserve currency is to grease the wheels of commerce by acting as an acceptable medium between two countries. If Argentina wanted to trade with Israel, for example, there might be a currency problem – while Argentina has little need for Israeli shekels, Israel probably has even less need for Argentine pesos. Enter the dollar. If both countries agree to do their trading in U.S. dollars, the problem is solved. This is so because, in theory at least, the world’s reserve currency is universally useful and desirable.

With these new currency swaps, China is in effect saying to its major trading partners, “You know what? How about we dispense with this intermediary dollar stuff? We’ll agree in advance to do a swap – providing you a line of credit of sorts – so that you can pay for your Chinese imports in Chinese yuan. And in turn, when China imports your products – beef, grain, natural resources or what have you – we’ll pay you in your local currency too. No greenbacks necessary.”

This “stealth action” has quite a long ways to go. The amounts involved are still very small in the context of global trade, and there are a lot of kinks to be worked out.

But in a way that’s the point. Challenging the world’s reserve currency – truly challenging it in the logistical sense, not just with rhetoric – is not something you just pull off in a fortnight. This is how “change at the periphery” works... small, seemingly innocuous, below-the-radar type developments that gather momentum and force over time.

Peripheral Action #3: Embracing the Industrial Inflation Hedge

A week or so ago I wrote the following in these pages

A very important question is whether the rally in copper is real. Because “Dr. Copper” is known as the metal with a PhD in economics, a lot of people look to copper as a global barometer of economic activity. I am coming around to the view that Dr. Copper’s message may well indeed be for real... but that the good doctor is more likely predicting the imminent return of inflation as opposed to renewed economic prosperity.

In hindsight, I think that assessment has turned out to be more or less correct – but with a twist. As Ambrose Pritchard with the UK Telegraph reported last week, China has been buying copper like crazy:

Hard money enthusiasts have long watched for signs that China is switching its foreign reserves from US Treasury bonds into gold bullion. They may have been eyeing the wrong metal.

China's State Reserves Bureau (SRB) has instead been buying copper and other industrial metals over recent months on a scale that appears to go beyond the usual rebuilding of stocks for commercial reasons.

Nobu Su, head of Taiwan's TMT group, which ships commodities to China, said Beijing is trying to extricate itself from dollar dependency as fast as it can.

“China has woken up. The West is a black hole with all this money being printed. The Chinese are buying raw materials because it is a much better way to use their $1.9 trillion of reserves. They get ten times the impact, and can cover their infrastructure for 50 years."
"The next industrial revolution is going to be led by hybrid cars, and that needs copper. You can see the subtle way that China is moving into 30 or 40 countries with resources," he said.
"I wish I could just get back to where I was!"

If you've been saying this to yourself, you need these 10 FREE picks from a maverick analyst who's profited hugely from every downturn of the last decade...

This is big news. The hybrid car element is further intriguing given
Warren Buffett’s 10% investment in Chinese hybrid car maker BYD, and the fact that China’s auto sales recently surpassed U.S. auto sales for the third month in a row.

But the bigger picture aspect of China as major league buyer, storer and horder of base metals is this. When paper can’t be trusted and precious metals markets are too small, raw materials are the way to go. This “industrial inflation hedge” concept could catch on like wildfire in the coming years.

It just makes sense. Gold and silver will do very well in an environment of global currency debasement and serious inflation problems – exactly the type of world we’re headed for. But the trouble with precious metals for countries like China has always been their relative lack of size. China alone could drive the price of gold up to many thousands of dollars per ounce, simply by attempting to ratchet up its percentage of gold holdings from one percent of reserves to some large multiple of that.

Raw materials, on the other hand, are far more abundant, and ultimately more pragmatically useful too, in terms of being plugged in to the demand equation. Hard assets like copper and nickel and zinc are immune to the whims of the printing press, and China will need all those metals and more, in substantial quantities, to build out the vision of economic prosperity it holds for the coming years. And what better time to stock up than in the quiet period before a stimulus- and debt-fueled inflation tsunami returns?

TEH : If you read these, you will agree that US market has NOT bottom-out. Seriously, think of it LOGICALLY ... can US continue to exert their SUPER-power over all the global contries. China certainly rebelling at the moment. Russia has always not been on US side. US allies, UK and France are being hurt badly at the moment ... Can they save themselves? Euro still in deep-s*it and US are to be blamed. US too large to collapse?

There is still more to the story... which is wholly to be expected, as it is a very BIG story... but that’s enough for now. In the short run, just remain aware that investing and trading are two different things, and thus the time to begin accumulating hard assets from a long-term investment point of view is not necessarily the time to trade them. There could be periods in the near future where the dollar looks quite strong and hard assets again look weak – but remember, this is the short game, not the long game.

In many ways I expect the second half of 2009 to prove tricky and challenging for buyers of hard assets. But the dynamics of the long game seem clearer by the day, and China’s embrace of the industrial inflation hedge concept (along with other peripheral measures to get shed of the dollar) will play a large role.
We will be trading and investing accordingly.

TEH : For trading opportunities, US-market could give us huge gains. But, if we are going to invest in US-stocks, we have to listen to the direction of China's Sun Tze strategies in place ... no one will dare to dis-miss the power of China, the emerging market. I m definitely on China's mission side. Perhaps, I m a chinese?

Other Related Topics: China , Currency , Justice Litle , Macro Trader


omores said...

Nice article. In fact, China had whispered about diversifying their foreign reserves 5 or so years ago. So we can assume that they have already planned out their strategies to this effect even before then.

CP said...


glad that you enjoyed it as much as I did.

Will post more such 'useful' and informative articles to be shared and we shall see how it could affect our investment point of views.