Posts Tagged ‘reserve currency’

Chinese-American military posturing, post-GFC (whatever that is)

Tuesday, August 4th, 2009

In our previous article, we gave a rough road-map of what can possibly happen in the short to medium term. Today, we are going to straining our vision to look further ahead. Since we are looking too far out into the future, we are essentially guessing. Our guesses of the long-term are as good as yours. Therefore, please feel free to pitch in some of your ideas in the comments below.

Currently, the US and Chinese economies are like two partners in an unhealthy co-dependency relationship. Simplistically speaking, one lends and produces and the other borrows and consumes. As with any unhealthy relationships, this state of affairs is unsustainable. In the long run, we believe it is only a matter of time before the Chinese economy decouples from the US economy. To imagine how such a scenario will look like, consider what we wrote in Can China really ?de-couple? from a US recession?,

The needs of the Chinese consumption economy is different from the US consumption economy. Some Chinese are rich. But some other parts of China are unbelievably poor. Wealth distribution in China is rather uneven and there are still many pressing social and environmental issues to be solved. Currently, the Chinese export economy is tooled towards US consumption. To re-tool and re-configure the Chinese economy towards its domestic needs requires a period of adjustment in which capitals are destroyed and built.

A de-coupled Chinese economy will be driven by its own internal consumption and trade with its neighbours. When such a day arrives, it is doubtful that the US dollar will still remain the world’s reserve currency because the Chinese will no longer have any reason to accumulate them.

The loss of reserve currency status will be a serious problem for the US. As we wrote in How does the US export inflation?,

Through this convention, the US can expropriate resources from foreign countries by buying their goods and services with its own printed money.

Without the ability to expropriate resources from foreign countries, the US government will not be able to honour its unfunded liabilities to its own citizens (see Is the GFC the final crisis?). What can the US government do? It can repudiate its unfunded liabilities to its own citizens and protect the US dollar (to still function as money) or fulfill them by destroying the US dollar (hyperinflation). It cannot remain solvent and protect the US dollar simultaneously unless it finds a way to expropriate resources from foreign nations by force (i.e. go to war).

But war is out of question in an age of nuclear weapons. A military dwarf can be on the same par as a military giant just by possessing nuclear weapons (and a way of delivering them). With mutually assured destruction (MAD) no nuclear armed nation can be at a military advantage from another nuclear armed nation.

Unless…

… the nuclear armed nation has a way of neutralising the other nuclear armed nation’s means of delivering nuclear weapons. Well, the US Pentagon is working on that as we speak- missle defence shield system. That’s the reason why American’s missle defence shield project is highly provocative. A working missle defence shield gives the US dollar a military backing, which is highly useful in forcing the status quo to be maintained.

The Chinese, on the other hand, mindful of their humiliation in the 19th century due to their weakness militarily, will not be standing idle (and surely, they will not mind if they can take over the role of America). Last year, they shot down one of their own satellites in space, which is said to be quite technically challenging.

We believe the ability to shoot down any satellite is a very powerful way to neutralise any missle defence shield. In a missle defence shield system, the challenge is to shoot a missle with another missle, which is like shooting a bullet with another bullet. That requires sophisticated communications between base stations and anti-missle missle, navigation and tracking capabilities- all done on real time. Without satellites, all these complex tasks will not be possible. And the Chinese had demonstrated that they can shoot down any one they wish.

In addition, the Chinese and Americans are now preparing cyberspace as another military frontier.

As we wrote in Nations will rise against nations,

Therefore, outwardly, the world may be at peace. But inwardly, we believe there will be jostling for power, influence and resources between the major nation blocs. Bigger nations will use smaller nations as pawns, international armed non-state groups will intensify their activities and inter-ethnic conflicts will arise. We have no doubt that there will be plenty of Black Swans appearing in the days to come.

Tags: , , ,
Posted in Looking Forward | 22 Comments »

How is China slowing the never-ending stream of $US? Part 1: Currency swaps

Tuesday, July 21st, 2009

In our previous article, we showed you the circuitous route made by a US$ from America (as consumer spending) to China and then back to America as investment in US Treasury bonds. Once you understand this process, you can easily see (as one of our reader David saw) how the US export inflation to China (see How does the US export inflation?). Also, it is easy to see (as another one of our reader Steve Netwriter saw) a problem with such an arrangement. This is what is commonly called a “massive global imbalance.”

So, you can see the never-ending stream of US$ flowing from America to China (and then back to America) as some sort of air streaming via a hose into a balloon waiting to burst. Recently, China has tweaked the rules in order to let some air out of the hose. What are the tweaks?

First, let’s take a look at step 7 of the process in our previous article,

Trade between China and other countries are also settled in US$, which means even more US$ are piled up in the PBOC.

Usually, when China trades with many other countries, the accounts used for the trade is denominated in US$. For example, if China wants to buy palm oil from Malaysia or sell textiles to Europe, US$ are used for settlement. Therefore, the net US$ that flows into China does not come from America alone.

What is happening today is that China is quietly setting up currency swap systems with its trading partners one at a time. With a currency swap system in place, the currency used for trade can be denominated in the Chinese currency (RMB) instead of US$. As this news article reported back in March 2009,

The agreement marks Argentina as the fifth nation to sign currency swap agreements with China following similar agreements with South Korea, Malaysia, Belarus and Indonesia. China ranks as Argentina’s second-largest trade partner.

Some people are saying that this is China’s scheme to slowly supplant the US$ as the world reserve currency. This will happen if/when one day, China captures more of the world trade then the US.

In August this year, China will open up another avenue for the US$ to ‘leak out.’ Keep in tune!

Tags: , , ,
Posted in Currencies, Economics/Finance | 12 Comments »

What good will come out of the G20 summit?

Thursday, November 13th, 2008

This coming weekend, leaders of many nations will gather together for a G20 summit to discuss longer-term solutions for the global economic crisis. This summit will involve not just involve the ‘rich’ and mostly Western economies, but also emerging economies like China. As the British PM said here,

The alliance between Britain and the US – and more broadly between Europe and the US – can and must provide leadership, not in order to make the rules ourselves, but to lead the global effort to build a stronger and more just international order.

There is plenty of rhetoric about the formation of a coming “new world order” from the G20 summit. But all these are just big talks and hot air.

Firstly, the world’s biggest economy (US) is in no position to lead. The US is the world’s biggest debtor nation who borrowed from the world’s biggest credit nation (China). As we said before in Will the US dollar collapse?,

Thus, this situation is akin to an individual owning the bank money. If he owes the bank a million dollars, he is in trouble. But if he owes the bank a billion dollars, the bank is in trouble?if he goes bankrupt, a large portion of bank?s loan portfolio will be wiped out, rendering the bank insolvent. The US owes the rest of the world so much money that they cannot afford to let the US go ?bankrupt.? But the rest of the world knows that sooner or later, the US will go ?bankrupt.?

Obviously, the debtor is in no position to be the boss. That’s why Gordon Brown’s empty talk about US and Europe providing leadership is a joke.

Secondly, although it is possible that the G20 summit will produce some substantial and coordinated actions from governments, it will be nothing close to a “new world order.” This is because it is all about trying to return to the status quo of fiat money, credit expansion and most importantly, maintaining the US dollar as the world’s reserve currency. As we explained in Awash with cash?what to do with it?

The US, being in the enviable position of having its money as the world?s primary reserve currency, is not subjected (for now) to the same rules as the other countries?it can spend more than it earns simply by printing its own dollars to pay foreigners.

There is no way the US will let their dollar relinquish its reserve currency status without a fight. Even if they are willing to do so, what will be the alternative? Gold? Not likely because this will be too tough a medicine for any nation to take. As we explained in Can there be an alternative reserve currency?,

All these problems leave only one candidate to function as the world?s reserve currency- gold. The world used gold under the classical gold standard (there is a brief history of money in Why should you invest in gold?) and it arguably worked very well until the interruption of the First World War. But it will require the global economic situation to deteriorate to the point of extreme pain for the idea of reverting to the gold standard to be entertained. So, don?t hold your breath on that.

So, at the end of the weekend, the G20 summit will most likely be another lame-duck session.

Tags: , , , , ,
Posted in Currencies, Gold, Looking Forward | 14 Comments »

Can there be an alternative reserve currency?

Tuesday, June 24th, 2008

Today, we will answer another of our readers’ question from our earlier article, What is a crack-up boom?,

Pete

So in a crack-up boom, will this be different to the times of Germany? There are so many fiat currencies out there, whats to stop Australia for instance adopting the Euro? (I bet there are many reasons). What about if people get sick of $USD, and start trading in Chinese Yuan instead? Or Reals? Is that possible? Due to our global trade system, that was not as highly developed in the time of Germany?s troubles, would that not alter the possible outcome when the crack-up ?conditions are met??

Sergey Stadnik

It the new hyperinflation hits the world, starting with US. What?s going to become such an anchor: gold, oil, Chinese Yuan?

For those who are new to this publication, the context of these two questions lies in the US dollar being the world’s reserve currency. Please note that as always the case, we are not making any predictions about the future. Instead, we are exploring the possibilities with a view to understand what are the economic signs to watch out for.

First, how will today’s crack up boom different “to the times of Germany” in the 1920s? Well, if a crack up boom is confined to only one currency, then it is only that currency’s country that get affected. For example, Zimbabwe is ravaged by hyperinflation today. There is no major economic effect on the rest of the world because of it. But the US dollar is a different- it is the world’s reserve currency. An inflating reserve currency will have an effect on to the rest of the world- see How does the US export inflation?. As we can all read from the mainstream media, inflation has become a global phenomenon, with the sky-rocketing oil prices blamed on the ‘weak’ US dollar (see Can ?weak US dollar? be partially blamed for rising oil prices?).

Now, let us suppose that the US will fall into a crack-up boom (i.e. hyperinflation). As we said before in What if the US fall into hyperinflation? (and we encourage you to read this article for the context), when that happens,

… a disorderly flight from the US dollar is a Black Swan event that will result in a mad scramble to find a reliable alternative. It will be a time of volatility and uncertainty. No prize for guessing that gold will be the primary beneficiary when that happens.

Will the Euro become the reserve currency? Or the Chinese yuan? There are a few problems with that:

Firstly, all these currencies are fiat money (in fact, all currencies today are fiat money). As we said before in What should be your fundamental reason for accumulating gold?, money is fiat if it

… enjoys legal tender status through the authority of the government instead of through the choice of the free market. This means that fiat money is not backed by anything physically tangible?it derives its value from an elusive intangible called ?confidence.? Simply put, fiat money is backed by nothing!

For this reason, we can liken choosing a reserve currency to a beauty contest that chooses the least ugly woman as the winner- all choices are bad choice and we have to choose the least bad choice.

Secondly, each of these currencies have their own unique problems.

Thirdly, if an alternative reserve currency is to emerge, it will involve unhealthy economic conflict and competition among the nations (similar to the years prior to the Second World War). A good way to illustrate this instability is to use the reality TV show, Big Brother, as an analogy. In that show, all house mates vie, plot, back-stab and struggle among each other in order to win the one and only top prize. In the same way, the country having the world’s reserve currency will be in a very commanding position. We can be sure that if China vies for this position, there will surely be opposition.

All these problems leave only one candidate to function as the world’s reserve currency- gold. The world used gold under the classical gold standard (there is a brief history of money in Why should you invest in gold?) and it arguably worked very well until the interruption of the First World War. But it will require the global economic situation to deteriorate to the point of extreme pain for the idea of reverting to the gold standard to be entertained. So, don’t hold your breath on that. But if it does happen (who knows?), we can imagine it happening the way we described in What is the future of silver?.

Lastly, can oil function as money? As we said before in Properties of good money, oil does not fulfil the necessary properties to function as money.

Tags: , ,
Posted in Economics/Finance, Gold | 14 Comments »

Awash with cash?what to do with it?

Tuesday, December 19th, 2006

Not long ago, an Australian executive went to the Middle East to promote one of his company?s software systems to potential Arab clients. In his sales pitch, he sprinkled the words ?low-cost? all over to stress the cost effectiveness of the product. After a while, one of the Arabs pulled him aside and growled, ?What do you mean by ?low-cost?? We don’t care about the cost! Just cut the nonsense and give us what we want now!? Upon returning to Australia, that executive remarked that the Middle East is ?just awash with money.?

Just where do all these money come from?

The answer, as you would have guessed by now, is the United States. The US, being in the enviable position of having its money as the world’s primary reserve currency, is not subjected (for now) to the same rules as the other countries?it can spend more than it earns simply by printing its own dollars to pay foreigners. Thus, it can sustain greater trade deficits than would otherwise be tolerated by foreigners.

For years, the US has been running a ballooning trade deficit?its imports, which is paid by its own printed dollars, has been exceeding its exports by an ever-widening margin. From China, the US has been importing consumer goods and from the oil-producing nations, oil. The US dollars that are used to buy oil are nicknamed ?petrodollars? (the money in the above-mentioned story is such dollars).

Today, those foreign countries that account for the vast majority of US imports (namely the oil-producing Middle Eastern nations, Russia, China and Japan) are sitting on so much US dollars that they do not know what to do with it. Therefore, they recycled much of those dollars by purchasing US Treasury bonds. As a result, the long-term interest rates in the US are being artificially suppressed by those purchases.

As we said before in Will the US dollar collapse?, some of these countries are murmuring about diversifying their reserves away from the US dollars because they see that such state of affair is increasingly unsustainable. With the US continually inflating its money supply (printing money), their reserves of US dollars are increasingly become more and more worthless. In fact, we believe that given the swelling amount of US dollars in the world, its current price is overvalued.

Now, here comes a problem. Countries like China and Saudi Arabia are sitting on a massive pile of US dollars parked in US Treasuries. They also know that the US dollars are overvalued and are becoming more and more worthless as each day passes. On one hand, they would not want the US dollar to collapse to its intrinsic value because that would mean the purchasing power of their US dollar reserves would be crunched. On the other hand, they would not want to continue maintaining their holdings of US dollars because they lack confidence in its value. Selling their US Treasuries at once and using the proceeds to buy alternatives to the US dollars will be unacceptable because by virtue of the magnitude of their US dollar holdings, such action will have an immediate and significant impact on the market prices. This will have a very disruptive and destabilising effect on the global financial markets. Thus, the only sensible solution is to quietly and slowly diversify away from their holdings of US dollars so as not to disturb the market prices unduly. This would take a long period of time.

The next question is, what would these countries buy to replace their US dollars?

Tags: , , , , , , ,
Posted in Economics/Finance | No Comments »

Will the US dollar collapse?

Tuesday, December 12th, 2006

As we mentioned in The ABCs of hedging, the first step in hedging our investments is to subject our portfolio to ?war-games,? where we work out how it may perform under various economic what-if scenarios and come up with strategies to counter the unfavourable outcomes.

Today, we look at one possible scenario?the decline (or collapse) of the US dollar.

Lately, we are again hearing that central bankers are murmuring about diversifying their foreign reserves away from the US dollar. Does it mean that there is an imminent liquidation of their US dollar reserves? Well, this is not the first time they murmured about it and it is definitely not in their (including the Federal Reserve?s) interest to see a collapse of the US dollar. The Chinese, with their US$1 trillion of reserves, would not want to see their stockpile of US dollars to lose significant value. The same goes for the Japanese and the oil-rich Middle-Eastern nations. The US too, would not want to see their dollar collapse as that would result in soaring inflation in their homeland. Therefore, we do not expect mass selling of US currency reserves by central bankers in the near term.

On the other hand, it is open knowledge that the status quo is unsustainable. This morning, we heard that Alan Greenspan (the former US head of Federal Reserve) warned investors in a business conference in Tel Aviv to expect a few years of dollar weakness. He further said that is imprudent to hold everything in one currency. This prompted a further slide of the US dollar against the Euro. The US has the dubious honour of having the world?s greatest trade deficit. If not for the fact that the US dollar is (maybe ?was? is the more appropriate word) the world?s reserve currency, the US would be consigned a banana republic long ago. The world cannot lend to the US indefinitely. Sooner or later, they will demand a pay back. The moment they decide that the US will not and is unable to repay its debt, what will happen to the US dollar? What will happen to the global financial system when that happens?

Thus, this situation is akin to an individual owning the bank money. If he owes the bank a million dollars, he is in trouble. But if he owes the bank a billion dollars, the bank is in trouble?if he goes bankrupt, a large portion of bank?s loan portfolio will be wiped out, rendering the bank insolvent. The US owes the rest of the world so much money that they cannot afford to let the US go ?bankrupt.? But the rest of the world knows that sooner or later, the US will go ?bankrupt.? (Of course, a country cannot be bankrupt in the same way as individuals do because there is always the option to print money to remain solvent. But the end result will be just as horrible?hyperinflation.) What can be done?

We are all living in a precarious situation. We shudder to think of the day when a black swan event happens. On that day, whoever owns gold will have a lot of friends.

Advertisement

Tags: , , , , , , ,
Posted in Looking Forward | 13 Comments »