22 July 2010

China and the Goldfinger Syndrome

I have had some interesting discussions recently with correspondents about the problem which China has with its very large US dollar reserves.

To summarize what I think, China is attempting to diversify their portfolio of US Treasury dollar holdings. They are obviously accumulating 'real goods' including stockpiles of basic materials, gold, silver, oil and investments in the means of production in their own region and in key regions around the world.

This is more difficult than it might appear on the surface. Real goods are often strategic, and governments are sometimes reluctant to allow them to be acquired by a government considered a potential threat. The first difficulty is the strategic importance of some assets, such as the China's offer for the purchase of Unocal.

But there is also a need for confidentiality, stealthiness if you will. If word were to leak out that 'China is dumping its Treasuries' there would be a run on the market and the Chinese could lose a portion of their reserve wealth rather quickly.

Now, would it matter. Well, yes. It would matter because US dollars are still the currency of choice for most international trade including the all important international commodity, oil. If you think that philosophically dollars have no value because they are just paper, I would be more than happy to dispose of them for you. Limited time offer, of course.

I also posited that China, while accumulating its real goods quietly against the constraint of perturbing the markets, could do short term hedges against the less catastrophic scenario of further dollar devaluation by going into the very deep and liquid financial assets markets, and hedging risk with CDS and other obvious investments including shorts of various types.

As anyone who has attempted to acquire a company or take a substantial position in or out of an asset or company, at some point you can affect the price, making other participants aware that the asset is in play, and end up selling or buying against yourself. In the case of China it could also trigger a run on the bank of the US, which is an immediate endgame.

With regard to the use of financial instruments, someone raised the obvious issue of counter party risk. Well, of course it is an issue. But less so if you are merely hedging a portion of the portfolio for the devaluation scenario, and not a catastrophic default. And the choice of counter parties can be managed to some degree. It is a big world out there and the Swiss are always open for a bet.

But correctly, if there is a catastrophic failure of the dollar, they will be carrying banks and brokers around the world out on stretchers and almost all financial assets, or bets, will be in default. Those who are holding leap puts as insurance against a collapse may as well be holding food vouchers for a restaurant in Brigadoon.

China would most likely not lose the value of its reserves in the extreme case of a US default, even if every one of their remaining Treasuries and the financial hedges on those Treasuries became worthless. Why?

It's the Goldfinger Syndrome. As you may recall, Auric Goldfinger did not wish to steal the US gold supply, at that time the currency of the nation, from Fort Knox. He merely wished to eliminate it, making his own substantial gold holdings significantly more valuable. It is a form of increasing value through deflation, a concept that is much more familiar these days thanks to quite a few amateur economists patiently waiting for the US dollar to gain in value because of it.

If the US were to actually default, the value of real goods, from basic materials to gold and silver and oil, would absolutely soar in terms of dollars of course, but in most other fiat currencies of the developed world as well. The perception of the risk of a fiat currency would border on hysteria.

Returning to the deflation meme, the elimination of US financial assets from the 'world currency base' would make all the other currencies extremely valuable, and China would be flush with them. For real goods are a form of currency suitable for the exchange of wealth. They are merely less liquid, and not often used as the unit of value anymore. But real goods are a form of currency. They just cannot be printed, except perhaps on the Comex and at the LBMA it appears, and they would be absolutely discredited and out of business.

So, that is something to think about. China need do nothing but slowly and stealthily acquire real goods, and hedging their positions along with way with financial instruments, waiting for the US to play itself into some beneficial outcome for them. I think the financial hedging is important because of the relative illiquidity of some of the real goods, and the difficultly of acquiring them in sufficient supply without triggering a 'run on the dollar.' The financial markets are deeper and more discreet than the markets for real goods.

The problem facing the holders of dollars is not inflation or deflation, per se. They are merely particular manifestations of currency risk, and the uncertainty of holding substantial assets denominated in a fiat currency that is risky, meaning something abnormal or unstable in the classic sense of the term. A serious deflation or inflation are both unusual and risky.

This is not hair-splitting. Rather it is essential to understanding why gold can increase in value during periods of both a significant deflation and inflation, which on the surface seem like opposites. In fact they are similar if view in the terms of probability. They are both the opposite of currency stability, what I call currency risk. The further one gets out on the probability curve with a currency, the better gold looks in relation to it. Gold is the ultimate in stability, almost inert, and highly resistant to corrosion and decay, bordering on the timeless, comparatively uniform in its supply.

There are those who say that when the time comes, and what is happening becomes apparent, they will buy some real goods, foodstuffs, land, gold and silver. I can assure you that when that time comes, there will be little or none available at almost any price. One has to have lived through a currency crisis first hand to understand the phenomenon.

You are holding a currency in decline and there is little or no place to spend it except as a throwaway, because no one wants it anymore. Barter becomes predominant, and any hard currency is king. This is how it was in Russia in the 1990's with the old rouble before it finally imploded, at which time I was thankfully out of country. It was quieter than you might imagine, despite the headline antics of their mafia, and a sense of quiet desperation as people watched their life savings simply evaporate.

There is almost no doubt in my mind that this is how the Chinese are playing this, and certainly Russia and a few others as well, who are playing the long game. It explains some of the recent moves in price of certain forward looking assets, a phenomenon so little understood by the many, even now.

I still see the greater probability for the US as a devaluation and a stubborn stagflation for quite a few years. But the policy errors being committed by Bernanke and the Obama Administration are making the possibility of an actual collapse more likely than I would have thought even six months ago. I suppose it is never well to underestimate the self-destructive tendencies of obsessive greed.

See also The Last Bubble: The Problem of Unresolved Debt in the US Financial System and Currency Wars: Selling the Rope