A Simulation of China's 2,$$$,$$$,$$$,$$$ Diversification/Writedown

Tuesday, August 04, 2009

Looking at the chart above is another good eye opener of the biggest imbalance the world has ever seen.
These days 3 jobs are the toughest in the world. Would you want to be in their shoes?
  1. US Treasury Secretary who has to raise $490 billion (AP says it is $1.8 trillion) in order to finance this year's record deficit, confronted with a growing unwillingness of China to finance the US war-machine.
  2. Chairman of the Federal Reserve who will increasingly monetize debts while shielding the dollar from an implosion, ultimately in vain.
  3. China's Treasurer who has to diversify out of more than $2 TRILLION, keeping the write-offs as small as possible.
Common sense suggests that option #3 looks comparatively better than the US trillion printers and handlers, the Fed and the Treasury.
Now lean back in your chair, cushioned with $2 TRILLION debt paper and ride through this monopoly game with the highest sums of money ever at stake.
As the clouds above markets turn darker and darker there is not much time left to start spending the 2 trillion before they devalue more. China does not have very much time left. With a possible worldwide financial collapse close ahead China will have to run for the exit before all other holders of US denominated pieces of debt paper.
Rocketing unemployment in the Western world has left deep scars in China's most recent export statistics. So the Chinese took the first $600 billion in order to spur domestic demand.
Now what to do with that shrunken surplus of only $1.5 trillion?
Considering that China plays good cop - bad cop, either talking up Treasuries or firing broadsides against a Ponzi scheme played with Federal Reserve Notes (FRN) it can be expected that China knows it cannot bail out of FRN debt without taking some potentially hard hits down the road.
While increasingly questioning FRNs as the prime reserve currency in the light of biggest tax revenue declines since the Great Depression, China has in the past indicated
  • to build up energy stocks to hedge its FRN holdings
  • upping its share of gold reserves in its Forex reserves
  • to buy commodities of all sorts, this explaining its #1 position as copper importer.
Unwinding these dollar holdings will lead to big adjustments in markets of all kinds. Holding some $585 billion in US Treasuries alone, a gradual shift to shorter maturities can already be noted as well as exploding coal imports. Chinadaily said,
China's coal import hit a new monthly high in May, while coal export slumped to a 11-year low.
The latest statistics from the General Administration of Customs showed China's coal import reached 9.43 million tons in May, more than double that in the same period of last year. China's coal import and export amounted to 32.20 million and 10.53 million tons respectively in the January–May period, or a net import of some 22 million tons.
Industry insiders predicted a net import of more than 30 million tons of coal for the whole year of 2009.
In a further diversification move China begins - with the approval of its central bank - to buy direct stakes in foreign companies, swapping currency risk for profit/loss risk.
Nouriel Roubini sees some commodity price deflation, claiming the Chinese have already poured billion over billion into strategic resources, thereby capping commodity price rises in the near future, reported Reuters on Monday:
"In the short term there has been a massive stockpiling of commodities by China," he said. "My concern is that China might have accumulated an inventory of commodities that is probably excessive to the growth of their own economy," (Roubini said.)

China went on a buying spree after the global collapse in demand for oil, metals and other industrial staples, bulking up its domestic government inventories and snatching up overseas assets from Australia to Africa to Canada to safeguard growth.

A state-owned Chinese firm bought most of the assets of one of Australia's largest mining companies, OZ Minerals, in a $1.4 billion deal earlier this year.

Another, Chinalco, came close in a failed bid to double its stake in global miner Rio Tinto, after Rio struck a separate deal with fellow Anglo-Australian miner BHP Billiton.

China's refined copper imports, at 1.8 million tonnes in the first half, were up 160 percent on the same period a year earlier, while primary aluminum imports rose a stunning 16-fold. Chinese buying has helped drive up both Shanghai and London Metal Exchange prices this year, by around 80 percent on both LME and Shanghai copper and 75 percent on LME lead, 40 percent on zinc and nearly 20 percent on aluminum.

As a result, there is a risk commodities prices will slump again as China now slows its buying spree.

"The risk in the second half of this year is that the rate of accumulation in China must slow down -- one of the factors that a downside correction in commodity prices, however modest, may occur," Roubini said.
Roubini only talked metals, but a quick look at MarketSkeptics blog reveals that this year's wheat harvest may decline dramatically due to a fungus. The US reports declining soybean and corn harvests this year, certainly a good support for world market prices in softs.
China also underpins oil markets. It is known since 2005 that it has been building up strategic oil reserves to smooth futures markets' wide price swings.
All in all one can safely conclude that the fate of FRNs lies mostly in the hands of China and its willingness to writeoff a substantial part of its forex holdings or delay this a little more. It will be inevitable to realize losses on its way out of FRNs. The remaining question is only what size of writeoff China will be willing to take.
has a much more extensive version of China's FRN trap.


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