China, The Dollar, and Inflation

[Bruce551]

China?s Dollar Trap

By PAUL KRUGMAN

April 3, 2009

OP-ED COLUMNIST, N.Y. Times

Back in the early stages of the financial crisis, wags joked that our trade with China had turned out to be fair and balanced after all: They sold us poison toys and tainted seafood; we sold them fraudulent securities.

But these days, both sides of that deal are breaking down. On one side, the world?s appetite for Chinese goods has fallen off sharply. China?s exports have plunged in recent months and are now down 26 percent from a year ago. On the other side, the Chinese are evidently getting anxious about those securities.

But China still seems to have unrealistic expectations. And that?s a problem for all of us.

The big news last week was a speech by Zhou Xiaochuan, the governor of China?s central bank, calling for a new ?super-sovereign reserve currency.?

The paranoid wing of the Republican Party promptly warned of a dastardly plot to make America give up the dollar. But Mr. Zhou?s speech was actually an admission of weakness. In effect, he was saying that China had driven itself into a dollar trap, and that it can neither get itself out nor change the policies that put it in that trap in the first place.

Some background: In the early years of this decade, China began running large trade surpluses and also began attracting substantial inflows of foreign capital. If China had had a floating exchange rate ? like, say, Canada ? this would have led to a rise in the value of its currency, which, in turn, would have slowed the growth of China?s exports.

But China chose instead to keep the value of the yuan in terms of the dollar more or less fixed. To do this, it had to buy up dollars as they came flooding in. As the years went by, those trade surpluses just kept growing ? and so did China?s hoard of foreign assets.

Now the joke about fraudulent securities was actually unfair. Aside from a late, ill-considered plunge into equities (at the very top of the market), the Chinese mainly accumulated very safe assets, with U.S. Treasury bills?; T-bills, for short ? making up a large part of the total. But while T-bills are as safe from default as anything on the planet, they yield a very low rate of return.

Was there a deep strategy behind this vast accumulation of low-yielding assets? Probably not. China acquired its $2 trillion stash ? turning the People?s Republic into the T-bills Republic ? the same way Britain acquired its empire: in a fit of absence of mind.

And just the other day, it seems, China?s leaders woke up and realized that they had a problem.

The low yield doesn?t seem to bother them much, even now. But they are, apparently, worried about the fact that around 70 percent of those assets are dollar-denominated, so any future fall in the dollar would mean a big capital loss for China. Hence Mr. Zhou?s proposal to move to a new reserve currency along the lines of the S.D.R.?s, or special drawing rights, in which the International Monetary Fund keeps its accounts.

But there?s both less and more here than meets the eye. S.D.R.?s aren?t real money. They?re accounting units whose value is set by a basket of dollars, euros, Japanese yen and British pounds.

And there?s nothing to keep China from diversifying its reserves away from the dollar, indeed from holding a reserve basket matching the composition of the S.D.R.?s ? nothing, that is, except for the fact that China now owns so many dollars that it can?t sell them off without driving the dollar down and triggering the very capital loss its leaders fear.

So what Mr. Zhou?s proposal actually amounts to is a plea that someone rescue China from the consequences of its own investment mistakes. That?s not going to happen.

And the call for some magical solution to the problem of China?s excess of dollars suggests something else: that China?s leaders haven?t come to grips with the fact that the rules of the game have changed in a fundamental way.

Two years ago, we lived in a world in which China could save much more than it invested and dispose of the excess savings in America. That world is gone.

Yet the day after his new-reserve-currency speech, Mr. Zhou gave another speech in which he seemed to assert that China?s extremely high savings rate is immutable, a result of Confucianism, which values ?anti-extravagance.? Meanwhile, ?it is not the right time? for the United States to save more.

In other words, let?s go on as we were. That?s also not going to happen.

The bottom line is that China hasn?t yet faced up to the wrenching changes that will be needed to deal with this global crisis. The same could, of course, be said of the Japanese, the Europeans ? and us.

And that failure to face up to new realities is the main reason that, despite some glimmers of good news ? the G-20 summit accomplished more than I thought it would ? this crisis probably still has years to run.

Monetary Inflation is Our Future

By Puru Saxena

Last week, Mr. Bernanke announced that the Federal Reserve would buy $300 billion worth of U.S. Treasuries and another $700 billion worth of government-agency mortgage debt.

In order to finance these purchases, the Federal Reserve would simply create this money out of thin air.

This latest development of the Federal Reserve monetizing debt is inflationary and confirmation that the Federal Reserve wants to debase the U.S. dollar.

It is worth noting that the total debt in the United States now exceeds $60 trillion, and its annual GDP is around $14 trillion.

$60 trillion is a lot of money?even for the United States. The U.S. owes its creditors a gigantic amount of money and a debt so large that it can never hope of repaying it in today's dollars.

So, the United States has two options:

a. Default or bankruptcy

b. Monetary inflation

Given the fact that the United States is still the world's largest economy, owns the world's reserve currency and has a democratically elected government, I think we can pretty much rule out the possibility of sovereign default. Therefore, you can bet your bottom dollar that the United States will try its best to inflate its way out of trouble.

Remember, politicians borrow money when it buys them a loaf of bread and they repay it when the same money is worth only a slice of bread!

(the Chinese Gov. know they are screwed, he ,he' he)

Over the years ahead, the United States, and all other debt-laden nations in the West, will engage in massive money- creation in order to debase their currencies and dilute the purchasing power of paper money.

Remember, monetary inflation is a debtor's best friend, as it makes the debt easier to service and repay.

On the other hand, monetary inflation goes against the interests of savers and creditors. Given the fact that most of the 'developed' nations are up to their eyeballs in debt, you don't have to be a genius to figure out that monetary inflation is our future.

At present, the global economy is dealing with deflationary forces due to credit contraction in the private-sector. However, even now, total credit in the United States is expanding due to rampant borrowing by the U.S. government.

So, I don't expect deflation to take hold; rather, I anticipate accelerating inflation, which has always led to rising asset and consumer prices. It is worth noting that apart from the Federal Reserve, other nations have also started monetizing their debt.

Recently, the Bank of England announced that it plans to buy GBP150 billion worth of its government debt by creating money out of thin air. Needless to say, such a move is inflationary and terrible for the health of the British currency.

Now that we have established that monetary inflation is our future, let us examine which currencies and assets will maintain their purchasing power. If history is any guide, nations that engage in monetary inflation always diminish the purchasing power of their currency.

So, in the years ahead, we can expect currencies in the West to depreciate in terms of purchasing power, but the trouble is that none of the fundamentally sound nations want a strong currency either! (Thailand)

As the world engages in competitive currency devaluations, I expect all the currencies in the world to lose significant purchasing power against hard assets. Therefore, in the years ahead, precious metals and other commodities with intrinsic value should appreciate considerably.

Even the values of fundamentally sound businesses with clean balance sheets should skyrocket as a result of inflation.

Last week, in the aftermath of the latest announcement by the Federal Reserve, we have seen significant strength in precious metals, crude oil and grains.

Conversely, we have seen a huge decline in the U.S. dollar. If the Federal Reserve continues on this inflationary path, we can expect a resumption of the commodities bull-market and renewed weakness in the U.S. dollar.

Contrary to popular opinion, I am of the view that most commodities and stock markets have seen the lows for the entire bear market and we may be in the early stages of a new cyclical bull market that could last for a few years.

Even if some asset prices break to fresh lows in the near- term, I suspect such a move will prove to be a 'head fake' and prices will soon rebound. So if you have a 4-5 year investment horizon, now may be a good time to convert some of your temporarily powerful cash into hard assets (precious metals, energy and industrial metals).

Editor's Note: Puru Saxena is the founder of Puru Saxena Wealth Management - his Hong Kong-based firm that manages investment portfolios for individuals and corporate clients. He is a highly showcased investment manager and a regular guest on CNN, BBC World, CNBC, Bloomberg, NDTV and various radio programs.

[SiamHotel]

you clearly overestimate TF'ers "cerebral activities"

[Oo.Cloud.oO]

you clearly overestimate TF'ers "cerebral activities"

overestimate

being

the

understatement

[gainesvilleman]

Bruce, fantastic read and exactly what I have been looking to get my hands on in regards to the American-Sino economic relationship. Seems like policy makers do have a plan to jumpstart the economy and take care of our national debt: by seriously screwing others haha, okay by me. The second article is scary as hell though. What should I do with my cash savings (my investments arent worth the time it would take to sell them after what happened this past year)?

Gold seems so expensive and I dont know if I can justify buying any. I called one of my college buddies who works on Wall Street, and his answer to what I should buy was also pretty telling as well: "bullets."

[dannyboy]

Bruce, fantastic read and exactly what I have been looking to get my hands on in regards to the American-Sino economic relationship. Seems like policy makers do have a plan to jumpstart the economy and take care of our national debt: by seriously screwing others haha, okay by me. The second article is scary as hell though. What should I do with my cash savings (my investments arent worth the time it would take to sell them after what happened this past year)?

Gold seems so expensive and I dont know if I can justify buying any. I called one of my college buddies who works on Wall Street, and his answer to what I should buy was also pretty telling as well: "bullets."

A couple of old fellers I know are insistant on pork bellies...Buy low, sell high...