Tuesday, May 22, 2012

Enter the SinoDollar: China and reserve currencies.

Given %60 of China's (~$3trn) reserves are held in US treasuries and USD denominated securities, at what point will Beijing decouple itself from a dependency on a deflating dollar, and what will decoupling mean?

Since a dramatic change in USD value would effect the majority of Chinese reserves, China cannot switch out of its USD reserves and decouple itself from US monetary policy without dramatically reducing the value of said reserves. Put another way, as soon as China started selling off its US holdings, it would get a lower and lower price for them as each chunk or tranche was sold off. The ~$2-trillion in USD denominated securities would be considered a huge oversupply that markets would only absorb at huge discounts. The current monetary consensus holds that a Chinese fire sale on their US treasury holdings would would be a wholesale destruction of value, and so they have been in a Mexican stand-off over the value of the USD vs. Yuan. We can even liken this situation to a monetary Mutually Assured Devaluation.

Gold has so far been considered by many to be a hedge against declines in the value (purchasing power) of the USD, at least due to monetary base inflation.

If China has a reserves portfolio worth ~$3-trillion, of which about %60 is denominated in USD, and given current negative interest rates (rate of inflation higher than interest paid out on bonds) cause the nominal value of this ~$2-trillion to diminish - then you add erosion of purchasing power of the dollar through monetary inflation - it is rational that the Chinese would be looking to hedge against inflationary risk to their USD holdings.

In spite of the country's hollow growth economy and imminent political instability, it appears that  elements in the military and party members still have aspirations to rebuilding China as an empire. There are many and more-practical reasons that China would want its economy to be less dependent on its current relationship with the US, but while nationalism is a sloppy explanation, it covers their intent and reasoning with some accuracy, even where it is accidental.

China devalues its currency not only to keep exports cheap and demand up, but more pragmatically, the government must also desire to control and maintain the velocity of money within its own borders. Beijing may need to print money to pay party members to keep it in power, or to pay military manufacturers and the massive security apparatus, etc. Major consumers of their exports (US, Canada, Europe) are already uncomfortable with the level to which China has weakened its own currency, as the cheap yuan makes it very difficult to compete with manufacturers who are paid a pittance in a weak currency. The US manufacturing economy is an example of one which has been almost completely hollowed out by competing unsuccessfully with debased Chinese imports.

However, without much credible domestic demand, and a high sensitivity to inflation throughout its mostly rural population, China may still have to loosen its monetary and credit taps even further to stimulate its own consumers into buying domestic products. This kind of monetary policy is what got the US in trouble, since printing money just inflated bubbles in credit, housing, automobiles, fuel, and other kinds of debt (student, consumer etc), but in many ways it also worked, since it has also subordinated global economies to US consumer demand. The Chinese could quite reasonably wish to adapt the US monetary model with fewer of the mistakes of the western one, and without the political irritants of western democracy. It seems reasonable that Beijing would seek to emulate this tactic.

What prevents China from reducing its exposure to the value of the dollar and decoupling itself from US monetary policy, is the small matter of a diminishing ~$2-trillion in USD reserves.

Given a Chinese GDP of ~$6-trillion, and a relatively modest (but objectively galloping) growth rate of %5-%10 per year, at what point does a significant loss in their US reserves net out? Not a %100 loss on the reserves, and half would surely be considered a catastrophe. A quarter in a short period (a few years) would be a serious crisis. And yet, when adjusted for GDP growth, and we are getting in under the $500-billion loss mark, that's something China could offset with hedges and collateral. If Chinese USD reserves lost %25 of their value ($500B) because of a fiscal/monetary or political decision, no doubt that is utterly huge, but in a realm that they could make up for, even by issuing debt based on some kind of hard collateral.

One wonders, if the value of your currency reserves has been decimated, what could they possibly use as collateral to make up for the shortfall? What, indeed.

If China wants to extricate itself from holding so much in USD reserves, how much gold would it need (and at what price) to hedge (offset) - using an incredibly high estimate - some fraction of a $500B writedown of its USD holdings?

Here's where the paranoia starts. China doesn't need the whole ~$500B, it just needs enough gold as sound collateral to back new debt, new currency, or special drawing rights on some acceptable portion of the forseeable loss so that the writedown does not appear as a significant hit relative to Chinese GDP.

Let's take a step back for a moment and restate that the numbers here are dart-board estimates. A high-to-hyper  inflationary situation in the US could wipe out half or more of the ~$2tr Chinese USD reserve, which would be the equivalent to a ~%8-16 decline in Chinese GDP. That's a massive and dangerous crash. It's a hard fail situation that everyone would sacrifice a great deal to avoid. That said, high US inflation (%10-15) would seriously erode China's reserves anyway.

In spite of all these hand-wavy figures, the question remains, given the deflationary effect of China selling off treasuries, how much collateral would China need to hedge coverage for the loss from discounting after selling off half of its USD reserves? With USD exposure of remaining reserves, what collateral will retain its value in the event of a USD devaluation? How much would China be willing to pay to have a monetary system independent of the US? And finally, how much underlying (fractional) collateral would a country need to back a new reserve currency, or viable "special drawing rights"?

China has signaled repeatedly that it wants monetary independence, and to reduce its exposure to US policy, even suggesting a few years ago it wished to re-denominate its reserves in IMF special drawing rights (units in a basket of currencies held by the IMF).

Standard fractional reserve banking levers every dollar of deposit at about 20:1 to 30:1, so I would  suggest that when the value of Chinese gold reserves hits 1/20th to 1/30th of USD holdings, there may be an opportunity (or an option) for Beijing to launch a competing reserve currency backed by gold and to absorb any of the more severe losses on their USD holdings the change caused. It would be a very Chinese way for them to extricate themselves from their subjection to US policy, and without dumping treasuries into the market. They may then plausibly insist they are not dumping the US, but merely going their own way.

China operates like a battle ship, where it takes tremendous power to maneuver it or change its course, but once pointed in the chosen direction, barring sea changes, its progress is all but inevitable. The party has already signaled the direction it intends to take quite clearly. The question now is how long it will take to get there, and what must be left in its wake.

Some figures for consideration:

 According to super-reliable global authority, Wikipedia, China has official gold reserves of 1056 tonnes. There are a few moving parts here, but assuming a gold price of about $1,600/oz this is about $60-million per tonne. Countries are notoriously secretive about their real gold holdings, and almost all figures are not audited. Some countries probably have more, and some less, depending on their respective agendas. Add to this that governments store much of their gold in other countries, notably with the New York Fed and other places, it's hard to know for sure how much a government holds and how much is just promised to them by a foreign repository.

There is little if any incentive for China to be forthcoming about how much gold it has. Officially, its holdings are valued at only %1.8 of their foreign exchange reserves, where the global average is nine times higher at over %16.  That is, China's official gold reserve numbers are not even statistically significant. While it is unlikely to hold none, we can make a baseless presumption it could have (or will shortly acquire) closer to 2-3000 tonnes. Somewhere between $120-180-billion at current prices. Why? Because it's a highly liquid hedge against devaluation of their USD reserves, and there would have to be some crazy and obvious reason for them to have purposefully eschewed the accumulation of gold, and in spite of the example of every other country accumulating it.

China is ranked as 8th in the world of gold holdings, but 6 and 7 spots each belong to Italy and France, who still hold more than twice as much as China. 

Funny thing about that Wikipedia average is that I've proposed China is lying after presuming everyone else is telling the truth in spite of how unreliable official gold figures are, but the deviation from average gold holdings as a percentage of reserves is so large (nine times), as to emphasize its improbability.

More interestingly, if gold were the collateral for a new competitive global reserve currency, at what point does it become the urgent interest of the current reserve currency coalition (US Fed) to undermine the value of China's (and perhaps the IMF's) gold reserves?

It would depend on the capital requirement for the new currency. If it were 20:1 (%5 capital requirement like a bank under a fractional reserve system), at current gold prices (~$60m/tonne) that's $1.2B of gold-backed sino-bucks per tonne. Or just under $1.5trn when measured in China's 1056 tonnes in reserve.

It suggests that there is significant incentive for western governments to undermine the price of gold as the unknown reserve levels in emerging powers could be of sufficient value as to back a competitor to the USD.

The question is: how much gold, at what price, and what leverage ratio will allow China to launch a parallel SinoDollar gold backed currency?

Or alternatively, at what price will governments intervene to drive down the price of gold as a last ditch effort to block Beijing's currency gambit, and what will it look like? Issuing more gold certificates and ETF-like products will drive down demand for physical gold in the short term. Or maybe something more radical like driving down domestic demand by confiscating gold in forced sales or exchange for certificates.

It's just a question of whether that will give enough time to use some political advantage to head off China at the pass.

And, just in time, it appears that the folks at Zerohedge are on the case.

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