China’s Fires the Warning Shot on US Debt

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China is the world’s largest creditor nation. While the US Federal Reserve has overtaken it as the largest owner of US debt, it is China, not the Fed, that determines the world’s attitude towards the US’s financial situation.

 

After all, the Fed has become the toxic waste depository for all of Wall Street and so consequently must continue its US Treasury buying in order to maintain the illusion that the US financial system is solvent.

 

China, on the other hand, is a voluntary purchaser of US Treasuries. And what China does, the rest of the world will follow.

 

With that in mind I want to alert you to the below news story:

 

China’s Sure Bet

 

As the dollar wobbles, China is pulling back from U.S. Treasury securities and buying up hard assets around the world. THIS YEAR, FOR THE FIRST TIME EVER, China has been investing more overseas in assets like iron, oil and copper than it puts into U.S. government bonds. China in this year's first half spent $31 billion on hard assets, compared with $23 billion on Treasuries and other U.S. government bonds…China’s preference for hard assets over Treasuries, taken by itself, will put upward pressure on U.S. interest rates and make U.S. economic growth somewhat more difficult…

 

I’ve commented on this news story previously in other articles. However its importance cannot be overstated. Understand that China CANNOT simply dump US debt on the open market in large quantities without risking a full-scale systemic meltdown (if it did, other US-debt holders would follow suit resulting in a full-scale implosion).

 

Instead, China must handle this issue delicately until it can risk a direct confrontation with the US without putting its economy at too much risk. With that in mind, consider that China has cut its US Treasury holdings by 7% year over year. 

 

This is a serious warning shot of what’s to come. We’re talking about China dumping some $68 billion in US debt in just one year. Indeed, it is clear China is making moves to continue its ascent to super power status, removing any potential weakness it might face in future conflict with the US (such as overreliance on the US as a trade partner or reserve currency).

 

To be clear, China has proven itself EXTREMELY adept at matters of international finance/ trade.  With that in mind, it won’t openly challenge the US regarding monetary policy or diplomatic matters until it holds ALL the trump cards and can openly challenge the US without exposing its economy to a massive downturn (much as it did with Japan during the fishing boat scuffle).

 

In that regard, going forward I believe China’s monetary/ economic moves will focus on two areas:

 

1)   Shifting its reserves away from the US Dollar

2)   Shifting its trade focus away from the US economy

 

Regarding #1, over the last five years, China has been on a mega-buying spree of natural resources. Because of its close proximity and natural resource riches, Australia has been the primary focal point of these efforts. Indeed, the below list compiled by The Australian represents just a handful of China’s moves in this regard:

 

March 2007: Shougang Corp steel group spent $56 million buying 13% or iron ore developer Australian Resources and agreed to fund $US2.1 billion development of the Balmoral South project;

 

July 2007: CITIC spent $113 million lifting its stake in Macarthur Coal from 11.6% to 19.9%;

 

September 2007: Queensland government awards Chalco rights to develop $3 billion bauxite project near Aurukun;

 

September 2007: Anshan Iron & Steel paid $39 million for 13% of Gindalbie Metals and signed $1.8 billion joint venture deal to fund Karara iron ore project in WA;

 

January 2008: consortium of five Chinese companies given FIRB approval to fund $3 billion Oakajee port and rail project in WA;

 

January 31, 2008: Shougang Corp spent $400 million buying another 20% of WA iron ore company Mt Gibson Iron, but has since been forced to sell for breaching takeover rules;

 

January 25, 2008: Sinosteel spent $100 million for more than 10% of WA iron ore hopeful Midwest Corp;

 

February 3, 2008: Chinalco spent $15.5 billion for 9% of Rio Tinto shares in London;

 

February 26, 2008: China Metallurgical Group announces proposed $400 million acquisition of Cape Lambert Iron’s namesake WA project. CMG already owns 20% of nearby $5 billion Sino Iron Project;

 

April 28, 2008: FIRB approves China Petrochemical Corporation paying $600 million for 60% control of the Puffin oil field in the Timor Sea, the first time a foreign government has operated an Australian oil field;

 

April 29, 2008: Midwest board recommends agreed $1.36 billion bid from Sinosteel priced at $6.38 a share.

 

Again, I want to stress that list represents just a handful of China’s moves in the natural resource space (my own research shows China grabbing as much as $20 billion worth of Australian resource companies from February-April 2009 ALONE).

 

As a stand-alone subject, these purchases can be taken as China merely trying to satisfy its economic demands. However, taken in the context of China’s dumping of US Treasuries, these moves are clearly part of a monetary shift away from US Dollar denominated assets. 

 

Indeed, aside from its acquisitions of natural resource deposits, China’s shift away from US Dollar denominated assets has also involved it heavily investing directly in commodities themselves:

 

China’s Gold Imports Surge Five-Fold

 

Gold imports into China have soared this year, turning the country, already the largest bullion miner, into a major overseas buyer for the first time in recent memory.

 

The surge, which comes as Chinese investors look for insurance against rising inflation and currency appreciation, puts Beijing on track to overtake India as the world’s largest consumer of gold and a significant force in global gold prices.

 

The size of the imports – more than 209 tonnes of gold during the first 10 months of the year, a fivefold increase from an estimate of 45 tonnes last year – was revealed on Thursday. In the past, China has kept the volume secret.

 

http://www.ft.com/cms/s/0/9742847e-fe3e-11df-abac-00144feab49a.html

 

 

Thus, we see China addressing its first weakness concerning the US (an over-investment in US Dollar assets) by moving out of US Treasuries and buying up natural resources and commodities (US Dollar hedges).

 

Regarding its second weakness related to the US (an overreliance on the US for trade), over the last five years China has been aggressively expanding its trade with non-US countries. Consider the table below:

 

 

As you can see, in just four years, the US has gone from accounting for nearly a third of China’s exports to less than a quarter. That is a MASSIVE shift in less than a decade (at this pace the US will be down to just 15% of China’s exports by 2015).

 

All of the moves I’ve outlined thus far, while hugely significant, have not involved China explicitly stating it was moving against the US and its currency. Indeed, to most commentators, China’s moves to acquire natural resources and commodities have been seen in the context of feeding its economic demands.

 

However, once you step back and begin to look at these moves in the context of China trying to rid itself of an over-reliance on the US currency and economy, this latest decision to dump the Dollar for all trade with Russia represents the first monetary move China has made that explicitly involves dumping the US Dollar.

 

This in turn should serve as a major red flag that going forward China will be challenging the US more explicitly which will most likely lead to trade wars and potentially even a physical war.

 

Indeed, we’ve already seen hints of this a few months ago when the US moved to put tariffs on Chinese tires. China responded by increasing duty taxes on US automotive parts and poultry.

 

Expect to see more of this. As in MUCH more of this. China has made it clear that it is NOT pleased with the US’s current monetary policy (China has blamed the Fed for its inflation woes with some officials going so far as to label the Dollar’s status as a reserve currency, “absurd”). The US has in turn responded by labeling China a currency manipulator and blaming it for the US’s economic woes.

 

This issue will continue to fester between the two countries and is likely to break out into more direct confrontations going forward. Considering the wide array of sectors that China exports to the US, virtually every good you can imagine will be at risk of potential price hikes due to potential supply shortages from tariffs or trade wars in the coming years.

 

 

Good Investing!

 

Graham Summers

 

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