China, Gold, and the Fiat Currencies

Conventional wisdom says the continuing Chinese trade surplus should cause the Renminbi (aka RMB, Yuan, or CNY) to rise or float to a higher level.  This logic would appear to be true if you sold the dollars and bought RMB.  Foreign exchange follows the laws of supply and demand – the more dollars you flood the exchange market with, the less the dollar should be worth.

Conversely, the RMB should rise in value against the dollar.  Yet the RMB has appreciated at a slow rate, 3% compounded annually for the past six years, with economists pointing to the intervention by the Chinese which prevents a true float of the currency.

Many economists believe there is no need to worry about trade imbalances.   The country with the largest trade imbalance is simply trading a fiat currency for goods or services.  Eventually the dynamics of supply and demand on a currency will will weaken the currency of the country with the trade deficit (and strengthen the currency of the country with the trade surplus).

The Great Economic War

The Achilles Heel of forex of fiat currencies is that currencies do not float against any logical model.   Too many of our monetary concepts are based on backed currency dynamics.  In the fiat currency world – countries have many more options available to them.

China had been able to exploit fiat currency dynamics by simply minimizing conversion of dollars into RMB.   Initially, this was accomplished by purchasing USA treasuries.  But the Chinese saw that not only was this postponing a day when it must convert dollars – but also saw through the game plan of the USA and other G-7 members to devalue their respective currencies.

The Federal Reserve zero interest rate policy reduced yields.  The Chinese began an offensive battle to divest itself of a currency which could devalue faster than the interest it was accruing by holding bonds.

Holding currency (any currency) as a storehouse of value is becoming a high risk strategy for investors.  The currency wars are in play,  and in all wars – everyone believes they will win.  Outcomes are uncertain.

One of the underlying strategies in the Federal Reserve game plan was to force some conversion of dollars into RMB or another currency – causing an appreciation of the RMB (or at least appreciation of another major currency against the dollar) – but most importantly to begin to equalize China’s competitive advantage.

The Chinese Game Plan

China went on a buying spree using dollars.  Instead of converting, they used the dollar’s position as THE international currency to buy commodities and mines (among other things).  The appreciation which economists believe should happen to a currency due to trade imbalances was shifted to the commodity sector.  China is defeating the plans of the G-7 central banks to revalue their currencies against the RMB.

The increased costs caused by commodity evaluation are a burden shared buy all countries.  This maintains the status quo – all currencies remain in their relative positions.  China shifted part of its currency evaluation dynamic to commodities – especially gold and silver.

In 2010, China has imported 209.7 metric tons of gold – more than the amount of gold added to the ETF GLD.  Their purchases go far beyond precious metals.  It goes into all commodities,  They are buying natural resource companies.  The are buying companies globally which will add to their strategic plans to continue to dominate global trade.

The Chinese are thinking outside the box.  They are experimenting with economic theory to strengthen their dominance.  Meanwhile, back in the USA – the great experiment appears to be the government buying its own debt – all while its fiscal policy is to overspend to stimulate the economy so the government can buy its own debt.

The Chinese seem to have the better strategy in this Great Economic War.

Economic News This Week:

Econintersect economic forecast for December 2010 estimated level or slightly negative economic growth.   This week the Weekly Leading Index (WLI) from ECRI improved from -2.4% to -1.5% implying the business conditions six months from now will be roughly the same as today.

Initial unemployment claims continued their WoW improvement with this week’s release from the Department of Labor.  Historically, with these improving numbers – there should be an improvement in the employment numbers.

As I have been suggesting since last year, the problem in the New Normal is not job loss, but job creation.  This is seen in the following graph.  The level of job creation has improved, but only to the level of the bottom of the period following the 2001 recession.

No data released this week was inconsistent with Econintersect’s November forecast of slow growth.   The table below itemizes the major events and analysis this week (click here for interactive table).

Bankruptcies Filed this Week: Ad Systems Communications

Bank Failures this Week:

8 replies on “China, Gold, and the Fiat Currencies”

  1. Steve,
    When you used to simply present your statistical analysis of economic and monetary trends with minimal commentary it was often difficult to see the significance of what you were telling us. Now that you are opening up with more detailed expositions, like the first few paragraphs of this post, you are making the realities that you are able to see more evident to the rest of us.

    In a Dec.6/10 National Post column (reprinted from the New York Times) titled, “On War and Peace and Healing the World”, David Brooks says of Leo Tolstoy,

    “There are many reasons to think about Tolstoy on the centennial of his death. Among them: his ability to see. Tolstoy had an almost superhuman ability to perceive reality.”

    Your commentary shows that you have the ability to “see”, Steve. When you tell us what you see it helps us see too. So I hope you continue adding your more ‘subjective’ commentary to your always informative objective presentations of the statistics. The statistics do not always speak clearly for themselves. You can give them the voice they need. The objective data keeps your commentary informed and accurate, and the public debate right now really needs this kind of injection of “seeing the truth” and “telling it like it is”.

    I hope I’m not embarrassing you too much by posting this on a public forum.

  2. Derryl,
    Thank you for the kind words. I am a facts person – I saw my role to clarify the existing data / analysis out there as I saw much of it misleading or wrong. Further, most of the analysis was by quants who really do not see the mechanics of the process they are analyzing.

    As you know I changed the format of my weekly post a few months ago. So in the future most of these weekly summary posts will now be more subjective.

  3. “The Chinese are thinking outside the box. They are experimenting with economic theory to strengthen their dominance.”

    Wonder what the next out of box thinking would be.

    Interest rate increase has not cooled the inflation as per latest Bloomberg report

    Will Yuan be revalued as a deflationary measure. They might buy commodities at higher rate but it would be better way to liquidate their foreign currency [ Euro and US Dollars]

    And then what would be the impact of these measures on jobs and their export industry?

    We wait with baited breath the next out of box move.

  4. We should be ahead in this game though. We can print dollars and buy natural resources from almost free money? while the Chinese have to spend hard earned RMBs? Why are we buying bonds (I guess I see why) and not natural resources streams for the future. Perhaps we don’t need them as much right now; however, there is something called a strategic resource stockpile.

    Of course, the correct way to do this would be to let US companies float ultra-cheap bonds, raise cash and then go out and buy *stuff*…

    Please comment.

  5. Nick, i believe in operational efficiency. a society / country needs to continually optimize. the path is not following or necessary countering another country – as that may not be the optimum path for you. you play the game to your strengths (and protect your weaknesses).

    China’s strength and weakness is the abundance of dollars. the do not necessarily want to inflate commodity prices, but it is the optimum solution for THEM.

    I believe our optimum path lay in more aggressive monetary and fiscal policy. at this point, the USA has the world’s currency – invest this in optimizing spending. this does not necessarily translate into a balanced budget – but to have your eyes fixed on not bankrupting your country with well intentioned programs that society cannot afford. The whole idea of issuing treasuries when you have the world’s currency eludes me. the logical value of a fiat currency is its perceived value which should include the negative dynamics of debt issued.

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