China finds Secret Door leading out of Dollar Trap

by RJ Wilcox on December 6, 2013

Meet Sun Zhaoxue

Sun Zhaoxue is president of China National Gold Corporation, China’s largest gold mining company.  He is on record indicating that in order to have a strong currency, it must be backed by significant gold reserves.

Below are his comments taken from an article written in 2012 titled “Building a Strong Economic and Financial Security Barrier for China.”  It was published in Qiushi maganzine, the main academic journal of the Chinese Communist Party’s Central Committee:

“Gold now suffers from a ‘smokescreen’ designed by the United States, which stores 74 percent of global official gold reserves, to put down other currencies and maintain U.S. dollar hegemony. Going to the source, the rise of the U.S. dollar and British pound and later the euro from a single-country currency to a global or regional currency was supported by their huge gold reserves.” [Emphasis added]

Mr. Zhaoxue is very influential in monetary policy circles within China.  In 2011, he received the economic person of the year award and is well known for advocating the importance of gold in promoting monetary strength and stability.

The rising frequency of such statements from various official Chinese sources makes it clear that the Middle Kingdom is becoming increasingly irritated with what it considers reckless U.S. monetary policy.

One such source is the Chinese news agency Xinhua, who published the following statement in August of 2011 with respect to the U.S.,

“International supervision over the issue [printing] of U.S. dollars should be introduced and a new, stable and secured global reserve currency may also be an option to avert a catastrophe caused by any single currency.”[Emphasis Added] 

The catastrophe Xinhua is concerned about is not hard to visualize if you are familiar with the severely skewed percentage of official foreign exchange reserves held in US dollars by the world’s central banks, as shown in the chart below.

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Composition of Worldwide Foreign Exchange Reserves

Again from the 2012 commentary “Building a Strong Economic and Financial Security Barrier for China,” Sun Zhaoxue contextualizes the above chart wonderfully:

“Especially noteworthy is that in the course of this international financial crisis, the United States shows a huge financial deficit but it did not sell any of its gold reserves to reduce its debt. Instead it turned on the printer, massively increasing the U.S. dollar supply, making the wealth of those counties and regions with foreign reserves mainly denominated in U.S. dollars quickly diminish, in effect automatically reducing its own debt.” 

In other words, Quantitative Easing (QE) is, at least in part, a means for the U.S. to quietly default on its debts without saying so.

China holds $1.27 trillion in U.S. Treasuries and other U.S. dollar denominated assets, making them the United States’ largest lender.  As a result, the Chinese government is particularly sensitive to monetary policies affecting the value of their massive holdings.

Another critical facet of China’s concern is the fact that they are the world’s largest consumer of a wide variety of natural resources.  The chart below highlights the country’s trade share of several major commodities.  Notice China is well over 50% in gold and iron ore and approaching 50% of world trade for many others, and they are the 2nd largest oil consumer behind the U.S..

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Chinas share of global trade-1

Since the early 1970’s, starting with oil, the U.S. has used its economic and military muscle to coax the world into an odd arrangement that requires countries to buy natural resources with U.S. dollars.  This means that for major commodities, countries must take the additional step of buying dollars before buying resources.

This state of affairs puts China in a difficult position.  Although they have no shortage of U.S. dollars with which to buy resources, thanks to a perpetual trade surplus with its largest trading partner (the United States), they are especially susceptible to U.S. dollar risk from the U.S.’s aggressive dollar devaluation policy of QE-Infinity.

Given China’s voracious and growing appetite for commodities to feed a massive economy that’s finally coming of age, the current U.S. dollar dominant international monetary arrangement is no longer a viable option.

China’s demand for commodities is massive and continues to grow.  At the same time, oceans of new U.S. dollars are being force fed into the global economy, which will ultimately put enormous inflationary pressure under prices.

China has clearly recognized their dollar risk and has responded by aggressively expanding the use of their currency, the renminbi (aka yuan), in international trade.

They are rapidly intensifying their efforts to provide not just themselves, but their global trading partners with an alternative to the inherent dollar trap built into the international commodity trade.

China is in essence developing an escape route for what they perceive as a looming currency crisis in connection with shortsighted US monetary policy and a dollar dominant world.

They are mitigating this issue in a couple of key ways, both of which we have written about before.  They are expanding the use of the Renminbi in international trade while simultaneously developing a robust domestic gold market.

We Prefer Ours, Thanks Though…

On the currency front, currency swap agreements with major financial centers and trading partners make renminbi readily available to merchants through banks in their various home countries.  This allows them to settle trades quickly and conveniently for natural resources without having to buy dollars.

These swap agreements lessen the necessity for central and commercial banks to hold U.S. dollars, thereby reducing exposure and the devaluation risk associated with holding the dollar.

China’s largest swap agreement is with South Korea in the amount of US$62.3 billion. Their second largest is with the European Central Bank in the amount of US$60.8 billion. These agreements are typically valid for three years and are renewable.

China has established swap agreements with 23 countries in all, totaling approximately US$412.6 billion, and the list of participating countries continues to grow.

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List of countries that have concluded swap agreements with China-1

A New Trend Emerges

Another way the use of the renminbi has been expanding is through trade finance. This refers to the facilitation of capital in the form of cash, credit, investments, and other assets that is essential for international trade to flow.

According to the Society for Worldwide Interbank Financial Telecommunication, or as the organization is more commonly known, SWIFT, the Renminbi overtook the Euro in October to become the second-most used currency in trade finance.

And although the U.S. dollar is by far the most utilized currency for trade finance, representing 81.08% of worldwide transactions, there is a newly emerging trend since last year that is worth taking note of.

In January 2012, the renminbi accounted for just 1.89% of global trade finance. By October 2013, this percentage had risen 4.6 times to 8.66%. Over the same period the U.S. dollar fell in this category from 84.96% to 81.08%.

Below are two pie charts that highlight the change.  It may not seem significant at first glance, but we believe it is fairly apparent that this is just the beginning of a tectonic shift in the international monetary order.  Note the rapid expansion of the use of the Chinese yuan in just 22 months.

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Currencies Used in Global Trade Finance

Anyone want to hazard a guess at what the pie chart will look like in another 22 months?

In response to this development Reuters reported that, “[T]he world’s second-largest economy [China] is accelerating the pace of financial reform to promote its currency to international players beyond Hong Kong. China aims to lift the yuan’s global clout and reduce its reliance on the U.S. dollar.” [Emphasis added]

China = Gold

As discussed above, China is concerned about the quality of its foreign exchange portfolio, especially the sizeable component made up of U.S. dollars.  Because of this, they are aggressively working to diversify both their foreign exchange reserves and their citizens away from dollars by developing the largest gold market in the world.

We have repeated ad nauseam the fact that China is now the world’s large producer and consumer of gold…by far.

They have not only opened the golden floodgates via production and imports, but they are also developing the laws, institutions, exchanges, financial vehicles, and incentives to encourage large-scale gold trade and ownership by its citizens.

At the same time, the People’s Bank of China (PBOC) is accumulating gold reserves at an unprecedented pace in an effort to diversify its U.S. dollar dominant foreign exchange reserves.

The PBOC is estimated to add 600 tonnes of gold to their reserves by the end of this year, which is roughly 25% of the world annual mine production (excluding China’s production).

In association with substantial PBOC purchases, China’s net gold imports from Hong Kong in October were 131.19 tonnes, the second-highest import month on record.

Taking into consideration this latest data, China has now imported, through Hong Kong alone, 1,586 tonnes of gold, or 66% of annual mine supply (again excluding China’s production).

To conclude this week’s commentary on the Chinese gold market, we would like to revisit an article we published back in July titled “China to Buy Barrick Gold.”

The synopsis of that piece was that China’s hunger for gold and its stated strategic initiatives for developing their gold market would lead them inevitably to secure part of this gold supply through the acquisition of a major gold producer. The logical target we posited at the time was mega-major Barrick Gold Corp.

This week, Barrick’s board announced that John Thornton, a former president of Goldman Sachs, would be their next chairman.  In an effort to right Barrick’s many woes, Mr. Thornton is reportedly trying to establish partnerships with Chinese companies.

One potentially interested party is rumoured to be China Investment Corp. (CIC), the sovereign wealth fund responsible for investing China’s massive foreign exchange reserves.  Mr. Thornton just happens to be a member of their international advisory board.

It’s probably just a matter of time now.

The Writing is on the Wall

“The writing is on the wall” is an idiom for “imminent doom or misfortune” suggesting “the future is predetermined.”

We believe China sees “the writing on the wall” in regard to the U.S. dollar and is taking action to position themselves for a new international monetary regime. This suggestion is echoed in a statement made by Liu Zhongbo of the Agricultural Bank of China in January of this year:

“Because gold has capabilities to absorb external economic shocks, growth of its use in the international monetary system will be imminent”

This statement suggests that China expects a monetary shift to happen sooner rather than later.  Their aggressive push to internationalize the renminbi and back it with substantial gold reserves, along with their sustained commitment to opening up and building the infrastructure for world leading domestic gold market, supports this contention.

China is taking concrete steps toward reintroducing gold to the world as a core component of monetary, trade, and global economic stability.  Given China’s economic heft, particularly in the realm of natural resources, this is bullish for gold and puts a very strong patron squarely in the yellow metal’s corner.

In this context, we believe that gold generally, and the shares of gold mining equities in particular, are deeply undervalued.  To help us separate the wheat from the chaff, we developed our Gold Miners Comparative Analysis Table, which has a multitude of critical metrics to use in evaluating and comparing gold mining companies.

In the pages of our newsletter we educate our subscribers on what to look for when discerning between the different gold miners and guide them towards those that suit their individual appetites for risk.

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gold_miners_analysis_table

That’s it for this week. Thanks for reading!

Regards,

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