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Vanishing $3 Trillion

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Vanishing $3 Trillion

How to Make $3 Trillion Vanish

Remember that old college prank where students would disassemble a Volkswagen, sneak the parts into the dean's office, and then re-assemble the vehicle for the surprised office staff to find the next morning? It must have been amazing the first time that stunt was pulled off. Everyone would be wondering how something so large could fit through such a small doorway?

There's growing evidence that China (and other Asian nations) may be pulling a similar prank. And the target of the joke is the dean of all deans, the U.S. government.

Nations like China and Japan have an issue with their foreign currency reserves. For years, they've run large trade surpluses with the U.S. China to the tune of $300 billion yearly. Japan about $100 billion yearly. Usually countries would turn around and convert a large portion of these dollars into their local currency. Exchanging dollars for yuan or yen that could be used in the local economy.

But both China and Japan have a problem. They want their currencies to remain weak against the U.S. dollar. A weak currency makes Chinese and Japanese goods more affordable for Americans. Creating a greater global market share for these nations. Exchanging their trade-won dollars for local currency would do the opposite. Push up the value of the yuan and the yen against the dollar. And discourage American buying.

The solution for both China and Japan has been to avoid the foreign exchange market altogether. They've simply kept their dollars as dollars. They've attempted to earn some interest on these dollar holdings by buying U.S. Treasury bonds. Buying U.S. bonds also helped finance the U.S. trade deficit, propping up American consumers so they could buy more foreign goods. The result being that China and Japan now own a combined $3 trillion in foreign exchange reserves, most of which is in U.S. bonds.

Central bankers in these countries are growing uncomfortable with their massive dollar holdings. China has voiced concerns over the last few months that money creation in the U.S. may erode the dollar's value. It's becoming increasingly obvious that Asia would like to move out of dollars.

But dumping the dollar isn't easy when you own $3 trillion. If China or Japan tried to exchange even a small portion of their dollars for some other currency, they would drive down the dollar's value. Impairing the value of the rest of their substantive dollar holdings. Getting rid of $100 billion would be a very small victory if the transaction shaved the value of the remaining $2.9 trillion by even 5% or 10%!

In fact, Asia probably couldn't even get to the foreign exchange market. To get dollars to sell, China and Japan would first have to cash out some of their U.S. bonds. And if the market ever saw China and Japan cashing out bonds en masse, the dollar would fall in value long before those nations could turn around sell their new-found dollars. It would seem that Asian bond holdings are just too large to whittle down.

China "Pranks the Dean"

But there is one potential "back door" that China and Japan can use (and probably have been) to secretly dismantle their "Volkswagen" dollar reserves, sneak them through the narrow door of the foreign exchange market, and then reassemble them like the auto in the dean's office.

This is a bit of a complicated lesson in central banking, but one that could be crucially important in understand currency markets (and by extension almost every other market on the planet). The main concept is that sometimes, money can be in two places at once. Let's examine this a little deeper.

Governments can create their currencies at will. The U.S. government can create as many dollars as they see fit. If they want to make 100 trillion new dollars, they can. The Bank of Japan can similarly print yen. Same for governments around the world. In practice, money creation is unlimited. The theoretical limiting factor is the value of that money. A unit of national currency represents a claim on the assets of that nation. The more claims outstanding, the less the value per claim. Take a very simplified example. The nation of Daveville has a gross domestic product of $1 million. If we assume that Daveville can keep up this level of productivity for 10 years, we might conclude that the total "value" of the Daveville nation is $10 million (this is very simplified). Now suppose the central bank of Daveville issues 1 million Dave Dollars. The value of each Dave Dollar would be $10 ($10 million in national value divided by 1 million Dave Dollars outstanding).

But what if the government of Daveville runs into trouble and needs money to bailout its banks? The central bank creates 1 million new Dave Dollars, which the government injects into its financial system. We now have a total of 2 million Dave Dollars outstanding. So the value of each Dave Dollar is now $5 ($10 million in national value divided by 2 million Dave Dollars). We've devalued our currency by 50%. If by the end of the financial crisis we end up with 10 million Dave Dollars outstanding, the value falls to $1. A 90% devaluation.

The potential for this kind of devaluation should prevent governments from printing massive amounts of new currency (or at least think twice about it). If Daveville prints too much money, its trading partners will eventually realize that each Dave Dollar is worth less and less. Eventually they will stop accepting this currency altogether.

One way to get around the devaluation problem is to increase the value of the nation. To torture our example just a little more, suppose Daveville does end up with 10 million Dave Dollars outstanding. But at the same time, the nation drastically increases its national value. Maybe by discovering some valuable natural resource like oil. Or by increasing trade with its neighbors and bringing more foreign currency into the nation. Suppose Daveville's value jumps from $10 million to $100 million. Now the value of each Dave Dollar stays at $10 ($100 million in value divided by 10 million Dave Dollars) despite the recent printing of new money.

China and Japan have been increasing their national value in just this way. Remember, the value of a nation depends on that nation's assets. And foreign exchange reserves are an asset. By accumulating $2 trillion in foreign exchange reserves over the last several years, China has upped its "national value" by that same amount, $2 trillion. This gives the Chinese government room to create new yuan without devaluing the currency. The printing presses have the green light!

The problem is, what can they do with this new yuan? The government could circulate the currency within the country, paying for public works, infrastructure projects and social programs. In fact, they are doing this with the recently announced 4 trillion yuan stimulus program. But internal spending of the national currency can be problematic. Japan tried it in the 1990s, leveraging the value of their accumulated dollar holdings to create yen and pay for huge domestic infrastructure projects. The spending however, failed to produce much lasting value. The nation simply ended up with a lot of unneeded concrete and a $5 trillion government debt.

China has learned from this. They're looking to spend their new yuan outside of China, where it can be put to more productive use. We saw the first major example of this "global yuan" policy this past week when China and Brazil announced they will work toward settling trade in their national currencies. Brazil would pay for Chinese goods in real. And China would purchase Brazilian goods using yuan. This deal would allow China to create yuan and put it to good, productive use. Buying foreign goods, particularly Brazilian oil.

This is the critical part. By creating yuan and using it to secure goods like oil, China is effectively monetizing its massive U.S. dollar holdings without actually selling dollars. Not a single dollar has moved out of China's bank accounts in the U.S. By all appearances everything is completely normal. No spooking the foreign exchange market. But China is using the book value of its dollar holdings as collateral against which to print new yuan and purchase valuable goods. This way, they don't have to actually move their dollars in order to make use of them. Brazil knows that China holds $2 trillion in dollars and is therefore willing to accept yuan backed by those dollars. Thus China can slowly and secretly dismantle its "Volkswagen" dollar holdings and sneak them outside the U.S. banking system to be reassembled as a portfolio of Brazilian oil, Australian uranium, African iron ore, and other useful goods. Joke's on you, dean!

Some of my colleagues have pointed out that this is an interesting theory, but one that is difficult to track and to prove. Deals between governments are often done in secret (or at least off the front page), so we have a hard time knowing how much new yuan and/or yen is circulating around the globe. Monetary base statistics give us some clue. China's monetary base was up 26% year-on-year in the first four months of 2009. That means 10 trillion yuan ($1.5 trillion) was created in the past year alone. That's a lot of new yuan that has to be going somewhere!

Other "indirect signs" of Asian money creation are becoming too strong to ignore. Just this morning the Bank of Japan announced that it is making some important changes to its loan policies. Most significantly, the Bank will now accept U.S. government bonds as collateral on yen-denominated loans. This rule change allows for exactly the type of scenario discussed above. Japanese investors holding large U.S dollar reserves (in the form of U.S. bonds) can now "monetize" those dollar holdings by borrowing yen against them. This yen can then be used to purchase goods. Traditionally, the Japanese have shied away from circulating yen outside of Japan (the way China is trying to do with yuan in Brazil). But they have done a few deals with Iran to purchase oil in yen. And today's policy change opens the door for more such operations.

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See also:

Chinese hoarders 'are causing oil price boom'

Oil industry experts Bernstein Research say they have been spying on the world's third-largest economy and have concluded China is actively hoarding supplies.

After the spectacular crash in the crude price last year following an all-time high of $147 a barrel, oil has soared again this year, up 70% since mid-January. In the past four weeks, the oil price has jumped 25% to trade around the $60-a-barrel level again.

Energy analysts have been scratching their heads for a reason, other than the recent dollar weakness which always pushes up the value of crude.

Analysts have argued that global demand remains weak, the Saudi-led cartel of major oil producers Opec has not cut production as deeply as it might and output from non-Opec countries is robust.

But according to Bernstein's Neil McMahon: "If the supply/demand balance is not driving higher oil prices, then what is?

"We believe that increased imports into China could be part of the explanation.

McMahon says Chinese imports spiked in March and April and the country's storage levels have reached a new peak.

"We believe [the rise in the oil price] reflects not strengthening demand, but rather China's efforts to boost its strategic petroleum reserve," he said. "To verify this we have utilised satellite tracking of tanker movements, as well as time-lapse satellite images to observe the amount of storage expansion.

"Our analysis confirms that tanker capacity arrivals into China have spiked up in recent months, in line with imports, but more importantly, tanker arrivals into the ports [holding strategic reserves] have increased materially.

"Satellite images confirm a significant increase in storage construction in the last few years. This suggests that China is stockpiling crude oil.

"This recent drive by the Chinese to fill their reserves should have offered some support to crude prices and will continue to do so going forward."

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Interesting problem is would anyone trading with China be happy ending up with worthless dollars?

Who would they blame?

China, or the US?

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It doesn't matter whether China buys assets with overvalued USD or overvalued Yuan, the problem remains (yields are depressed by the pyramidding and then prices assume a negative outlook once it has passed).

No free lunch, sorry.

The problem is excess capacity (idle bellies and hands need fuelling at near-on the same energy cost regardless) and the tried, tested, and proven solutions* to it are isolationism, and/ or fewer consumers.

My guess is a little from column A and a little from column B.

Protectionism.

And then war.

(* one day we'll grow up and address the real problem and put the same effort into reducing - by four or five orders of magnitude - the amount of energy required to produce a human capable of producing more humans; but I don't think we're adult enough for that yet)

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Interesting problem is would anyone trading with China be happy ending up with worthless dollars?

But what could make them become worthless if the major holders never wanted, nor needed, to dump them? ;)

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Most significantly, the Bank will now accept U.S. government bonds as collateral on yen-denominated loans.

Like, for instance, eastern-europeans and dollar-denominated mortgages.

But they have done a few deals with Iran to purchase oil in yen.

Iraq got invaded for denominating oil in Euros. Can yen be allowed?

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