Britannia Radio

The Daily Reckoning | Tuesday, February 23, 2010 The New Phase of Chinese Growth To sell or not to sell US bonds Joel Bowman [Ed. Note: Your wayfaring editor is on the road again today, so we’ll turn you over to our Australian-based counterpart, Dan Denning, who offers some thought-provoking musings on the reshaping of the new world. Please enjoy and send any comments to the address below...] Dan Denning, reporting from Melbourne, Australia... Recently we claimed that borrowing your way to national prosperity is a sure-fire way to servitude and political instability. Today, we aim to prove it. To do so, we cite this article from Reuters. It suggests that China is using or should use its large holdings of US Treasury bonds as a cudgel with which to bludgeon the United States, its strategic adversary/indispensable economic partner. Figures in the People’s Liberation Army want the financiers to sell US bonds as a way of punishing Washington for selling arms to Taiwan. Mind you this might not seem like such a good idea if the bond selling triggers a run on the dollar and swift devaluation in China’s forex reserves. But maybe China’s arsenal of US bonds is like a pile of bullets – they’re no good unless you fire them. Of course what we’re suggesting is that China accumulated US debt as both a by-product and a weapon. The huge stock of US government securities was a by-product of China’s trade strategy. That strategy was to keep its currency low and gain global manufacturing market share through low labour and production costs. The result was a blizzard of US dollar trade surpluses that were reinvested into US bonds. You could say it’s China that’s paid for the wars in Afghanistan and Iraq. But why is this bundle of bonds now a weapon? We think China’s export-driven growth strategy is on its last legs. Labor unions in Europe and America – given today’s political climate and high unemployment – will have the ear of politicians. And they will be saying something like this, “Make the Chinese pay!” What they’ll mean is that China will be pressured to give up its main economic weapon – currency manipulation. This has kept Chinese exports cheap all over the world and led to the gutting of American manufacturing jobs. It’s made it pretty tough on exporters in Europe too. As a result of China’s dollar peg, European exporters suffered doubly from a weaker US dollar. American goods were cheaper in Europe. But European goods were not cheaper in China. So the unions and the politicians will probably not tolerate another leg of the global recession in which China gains more market share by keeping the currency peg and exporting its way to more growth (if growth is to be had). It brings us to the end-game of China’s export-driven development. It also brings us back to one of the great monetary questions of the day: when will China de-peg? The answer has always been simple: when it is in China’s interests to do. To us, that means China will de-peg when the benefits of increased purchasing power in the currency are more important that dwindling export profits. In other words, we think China is close to a new phase of growth that’s driven by consumer demand, domestic consumption, and more mature Chinese capital markets open to foreign investment. A de-pegging of the currency would see a much stronger yuan. This would give Chinese savers a lot of spending power on global markets. They would also be able to buy more Chinese goods, which might lead to higher wages in China too (and more stoking of consumer demand). This is all a theory, of course. And we could be way wrong. But there will come a day when Chinese customers are worth more to Chinese producers than American customers. De-pegging the currency will bring that day forward. And it could be sooner than you think. This means that the accumulation of forex reserves was never really meant to protect China from external trade shocks, although they would be handy in that event. It means they were a side effect of a trade strategy whose ultimate objective was to gain as much global manufacturing market share as possible. Now, you might wonder why China would damage its own interests by “punishing” the United States and selling bonds. But it depends on what China’s interests are. If China’s interests are in fundamentally weakening an economic competitor and strategic adversary, then selling US bonds is in China’s interests. China’s ultimate interests are in regaining Taiwan. And we’d suggest it try and use its bond leverage to weaken US resolve about defending Taiwan. And selling US bonds or crashing the dollar wouldn’t just weaken US resolve. It would expose the loss of strategic influence that occurs when you are a chronic debtor nation. Mind you the US still has a lot of aircraft carriers, strategic bombers, and nuclear weapons. It’s not like it is bereft of tools of persuasion. But the basis of all those tools has always been a strong economy, a strong industrial base, and sound finances. The question now is, if the base of military strength has been eroded, how long will the US maintain its military advantage? Can America afford it? And when push comes to shove, will American voters demand that an American President defend Taiwan? Hmmn... The Daily Reckoning Presents The Sovereign Debt Disaster Egon von Greyerz Wherever we look at the world economy today, we see a wall of risk...and potential financial catastrophe. We see a large number of virtually bankrupt major sovereign states (US, UK, Spain, Italy, Greece, Japan and many more) teetering atop a financial system that is bankrupt, but is temporarily kept alive with phony valuations and unlimited money printing. Increasingly, therefore, investors will want to exchange this funny money for gold. Governments like the US and the UK are committed to printing increasing amounts of worthless paper money in order to finance their growing deficits. The consequence of this rescue mission will be a hyperinflationary depression in many countries, due to many currencies becoming worthless. The list of countries at risk of bankruptcy is increasing by the day. The acronym used to be PIGS (Portugal, Ireland, Greece and Spain). It is now PIIGSJUKUS and growing. The main contenders are currently: USA, UK, Japan, Spain, Italy, Greece, Ireland, France, Portugal, Baltic States, Eastern Europe and many more. On a proper accounting basis all of these countries are already bankrupt, but since many nations can either print money, like the US and the UK, or increase their already high borrowings, like Greece and the Baltic States, they have technically avoided bankruptcy. The problem is not just the current debt levels of these nations, because the deficits in all the countries are rising. Tax revenues are collapsing at the same time, while the governments’ expenses for social charges are soaring. In the US for example the federal deficit in 2009 was $1.5 trillion (10.7% of GDP) and is forecast to stay around that level for many years. The plight of the US states is just as bad. Out of 50 states only four are expected to have a balanced budget in 2010. It took almost 200 years for US Federal debt to reach $1 trillion, which it did in 1981. In 2009 the debt increased by $1.9 trillion in just that year to $12.4 trillion. In the next ten years the US debt is forecast to reach $25 trillion. And this doubling of the debt does not include any funds to continue propping up a bankrupt financial system. The forecast also assumes optimistic growth in GDP, which is extremely unlikely. Currently, US Federal debt is six times what it collects in tax revenue every year. With debt exploding and tax revenues collapsing, there is no chance that the debt can ever be repaid with normal money. Also, with debt out of control, interest rates will rise substantially to 10-20% per annum. Applying a 15% interest rate to a $25 trillion debt would give an annual interest bill of $3.75 trillion, which is the same size as this year’s ENTIRE budget. The chart below shows the US Federal Debt per person. In the last ten years it has gone from $ 20,000 to $ 40,000. If we were to also include the present value of the government’s future unfunded liabilities like Social Security and Medicare, the debt per person would soar to more than $250,000. Therefore, the indebted governments of the world have two choices: continue to borrow and print money or reduce government spending. This is a lose-lose situation. Countries within the EU like Greece or Spain are introducing austerity programs that forecast their deficits to come down to 3% of GDP, which is the EU maximum deficit limit. These are totally unrealistic targets that are mainly based on an improvement in the economy. Ironically, not one single country within the EU is below the 3% limit, not even Germany. Furthermore, the austerity programs would lead to such a major contraction of the economies that tax revenues would collapse, further exacerbating the plight of these countries. The alternative is to print or borrow more money. Printing is not a luxury that individual EU members have. And borrowing is becoming increasingly expensive...or impossible. But the European Central Bank can print money and this is likely to be the path they will initially choose to save Greece and possibly Spain. Countries like the US and the UK can still borrow and print money. And this is what they will continue to do. With rising deficits, rising unemployment and the problems in the financial system re-emerging they have no choice. We will see trillions of pounds and dollars printed in the next few years. We will also see trillions of pounds and dollars worth of new government securities. But the buyers of these government securities might start to become scarce. The rest of the world may dump their holdings of US and UK debt, which would result in both the dollar and the pound dropping precipitously and interest rates rising substantially. The effect of a collapsing currency will be a hyperinflationary depression. This is the inevitable outcome for the UK and US. All the countries of the major trading currencies – the dollar, euro, pound and yen – have major economic problems that can only be resolved by massive money printing. This is why it is a futile game to try to predict which currency will be the weakest out of the above four. They will all weaken substantially but not at the same time. Therefore, we will have incredible volatility in currency markets in the next few years whilst speculators lose their shirts jumping from one currency to the next. There will be very few winners in that game. So the last 100 years will be seen in history as an extraordinary period when governments thought that they had invented a new economic miracle based on unlimited credit and money printing. But sadly this miracle will be seen by future historians as another failed delusional economic theory dreamed up by politicians. Therefore, as many paper currencies become virtually worthless in the next few years, gold will continue to do what it has done for 6,000 years. It will maintain its purchasing power and therefore appreciate substantially against all paper currencies. The recent correction in gold is the weak hands getting out of speculative positions in the paper gold market. There has been virtually no selling in the physical market. So far gold has gone up more than four times in the last ten years in a stealth bull market that very few investors have participated in. There is no other asset during this period that has given such an excellent return whilst at the same time providing the highest form of wealth protection (provided it is physical gold). The chart shows gold in 2009 dollars adjusted for inflation, as calculated by Shadowstats.com. (Shadowstats.com is a superb service that analyzes government statistics on a true basis, taking out all adjustments, revisions and other manipulations). Applying the true inflation rate on the gold price shows that the gold high in 1980 of $850 in today’s terms is $6,400. Governments have suppressed the gold price in the last 30 years by both overt operations (official gold sales) and covert operations (manipulations in the paper gold market and unofficial sales). Central banks have now stopped official sales and China, India, Russia and many other countries are major buyers. Production is falling steadily and investment demand is soaring. With the fundamentals so much in gold’s favor, it should have no problem to reach the 1980 inflation-adjusted high of $6,400. With inflation or hyperinflation, gold will go a lot higher than that. During the next phase up in gold, which we expect to start within the next few weeks, mainstream investors will discover what only a few investors have understood in the last ten years, namely that physical gold is one of the very few ways to protect their assets and preserve capital. Regards, Egon von Greyerz for The Daily Reckoning Publisher’s Note: “We’re sold out,” read a brief message our publisher, Joe Schriefer, sent us this morning. If you took advantage of our partnership with First Federal Coin Corp. and got yourself a perfectly graded 2010 First Strike Chinese Silver Panda coin, congratulations...you’re in rare company. If, however, you waited to act and missed out on the offer...shame on you. Kidding, of course. We’re here to help. So here’s our solution for you: If you’d like to be alerted first to any future finds, click here to put your name on our exclusive “first right of refusal” coin offer list. You won’t have to buy anything you don’t want to, we’ll just let you know when the deals materialize. Again, here’s that link.