One of the most significant changes in the
world of investing has been quietly unveiled by
China in recent weeks. Even as its details are
being finalized, and agencies determined, impact
on the rest of the world is already coming
through, be it in stock markets or the prices of
commodities.
Proposed versus old
regime The old regime of investing by China
was in essence the classical one that is
recommended for all developing countries by the
luminaries at the International Monetary Fund
(IMF) or other such multilateral agencies. This
involves the purchase of high-quality
securities issued by
Organization for Economic Cooperation and
Development countries, but mainly the United
States and Germany (and now a broader group of
Eurozone members including France and Italy) as
part of foreign-exchange reserves, which should be
sufficient to pay for at least six months' worth
of imports.
The IMF and its policies have
been out of touch with market realities since the
mid-1990s. Indeed, it was the agency's proposals
for Latin America-type reforms that helped to
perpetuate the Asian financial crisis of 1997, and
has in turn set off the most significant imbalance
in economic history, namely the US current-account
deficit. While the IMF cannot be blamed for all
the consequences, it can certainly bear the blame
for proposing a lopsided arrangement.
In
any event, the idea of foreign-exchange-reserves
management has failed precisely because of what
the IMF designed. Think about it like this: in an
environment where oil prices are at US$25 a
barrel, and country X has $100 million in
reserves, it can purchase about 4 million barrels,
which we will assume is four months' supply. Now,
when oil prices go to $50 a barrel, it
automatically reduces the country's "reserves" to
two months' supply. In this case, to have the same
four months' coverage, the country either needs to
add $100 million to its reserves or else earn
enough on its reserves to make a $100 million
profit that can be used to purchase the extra oil.
It is in this dynamic that today's low
returns in global bonds and equities affect the
management of various countries' external
requirements. Even as the significant weakening of
Asian currencies against the US dollar produced a
marked increase in trade competitiveness, and thus
accentuated the US trade deficit (as its local
producers could no longer compete with imports),
the excess of money at hand also helped to
increase the value of physical goods and, in
particular, inputs such as commodities.
Thus a new problem confronts developing
countries, which is that instead of a lack of
capital that used to pose physical capacity
constraints on their exports, it is the rising
prices of imports that presents the greatest
threat to continued growth.
Therefore, it
becomes important for countries to protect their
future growth with current cash, and that is why
increasingly the focus is not so much on how many
dollars of reserves a country has, but more about
what has been done with those dollars.
Financial-market
implications One of the easiest changes to
foreign-exchange reserve management is for central
banks to sell their dollar holdings, substituting
them with other global currencies such as the
euro, sterling and the yen. [1] Notably, bond
yields in all three of these markets have declined
in real terms (ie, compared with economic growth)
over the past few years. Alongside this, prices of
equities have also gone up, as some central banks
are allocating money away from bonds altogether.
Second, prices of commodities have
increased sharply, but speculative activity has
grown even more. China has a stated goal of
building a strategic petroleum reserve, like the
United States and reportedly Russia.
Third, any slowdown in the US economy such
as being indicated by the decline in employment
growth in the January payrolls will cause fewer
dollars to flow into the coffers of developing
countries. In turn, this will cause their
purchases of US securities to fall, thereby
pushing up US bond yields. This is a new
"conundrum" for financial markets, when an economy
heading into a recession sees its bond yields
rising.
The art of war As I
wrote in previous articles, [2] China needs to
increase its say in global affairs to guarantee
growth for its citizens. This means that rather
than focusing on its humongous $1 trillion in
reserves, China needs to buy physical goods such
as oil, copper and iron ore that form the backbone
of its economy.
Inevitably, this forces
China to deal with the world's rogue governments
such as nasty Middle Eastern regimes and cruel
African despots. There is no reason to criticize
China because the greater good, ie the development
of its own people, overwhelms other concerns such
as human rights and nuclear proliferation.
In any event, Western regimes are hardly
in a position to criticize China, given their
backing of the self-same nasty Arab governments,
and their historic support for apartheid South
Africa.
Second, it is normal evolution for
China to use its reserves to its advantage. When
American politicians do not give enough respect to
its role in the world, it is quite easy for China
to go and sell a few billion US bonds, thereby
pushing up interest costs for all US companies and
residents. In the terminology of war, China is
upstream from the US, imagining money like a
flowing river. The US uses the river to irrigate
its economy and keep its residents happy, but only
so long as China decides not to open up its dams
that could flood the whole region and cause havoc.
Third, China is not yet in a position
where it can wield its power wantonly. This is
because it continues to import oil from the Middle
East, and needs North America and Europe to buy
its products. As its own domestic demand
increases, China will need the rest of the world
less. That is why I believe that, using US
pressure as an excuse, China will let its currency
rise against the US dollar sharply this year,
perhaps as soon as April. This will produce high
costs initially for China's exporters and banks,
[3] but eventually will provide a stronger basis
for China to dominate foreign policy around the
world.
As for the Islamic powers of the
Middle East, they will sell oil to China if only
to spite Europe and the US. In doing so, they will
also invite more unwanted attention from the US,
which is reeling from its lost campaign in Iraq.
The main scenario of the US trying to consolidate
its hold over the Middle East continues, and
argues for getting more desperate in the light of
China's growing self-sufficiency in commodities.
Thus, to preserve its role, the US has no option
but to attack Iran. [4] The consequences will be
horrifying for both parties, and push both
combatants toward an inexorable decline. About
time, too.
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