Chinese Dollar Torture

Recently, the US Treasury Department released data showing an 11% decline in official Chinese holdings of US government bonds during the past year. For US dollar holders, this is a troubling trend. Not so much for those holding gold.

To put it simply, the Chinese government isn’t adding to its US bond position, at least not in any meaningful way. Nor is it rolling over its previous purchases.

According to the latest Treasury International Capital report, China resumed net purchases in July for the first time in three months. China’s US Treasury holdings rose $3 billion. Dollar bulls looking to cheer the modest purchase may first consider the following, longer-term trend: Between September 2009-July 2010, Chinese holdings of US bonds fell from $938.1 billion to $846.7 billion, a drop of over $91 billion over nine months.

In short, the Chinese are backing away from US debt. They’re reducing their exposure to the US dollar, and by extension their vulnerability to a declining US economy.

What’s going on? Is the decline in Chinese holdings of US bonds strictly an economic assessment? Or is there something else afoot? What factions are driving this decision? And what does all of this mean for precious metals?

First let’s note how, in recent years, China has exhibited a newfound measure of international confidence, if not swagger. It’s easy to understand why.

China’s leaders see that the US suffers from a weak economy, hampered by chronic overspending on consumption and underinvestment in new capital. In the wake of the global financial crisis of the past few years, Chinese leaders have concluded that US-style democracy and Wall Street-style capitalism are discredited.

In other words, to use a Chinese term, the US is a “sunset power.” China, on the other hand, sees itself as a “sunrise power.” The Chinese are going places in this world. The Chinese have developed a different approach to development than other nations, and they have the economic statistics to back it up.

The Chinese are not afraid to trumpet their success, either. Recently, for example, the German magazine Der Spiegel noted, “All around the world, from Africa to Asia to South America, Beijing is trying to tout its model of authoritarian state capitalism as the better alternative.”

One way to look at things is that we’re watching historical waves unfold. China is on the rise, while US power and influence wanes. But in a nation and culture as complex as that of China, it’s also useful to take a close look at how and why things happen.

One key source of influence within China is a hard-core military faction. The Chinese military offers a viewpoint that almost always holds sway on issues of supreme national importance. Such issues definitely include areas of so-called “core Chinese interests” that cover Taiwan and Tibet, as well as the South China Sea and the Yellow Sea.

It’s common knowledge, for example, that Chinese military advisers are incensed over US arms sales to Taiwan. No amount of US diplomacy ever is enough to smooth the troubled waters that divide mainland China from Taiwan. Indeed, the Chinese view their relations with Taiwan as an “internal matter” and consider most US activities that touch on that relationship as “officious meddling.”

In a new development this summer, the Chinese military expressed outrage over joint US-South Korean military maneuvers in the Yellow Sea.

That is, the US and South Korea announced plans to conduct military exercises in the waters west of South Korea where a South Korean warship was sunk – apparently by a North Korean torpedo – in March of this year. The Chinese military, in turn, went ballistic (so to speak).

One recent article on the state-run Xinhua news website warned the US not to move the aircraft carrier USS George Washington into the Yellow Sea. The author of the article took care in his choice of words, but left no room for doubt about the Chinese position:

Offending Chinese people is not in the fundamental interest of the US. Any activity aimed at pushing a country with a 1.3-billion populace with enormous potential would be inadvisable.

On another news site, People’s Liberation Army Daily, Rear Admiral Yang Yi, former head of strategic studies at the Peoples’ Liberation Army’s National Defense University, was no less forceful, stating:

On the one hand, [the US] wants China to play a role in regional security issues. On the other hand, it is engaging in an increasingly tight encirclement of China and constantly challenging China’s core interests.

Adm. Yang believes that the US threatens China. Earlier this year, he said:

The US is the only country capable of threatening China’s national security interests in an all-round way… Japan has no such ability, while Russia has no such motivation and India is more worried about China.

In a recent editorial, Adm. Yang expressed dismay over US policies, stating, “Rarely has there been such wavering and chaos in US policy toward China.” Adm. Yang expanded the point in another article in China Daily, China’s main English-language newspaper: “Washington will inevitably pay a costly price for its muddled decision.”

Not to be outdone – or perhaps simply to offer a consistent message – Maj. Gen. Luo Yuan, deputy secretary-general of the People’s Liberation Army Academy of Military Sciences, added his authority to the discussion. In a scathing editorial in the Chinese newspaper Global Times, Gen. Luo said that moving the USS George Washington into the Yellow Sea was a “deliberate provocation” toward China and that the US should “think twice about the maneuver.”

Gen. Luo followed up with this comment: “Imagine what the consequences will be if China’s biggest debtor nation challenges its creditor nation.” China is the “world’s largest market,” and “offending China means losing, or at least decreasing, market share.”

I don’t think we have to “imagine” the consequences at all. I believe we just have to look at the decline in Chinese holdings of US bonds – or “decreasing market share,” like the man said.

Thus, I believe that in addition to the Chinese economic concerns about the future of the US economy and US dollar, the Chinese military is also pushing its leadership to back away from holding US dollars. There’s a component of military strategy to the decline in Chinese bond holdings.

Then next question is if the Chinese are NOT buying US bonds, then who IS buying them?

My hunch is that it’s the US Federal Reserve. That is, the Fed is covering China’s retreat from the dollar. For reasons both economic and military, China is gradually exiting is dollar position. The Fed is allowing this to happen quietly, without causing a dollar panic.

Meanwhile, the consequence is that the Fed is monetizing the US national debt. Over the long term, this can only lead to the further decline of the U.S currency. Looking out over the medium and long terms, it can only mean higher prices for precious metals.

And that, for our money, is exactly where the sunrise investors will want to be.


Byron King
for The Daily Reckoning

The Daily Reckoning