February 3, 2012

We, as American citizens, owe the Chinese government almost $1,500,000,000,000. That amount is hundreds of billions more than the IRS collects from all individual and corporate income taxes each year. It is approximately 1/10th of our government debt, which stands at more than $15.3 trillion as I write this. That amount translates to roughly $5,000 owed by every American man, woman, and child to the People’s Republic of China.

Much of this debt is in the form of T-Bills and T-Bonds. Since the Chinese are repaid in dollars when their T-Bills and T-Bonds mature, our rampant printing of money reduces the value of the dollar and effectively reduces the value of their holdings. They realize that we cannot pay them back without manipulating our economy and depreciating the dollar. Nevertheless, they cannot just sell off their holdings. Because they hold so many T-Bills and T-Bonds, selling them would overwhelm the market, and the price of those bills and notes would plummet. The situation has devolved into a kind of Mexican Standoff: Hold or sell, China loses either way.

Obviously, the Chinese do not like losing their money, so they devised a plan to extricate themselves and their money from this standoff. The plan? Call for a new world currency to replace the dollar as the world’s reserve currency. The People’s Bank of China (PBOC) has been actively promoting this plan since 2009. This will allow them to stop buying our bills and notes. They want to end the need to invest in our Treasury securities because they expect the dollar will continue depreciating. It also gives them a chance to promote their own currency as the possible replacement for the dollar as a world reserve currency.

How did America get into this debt mess with China?

Since China’s Reform Era began back in the late 1970s, China has continuously exported more goods than it has imported. When a Chinese company sells goods overseas and earns dollars, the government requires the company to give the dollars to the PBOC. The PBOC then exchanges the dollars for Chinese currency, known as “yuan” or “renminbi,” at a rate fixed by the government. This exchange has allowed the Chinese government, which owns the PBOC, to amass foreign dollar reserves of approximately $3.2 trillion!

Over the last 30+ years, the Chinese government has invested about two-thirds of these funds in US Treasuries. They have not made much on these holdings, since the US artificially holds interest rates down. They tried diversifying into stocks and real estate, but they tended to lose money. Now they have settled on their new “anti-dollar” strategy. It appears that they have done their homework regarding monetary history.

Countries that abandon their gold-backed currency in favor of fiat currencies most always end up in the trash heap of history. Most of the time, countries abandon their gold standard so they can spend more than they have to finance war. It was true of Rome, Great Britain, France, and Germany and now it is true of the US. The US debated for a long time about raising the debt ceiling last summer, but we are not debating it anymore. The rest of the world has watched in absolute shock as we willingly destroy our own currency. Like China, they understand that we have decided to pay them back with dollars that will be worth less than when they loaned us the money. Like China, none of them are pleased.

What is China doing about this?

Xinhua, China’s official new agency, published the following quotes last August:

“China . . . has every right now to demand the US address its structural debt problems and ensure the safety of China’s dollar assets.”

“The US government has to come to terms with the painful fact that the good old days when it could just borrow its way out of messes of its own making are finally gone.”

China probably assumes correctly that its demands will not be met immediately. In the meantime, they have decided to backstop their currency with as much gold as possible in order to make their own currency a better option for a world reserve currency in the future. They will buy and buy and buy (gold) over the next 3-5 years to make this possible.

Even though India has historically been the largest purchaser of gold, China overtook them in the first quarter of 2011, according to the Wall Street Journal.

China has also become the largest producer of gold, based on figures released from the World Gold Council. The Chinese government requires that all gold mined in China be sold to them, and they surely do not report all they mine. This nifty system has multiple benefits. First, it allows them to refrain from purchasing so much gold from the world markets, which hides much of the true demand for gold in the world. Second, by keeping this accumulation of gold a secret, it artificially keeps gold prices lower. The combination of these two elements allows China to back their currency with gold at lower prices.

Where does all of this lead?

China will make a push to establish its own currency as the world reserve currency and it will be largely backed by gold.

China started purchasing and producing large quantities of the precious metal over five years ago, and will continue to do so for some time. Still, it has a long way to go to catch up to some countries. As of August 2011, China was the fifth largest holder of gold reserves, with approximately $63 billion worth. By contrast, the US, which is the largest holder of gold reserves, had $487 billion in gold at that time.

In addition, China is actively buying gold producers. They are buying interests in both public and private gold producers. The details of the purchase of private companies are not disclosed. However, I am quite sure China has amassed quite a bit more gold since the report I mention above, both in actual gold reserves and in buying companies that produce gold.

The Chinese government mints its own gold bars and coins. They have set up stores in major cities where citizens can buy little gold bars as small as 5 grams up to 1 kilogram. The government is thus encouraging its citizens to purchase gold for their savings.

New gold reserves, gold producers, and gold stores pave the way for China to enter the metals exchange business, which will place them in direct competition with London and the COMEX in New York. Their metals exchange is expected to go live this summer. I am quite sure New York and London are not happy about it though, since it will loosen their grip on metals price manipulation of gold and silver. Gold and silver will be traded on an international exchange for the first time in a currency other than dollars.

What does this mean for investors?

Since more gold is bought in Asia these days than in the west, I think the spot markets for metals will be taken over by the Chinese and this will further bolster their currency relative to the dollar. They will slowly hedge their dollar exposure with gold and take over the world gold market and ultimately back their currency to the extent that it may deserve to be the world’s reserve currency.

I believe that this trend will push the price of gold higher and the dollar lower over time. I suggest you consider holding some of your own reserves in gold. We include gold in the portfolios we manage for our clients. Do your advisors have gold in your portfolios?

Randy M. Long, J.D., CFP®, President
Long Investment Advisory, Inc.

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