A Golden Solution To The China Syndrome?
Richard Lehmann

 

Put yourself in China’s shoes. Your economy is heavily dependent for its economic growth and well being on exports to the United States, long its least-favorite country. It has to accept payment for its exports in U.S. dollars,a currency over which it has no control other than to cause it to depreciate by trading out of the dollars it holds and into another currency. (Note: This is something the U.S. is
trying to get China to do to itself by revaluing the yuan.) To add insult to injury, it has accumulated a staggering $700 billion of such dollar reserves and sees no other investment option besides the U.S. Treasury market.

Hence, they not only supply cheap goods to this least-favored country, they then lend it back the proceeds of their labor—lending which makes them vulnerable to a freezing of these reserves by the U.S. should serious enough policy differences arise, à la Iran. Welcome, China, to the World Trade Organization, or should I say, "Welcome to the Hotel California."

Fairly recent history offers two examples of countries who have dealt with this problem with mixed success. In the 1970s, when OPEC managed to take control of the oil market and more than double prices, their foreign reserves quickly built up as they had not yet figured out how to spend these vast sums. Their solution was to invest in CDs with large international banks, thereby providing the funds necessary for oil-importing countries to fund their higher oil import bills. This dubious arrangement lead to an international banking crisis, as the debtor nations
defaulted nearly causing some major international banks to fail.

The 1980s saw a replay of the reserve problem, only this time the country with the excess reserves was Japan. Their attempt to diversify out of dollars led to an organized spending spree involving the purchase of hotel properties, signature office buildings and golf courses. The problem with this strategy was that it was premised on the notion that property values overseas were cheap in comparison to those in Japan. The flaw in that thinking was that it was the Japanese values that were out of line, not those in the rest of the world. Bottom line, the Japanese overpaid. As for their infatuation with buying and building golf courses around the world, leave this to a psychologist to explain.

The recent purchase attempt of Unocal (nyse: UCL - news - people ) by CNOOC (nyse: CEO - news - people ), the state-controlled China oil company, exemplifies an attempt to pursue yet a different route for diversifying out of dollars. China appears to be trying to spend its foreign reserves to buy entire U.S. companies. From a Chinese strategic point of view, this is definitely the right policy: Buy the means of producing the raw materials you need or alternatively, buy the companies that have the technology and distribution channels for the products you produce or want to produce.

For the United States, however, this strategy is a serious threat that goes beyond trade rivalry. Let no one kid himself. International trade and capitalism is a form of warfare where domination is the objective. A country such as China is playing a different game from most WTO members—they are mercantilists. That means they are not interested in creating a level playing field and letting private enterprises compete. They want state involvement to a much greater degree than is practiced in the U.S. This means direct ownership of key enterprises, setting economic priorities, controlling foreign ownership participation, rule-making that favors national enterprises and using commerce to achieve foreign policy ends.

The U.S. has allowed foreign ownership of domestic companies except in cases involving national security. This usually means protecting against foreign control of sensitive technology, defense companies or vital sources of supply. Even excluding these types of companies, China could make major inroads in dominating key industries in this country.

Such dominance by a country that is fundamentally hostile to U.S. interests will not be tolerated by the U.S. government. We already see this with the protests over the CNOOC tender for Unocal, the acquisition of which is, at best, peripheral to U.S. interests. That protest, however, should be a clear signal to China that acquisition of U.S. operating companies is a non-starter that can only lead to
further strained relations.

How then can China reduce its subordination to U.S. interests and use its dollar reserves to strengthen its role in world affairs? I believe China will eventually find gold as a partial solution to its foreign-exchange problem. While an immediate reaction may be to think this is nonsense, a closer examination may provide some food for thought. Gold was the world reserve standard for centuries until former President Richard Nixon closed the "gold window" on Aug. 15, 1971. What he did, in effect, was end the exchangeability of gold for dollars at the fixed rate of $35 per ounce. In effect, the U.S. stopped being a sponsor of gold under a system whereby it set the price and became the buyer and seller of last resort.

The change was necessitated by the fact that foreign holdings of dollars had gotten well beyond the U.S. reserves for gold. Even a steep rise in the pegged gold price would not have solved the problem for long and would have rewarded Russia and South Africa, two countries not then in favor with Washington. Also, the U.S. stood to gain tremendously from the new world order in which the U.S. dollar became the world’s reserve currency by default. It would be no exaggeration to say that Nixon’s action was one of the keys to America’s subsequent world economic dominance.

When America abandoned gold, no one was inclined to step in and continue the gold standard. And since gold earned no interest, nations around the world began to systematically reduce or eliminate their gold holdings. Time has shown that such gold holdings would, through subsequent appreciation, have served quite well as an alternative to U.S. Treasurys. However, in today’s world of multibillion-dollar reserves, the gold market is too illiquid to serve its former role.

To revive gold’s role as a reserve currency, it again would need a sponsor—a buyer and seller of last resort who dictated the support price. That price could increase each year, per government policy, by a set amount. China, with its $700 billion in reserves has the clout to assume this role. Keep in mind that gold is still a scarce resource that has not kept up in supply with the growth of world economic activity. It is insufficient in quantity to serve as the main world reserve currency unless its price was vastly higher. It could, however, be a close second or third. More importantly, like the De Beers diamond cartel, it can be extremely profitable for its sponsor.

Dominating the gold market would offer a number of benefits to China. It offers a viable alternative to buying more U.S. Treasury debt. It allows them to set the rate of return on their gold investment, much as De Beers sets the price of diamonds. However, their control of prices would be even stronger since a net buyer role is much stronger than the De Beers role as a seller. In fact, once China let its newly assumed role in gold become known, a worldwide gold rush would commence, driving prices well above current levels. China will not be able to take control until well into this initial rush. Over time, other nations would join China in again holding gold as a way to reduce their dollar exposure.

Holding large gold reserves can serve China’s domestic economic policy, as well. China does not want to see its citizens investing abroad. Allowing Chinese citizens to buy gold would help satisfy domestic saving and investment desires while also giving the government a means of regulating the money supply. Gold has a long history with individual Chinese as a way to hide and preserve wealth—a way made no less attractive by the mistrust that is always present with an autocratic central government.

The ultimate attraction of such a policy for China is that it allows them to reduce their vulnerability to the United States. Even more so, it allows them to play a dominant role in international affairs, clearly a high priority with current Chinese leadership. While it is not in the U.S. interest to strengthen China’s role in world affairs, it is a better alternative than letting pressures build inside China’s government over a perceived, if not actual, threat to their sovereignty. Also, other solutions to the dollar reserve problem may be dreamed up that prove to be far more dangerous to the current international order. Forecasts are for China’s reserves to grow to $1 trillion dollars by June 2006. Such an accumulation only puts more pressure on the Chinese to find an alternative solution.

Richard Lehmann is editor of Forbes/Lehmann Income Securities Investor. Read more analysis and information from Lehmann, or subscribe to Income Securities Investor.

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