Tuesday, August 14, 2007

What is going on in China?

Last week, we reported the inconvenient truth that M3 is increasing at 12% a year.

M3 is the fullest measure of the U.S. money supply… and it is going up three to four times faster than the GDP itself.

The Fed’s irresistible desire to print more fiat dollars helps explain why the world is saturated with liquidity right now. And many of those dollars have conveniently found their way into the war chests of the world’s top ten sovereign wealth funds.

Morgan Stanley estimates these funds now control $2.5 trillion dollars.

Relatively speaking, SWF’s are already equivalent in size to roughly half the gross official reserves of all countries.

And if these government-backed hedge funds weren’t large enough, Morgan Stanley estimates their reserves will increase to $5 trillion by 2010 on their way to hitting $12 trillion by 2015.

China alone holds more somewhere between $1.2 trillion in foreign exchange reserves. These reserves are traditionally invested in liquid assets like U.S. Treasury bonds. Buying U.S. Treasuries enables China to peg the RMB to the greenback.

We knew China’s thirst for American Treasuries wouldn’t last forever. Nothing does…not even the world’s greatest empires.

So earlier this year, when China decided to set up its own sovereign-wealth fund, your editors became somewhat suspicous. This fund enables Beijing to shop for assets more exciting than stodgy, old government bonds. China can effectively take a chunk of that $1.2 trillion and search for things where it might make a better return…things like old-school British banks and white-shoed American PE funds.

What better way to own the world, right?

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But when we read that China, for the second consecutive month, has been a net seller of U.S. securities, we stood up and took real notice.

China sold a net $6.6 billion of U.S. securities in May following net sales of $5.8 billion in April. The last time China sold U.S. securities for two consecutive months was during January/February of 2004.

We said that if this move proves to be more than a passing trend, this could put further pressure on the U.S. dollar.

Well, that may be the case.

In The Turning Point in China’s Economic Development, editors Ross Garnaut and Ligang Song point out:

"China has or is fast approaching reached the turning point in its economic development, at which 'surplus' labour from agricultural employment in the countryside ceases to be available to drive the growth of the modern economy; so that labour becomes scarce and valuable; forcing large real wage increases and real exchange rate appreciation; which generate structural change towards more capital-intensive and technologically sophisticated industrial structure at the relative expense of labour-intensive manufacturing and agriculture; and changes fundamentally the character of China's interaction with the international economy."

I’ve always believed China’s path for floating the RMB would take place in three distinct stages. First, China would clean up the state banking system. Second, Beijing would gradually liberalize capital account convertibility. Finally, the Chinese RMB would be allowed to float alongside the dollar, euro, yen and pound.

We may be on the verge of reaching step number two. Meaning, China’s appetite for U.S. dollars may not be with us too much longer.

This may help explain the gradual shift taking place on Beijing’s shopping list.

But the real question is… If you had a $300 billion shopping budget and you knew the world’s demand for U.S. dollars was about to fall as M3 kept growing at a double-digit pace, what would you buy?

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