Buy America II: The First Shoe Drops
by Dr. Richard S. Appel
October 13/04
The featured article of my February 2004 issue of Financial Insights was entitled: “Will ‘Buy America’ Become the World’s New Mantra?”
http://www.financialinsights.org/archives/FI04-02.asp
In that essay I discussed the various options available to foreigners,
to manage the mountain of U.S. dollar credits that rested in their coffers.
Further, I compared today’s condition with that existing during
the late 1970's through late1980's. During that period alien governments
and individuals, led by the Japanese, began to dis-hoard their vast dollar
holdings. The latter part of that era was hallmarked by the purchase of
numerous prized American treasures, and the threatened acquisition of
untold others.
Under current conditions, given the enormous increase in dollars that
have since been amassed by our trading partners, the U.S. now finds itself
in a far more precarious state. When the world’s major economies
finally decide to divest themselves of their U.S. dollar hoards, rather
than continue to accumulate them, our nation’s citizens will be
forced to bear the brunt of the fall-out from the trend reversal.
It was recently announced that Minmetals, a large Chinese government controlled
corporation, is in the process of acquiring Noranda, Canada’s foremost
mining company. In addition to the other metals that it mines, Noranda
is the world’s ninth largest copper and the number three zinc producer.
Additionally, Noranda controls a 59% interest in Falconbridge, which is
a major nickel and copper miner in its own right. Of similar note is the
concurrent announcement that Sinopec, another massive Chinese government
sanctioned company, is attempting to purchase a large lease-holding covering
an important segment of Alberta’s rich oil sands. A combination
of today’s high oil price and recent advancements in technology,
have thrust these heretofore uneconomic hydrocarbon bearing sands into
a position where they can now be economically exploited.
In essence, if these acquisitions are consummated China, which is rich
in U.S. dollar credits and is commodity poor, will essentially be able
to “kill two birds with one stone”. It will find a home for
some of the U.S. dollars that it has accumulated, and it will simultaneously
secure some of the resources that they desperately require to satisfy
their insatiable mineral thirst. The price tag for Noranda is currently
about $5.5 U.S. billion, and that of the oil sands also runs into the
billions of dollars. While both acquisitions may primarily require Canadian
dollars, U.S. dollars will first be exchanged for those of our northern
neighbor, which in turn will be used to complete the purchases. As an
aside, this will benefit the already strong Canadian Dollar and will help
drive it to even greater heights against its U.S. counterpart.
China is presently accumulating dollar credits at the mind-blowing monthly
pace of over $10 U.S. billion. This is in addition to the reported one
half trillion plus dollars that they currently possess. This incredible
cache of U.S. credits is acting as both a boon to China and an Albatross
around it’s neck. On the positive side it is utilized to fund the
purchase of massive amounts of raw materials that are direly needed by
their industries. Negatively, it forces the government to generate a substantial
and undesirable increase in their local currency, the yuan. This is fostering
inflation in their domestic price structure which is threatening to undermine
their economy’s future growth and health.
When a Chinese business acquires U.S. dollars they exchanged them for
yuan through their banking system. The yuan are created by the Chinese
central bank. By significantly inflating their money supply inflation
is generated. Additionally, this greatly expanded availability of capital
is stimulating poor investment decisions and an overexpansion of projects
which may outpace the markets that they hope to service. This too can
do long-term harm to their economy.
Further damage accrues to China as the result of the ongoing decline of
the dollar. The dollar’s fall is generating currency exchange losses
for all of the United States’ trading partners, including the Chinese.
This threatens China’s dollar holdings with further depreciation,
and gives them an additional reason to find avenues to rid themselves
of their dollars, before they lose even more of their value.
Most of the dollar credits that leave the United States to fund our balance
of payments deficits return, and are invested in U.S. Treasury paper.
This results because foreign states have only a few primary fashions to
utilize their amassed dollars. They can use them to acquire other currencies,
American products or assets, or they can invest them in U.S. Treasuries
where they will bear interest.
This circumstance has worked exceptionally well for the U.S.. First, the
dollars leave our domestic monetary system and therefore are no longer
counted in our money supply. Next, it allows our government to run budget
deficits, and fund them through the issuance of Treasury paper which our
trading partners largely purchase. In effect, the dollars that leave our
nation, only soon to return, are invested in our Treasuries, thus restraining
an increase in our monetary aggregates. Had these dollars remained within
our monetary system they would have fostered inflation. Unfortunately,
recent events may be aligning to create a condition where this situation
may be in a state of change.
Foreign entities own nearly 50% of all outstanding U.S. Treasury debt.
Further, from the dollar’s peak at the end of 2001, it’s international
value as measured by the U.S. Dollar Index has eroded by 33%. This places
all external dollar holders in a very difficult position. They have already
lost one-third of the value of their holdings, and are likely becoming
frightened that they will lose more. The recent action by the Chinese
in their effort to acquire Noranda and the Alberta oil sands, may be the
first obvious sign that one of the world’s two largest dollar holders,
may have reached their limit.
Importantly, this may be the first indication that the Chinese have struck
upon a method where they can solve two problems. They can acquire needed
mineral and hydrocarbon resources, while simultaneously ridding themselves
of some of their unwanted dollars.
As I stated in the precursor to this essay, “If you will recall,
during the latter half of the 1980's, a wave of foreign purchases occurred
of American real estate and businesses as well as irreplaceable works
of art and other items ....This ‘buying of America’ was led
by the Japanese, and at times a certain amount of U.S. outrage occurred
as asset after asset was being gobbled up by our foreign trading partners.
During this era, landmarks such as Rockefeller Center, Pebble Beach as
well as Universal Pictures were acquired by the Japanese.”
It remains to be seen if we are experiencing the first in a series of
similar Chinese acquisitions. However, I believe that this is only one
of numerous ideas that China is considering to divest themselves of their
mountain of U.S. dollar credits. China’s government is likely already
directing their efforts to make purchases in other areas, and in different
asset classes, using their dollars. In any event, it is my contention
that we are witnessing the early stage of a flight from the U.S. dollar,
as visibly depicted by the recent actions of the Chinese. When a widespread
movement out of the dollar occurs with a vengeance, this time it will
be different, and it will likely be far worse than our 1970's experience.
WHEN THE DOLLARS COME HOME TO ROOST
A major problem will result when foreigners begin to dis-hoard their
dollar stockpiles. It has the potential to generate a U.S. inflationary
episode that will make the one that occurred during the latter part of
the1970's pale by comparison. To my mind, it is not a question of if,
but of when! At some point foreigners will become terrified of holding
our currency. They will become fed up with watching our hemorrhaging balance
of payments deficits, and the dollar’s seemingly endless deterioration
in value.
When that time arrives we will likely be subjected to a flood of dollars
entering our monetary system and markets. As I have described, the dollar
credits that were exported to “pay” for our balance of payment
deficits, actually temporarily mitigated any inflationary impact on our
economy. However, a very different set of circumstances will occur when
these earlier expatriated dollars return to U.S. shores and enter our
money supply.
Heretofore, U.S. budget deficits were largely funded by foreigners in
their effort to at least achieve some benefit from holding dollars; they
bought and received interest on U.S. Treasuries. These hundreds of billions
of U.S. dollars circumvented entering our domestic money supply. The dollar
credits were instead acquired by the Federal Reserve and exchanged for
Treasury bills, notes and bonds. This greatly benefitted all Americans
and allowed our citizenry to increase our standard of living while simultaneously
reducing the inflationary effects. Unfortunately, the reverse will result
when foreigners ultimately jettison a substantial amount of their U.S.
Treasury holdings.
When foreigners sell their U.S. Treasuries some will take the received
U.S. currency and purchase other currencies. This will further weaken
the dollar’s value on the international market, and will trigger
a further liquidation of foreign held dollars. Others will use their dollar
proceeds to acquire U.S. dollar denominated goods and assets.
This is where the problem arises! A flood of dollars that are issued when
foreigners sell their Treasuries will enter the U.S. monetary system and
dramatically inflate it. The resultant exploding money supply will have
the potential to foster a serious inflationary event.
A balance occurs in a country between the size of its money supply and
the value of the goods and services offered on their markets. When this
is in a state of equilibrium, prices are stable. Throughout history whenever
a nation fostered an increase in their money stock, without a similar
rise in the quantity of their offered goods and services, prices rose.
In effect, a condition results, called inflation, where too many monetary
units are chasing the same number of goods. An extreme case would be the
German hyperinflation of the early 1920's, of which we have all heard.
In that event, their government was creating so many deutschemarks that
in the end, before the currency and the country collapsed, it required
a wheel barrel full of currency to purchase a loaf of bread.
I sincerely hope that this is not the state of affairs that awaits our
future. True, gold will benefit and may trade at monstrous heights. However,
we and our family and friends will have to live in our great country.
No amount of gold profits can compensate for the misery that the ultimate
return of our expatriated dollars can and likely will produce.
I publish Financial Insights. It is a monthly newsletter in which I discuss gold, the financial markets, as well as various junior resource stocks that I believe offer great price appreciation potential.
Please visit my website www.financialinsights.org where you will be able to view previous issues of Financial Insights, as well as the companies that I am presently following. You will also be able to learn about me and about a special subscription offer.
CAVEAT
I expect to have positions in many of the stocks that I discuss in these letters, and I will always disclose them to you. In essence, I will be putting my money where my mouth is! However, if this troubles you please avoid those that I own! I will attempt wherever possible, to offer stocks that I believe will allow my subscribers to participate without unduly affecting the stock price. It is my desire for my subscribers to purchase their stock as cheaply as possible. I would also suggest to beginning purchasers of these stocks, the following: always place limit orders when making purchases. If you don't, you run the risk of paying too much because you may inadvertently and unnecessarily raise the price. It may take a little patience, but in the long run you will save yourself a significant sum of money. In order to have a chance for success in this market, you must spread your risk among several companies. To that end, you should divide your available risk money into equal increments. These are all speculations! Never invest any money in these stocks that you could not afford to lose all of.
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