Little China

China’s Stealth Abandonment of the Dollar Has Begun (Part Two)

China wants to get shed of its excess dollar reserves – and to eventually see the dollar replaced as the world’s reserve currency – but in its deep ambition China must tread carefully. The great game has begun…

“If you owe your bank manager a thousand pounds, you are at his mercy. If you owe him a million pounds, he is at your mercy.”

– Yu Yongding, influential Chinese economist, citing John Maynard Keynes

A quick note relating to Friday’s Taipan Daily, “The Last Western Country Where Banker isn’t a Cussword.” TD reader from down under Roger K. writes,

There is another western country where banks are also doing well, that is Australia. The banks here have similar stringent regulation and conservative management… and Australia is a western country and we speak english – well sort of…

Good on ya Roger. (An Aussie expression, for those unaware.) I should have thought to include Australia in my mental checklist of Western countries.

When I took a semester at Macquarie Uni in Sydney (back in the late 1990s), there was a lively debate taking place as to whether Australia should consider itself a part of the West or a part of Asia. Perhaps I subconsciously resolved the question in favor of the latter.

Anyhow, getting back to the opening quote (and today’s topic at hand)…

China is well aware of its little “problem” – that is to say, the problem of what to do with $1.3 trillion worth of U.S. dollar reserves. (China’s total reserves are pegged at just under $2 trillion. Roughly two-thirds of that sits in dollar-denominated assets.)

Nor is it an easy problem to solve. In many respects the United States has China over a barrel. There is no way China can credibly threaten to dump its dollar holdings over the side en masse, as such would be an act of financial self-destruction. This “gotcha” situation gives Uncle Sam a certain degree of freedom to be as abusive as he likes when it comes to the printing press.

But hold on, that’s not quite accurate. If things get desperate enough in Beijing, the mandarins can, in fact, threaten America with a full-scale dollar blowout. They can put the gun to their own heads, so to speak, and in so doing put it to Uncle Sam’s head too. (For more along this line, see the March 20 Taipan Daily essay, “China, the Fed and Financial MADness revisited.”)

Of course, that action is only palatable as a last-ditch resort. Playing the madman requires a certain air of desperation, a certain loss of face at home… and no doubt the mandarins would prefer avoiding that indignity if they can.

Something has to be done about the dollar situation regardless. And as we try to handicap the moves, we have to remember that China is very comfortable playing the long game. While U.S. politicians are content to play checkers, in other words, China prefers to play chess. Or, to make the analogy more apt, perhaps China prefers to play “Go” – an ancient game involving the placement of black and white stones that is, in its own way, even more subtle and complex than chess.

Change at the Periphery

The first tactical concept China seems to be embracing is “change at the periphery.” If you cannot challenge your opponent bluntly and head on, then you do so obliquely and from the side. You undertake a series of quiet, subtle maneuvers – perhaps so subtle that your opponent does not notice them at first – and slowly build strength in that fashion.

This process of change at the periphery is related to a powerful concept from the theory of evolution known as “punctuated equilibrium.” I gave a talk on this subject (as it relates to markets) in New Orleans in 2006.

A key thrust of the punctuated equilibrium idea is that, despite what many assume, the center does not actually evolve or change. Instead, the center remains relatively stable, while interesting things happen out on the fringes (the periphery). These fringe-area happenings are mostly inconsequential… little bubbles of experimentation that come and go.

But then, given enough time, something happens. One of those fringe happenings out on the edge catches on. Something new and powerful takes place at the periphery. This new model or idea or experiment or whatever it is – the precise technical term doesn’t matter – begins to catch on.

The source of peripheral change then begins to compound in force and impact, reaching a stage where it grows and expands rapidly. And then, seemingly out of nowhere, the dominance of the old center is challenged.

As mentioned before, the old center does not actually change or evolve. Instead it is challenged and eventually dominated – perhaps dominated out of existence – by a new center that quietly grew in the shadows, out on the fringes, while few were paying attention.

One Shovel at a Time

This roadmap of “change at the periphery” is the path China must take to free itself from the heavy yoke of excess dollar reserves. The mountain is too big to be moved all at once. And so, instead, China must figure out how to move the mountain quietly and in stages… one shovelful of earth at a time.

At the same time, China is obviously thinking of power on the geopolitical stage. It is not just enough to get shed of overwhelming greenback exposure – that is only half the goal.

The other half of the goal is finding ways to accelerate the twilight of the dollar as the world’s reserve currency, in such a manner that Beijing’s power can wax as Washington’s wanes, without disturbing the existing order of things so much as to bring the current system crashing down on everyone’s head. This, too, is a delicate business.

And so China must start small, and proceed with caution. But there is a time factor here too… the longer Beijing waits to carry out a strategic plan of action, the greater the risk that large stores of Chinese wealth could evaporate through the ongoing process of dollar debasement. There is no element of leisure here. In many ways time is of the essence, and this requires certain movements to be perhaps a little less subtle and a little more blunt than the mandarins would ideally prefer.

So that’s the setup… tomorrow I will tell you about the three key “peripheral actions” China has recently undertaken, and show you how these actions could have dramatic impact on our trading and investing strategies in the years ahead.

http://www.taipanpublishinggroup.com/taipan-daily-042109.html

About the Author

Justice Litle is Editorial Director for Taipan Publishing Group. He is also a regular contributor to Taipan Daily, a free investing and trading e-letter, and Editor of Taipan’s Safe Haven Investor and newly introduced service Macro Trader.

Justice has worked with hedge funds, traded equities for a private partnership, written multiple articles for Futures Magazine, been quoted in the Wall Street Journal, sought for market commentary by the likes of Reuters and Dow Jones, made contributions to the book, Trend Following: How Traders Make Millions in Up or Down Markets, and also filled the lead editor of Outstanding Investments, a popular natural resource newsletter.

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