China Performs a Kind of Financial Alchemy

Wherever we’re going, are we there yet?

Nope! But we’re getting there. That is, America is sleepwalking its way into poverty. China is performing a kind of financial alchemy. And Australia finds itself subject to American-style problems, but benefitting from China’s Grand Economic Strategy.

But how about those powerful idealists on U.S. markets? Both the S&P 500 and the Dow were up nearly three percent. If you can believe it, they were led by financial stocks and retailers. Bank of America finished up 9.9% after Goldman Sachs put it on its “conviction buy” list. Home hardware retailer Lowes was up 8.1% after a survey of U.S. homebuilder confidence surged.

By the way, what the hell is a “conviction buy” list? Does that mean you can only recommend stocks in which the executives have been convicted of a crime? And if it means a share you can buy with conviction, is there a “non conviction buy?”

Can you see yourself calling your broker to say, “Hey Bob. I don’t much like stock XYZ. Earnings suck. It’s got heaps of debt. Management is incompetent. But stocks are rallying…so yeah…let’s do this baby. Buy. Just… you know…don’t do it with any conviction.”

Does anyone still take broker recommendations seriously?

Still, the rally in U.S shares-based on whatever it is based-is giving some investors the impression that demand for commodities will increase if the U.S. and world economies begin to grow again later this year. We think this is the dying convulsions of the “green shoots” theory/sucker’s rally. You know, the one that ignores another $1.5 to $3 trillion bank losses from residential and commercial real estate.

But if you’re a market neutral trader, why complain? Crude oil prices surged 4.8% in New York. Part of that rise stems from a shooting war between Nigeria’s government and rebels who operate in the Niger delta. It’s another reason to be bullish on oil. Not only has capital investment in new supply crashed, existing supply comes from national oil companies who are likely to use oil as a strategic and political weapon. Or it comes from countries like Mexico, Nigeria, and Venezuela that have fiscal stability issues.

Incidentally, Nigeria supplies 2.1% of the world’s oil each day, or about 1.76mbpd. It would be more if about 500,000 barrels of capacity weren’t idled because of the ongoing guerrilla conflict. The slack in global oil demand from the worldwide recession has made people forget about how slim the margin in is between daily global supply and daily global demand. Any combination of even more reduced supply (inevitable with the cap ex collapse of 2008) and increased demand will put oil right back into the red zone.

What about metals? Copper was up too. It closed up 2.7% in New York trading. And hey, what’s this? In late April we reported that China’s State Reserves Bureau was stock-piling metals at low prices. Bloomberg reports today that, “China is stockpiling commodities such as copper and iron ore as part of a reallocation of its sovereign wealth amid concern that the value of its dollar assets may decline.”

The report cites a Royal Bank of Canada report on China’s strategy to hedge its risk of owning US$796 billion worth of U.S. government bonds and notes. “Increased spending on commodities represents a reallocation of China’s sovereign wealth away from the accumulation of financial assets,” said Royal Bank analyst Brian Jackson.

China, by the way, increased crude oil imports by 14% in May and imported a record 57 million tonnes of iron ore. In fact, the China Iron and Steel Association (CSIA) is trying to blame the import surge on speculators who are front-running what they think will be an increase in demand, according to an article in today’s Australian.

Remember, the annual iron ore negotiations are part of this public hemming and hawing. Chinese buyers of Aussie ore want to talk down demand growth, which would suggest a lower contract price. The CSIA says six of the top ten Chinese ore importers in the first quarter were traders, not steel-makers. But is reporting that Chinese steel-maker Baosteel said earlier this week that, “orders from auto sector hit a new monthly record of 937,000 tonnes in May up 317,000 tonnes or 50% over April.”

Hmm. China has a current steel-making capacity of 650 million tonnes per annum (mtpa) according to Boatel chairman Xu Lejiang. That sounds like too much.

Meanwhile, we can’t go into it in great detail, but could the great U.S. dollar exodus be happening right under our noses? China has been busy setting up bi-later currency swaps with its trading partners. The purpose is to settle cross-border transactions in currencies that are not the U.S. dollar.

Today’s Financial Times reports that, “Brazil and China will work towards using their own currencies in trade transactions rather than the US dollar, according to Brazil’s central bank and aides to Luiz Inácio Lula da Silva, Brazil’s president. The move follows recent Chinese challenges to the status of the dollar as the world’s leading international currency.”

China’s government has set up currency swaps with Hong Kong, South Korea, Indonesia, Malaysia, Argentina, and now Brazil. The purpose of the swaps varies from county to country. But the main benefit is that China can conduct more of its trade using its own currency and not the U.S. dollar. It also is a kind of vendor financing deal in which China supplies currency to countries from which it buys a huge amount of commodities (Argentina and Brazil, not yet Australia.)

Does it mean the remnimbi is the next world reserve currency? Nope. But it does mean that the Chinese are not looking to accumulate large financial reserves held in U.S. dollars any longer. They believe it’s better, judging by these actions, to accumulate real assets that will be needed in the future by Chinese industry and Chinese consumers.

And what about all those dollars? Well, most of China’s dollar reserves are held via U.S. Treasuries. And it’s possible China has been performing a kind of financial alchemy, turning financial reserve assets into tangible commodity stockpiles. As this article points out, you’d think it’d be easy enough for Chinese holders of USTs to loan them to U.S. banks (who just love that sort of collateral at the moment) in exchange for cash which can be used to stockpile real stuff. It would be a clever trade.

Australia, of course, would stand to benefit from that trade. As Glenn Stevens pointed out in his speech to the Canadian Australian Chamber of Commerce, Australia’s exports are biased towards commodities rather than manufactured goods. He says this has cushioned Australia from the world-wide slump, without damaging the huge improvement in terms of trade.

Why have Australia’s export volumes not weakened. Stevens says that, “One reason is that the slump in global trade was initially concentrated heavily in manufactures, which is a smaller share of exports for Australia than others. Another is the stronger linkage of key commodity exports to China, which appears to have seen a pick up in growth this year.”

“Chinese industrial output fell for four months between July and November, but has since recovered all those losses. A similar pattern has been seen in Korea, where industrial output suffered a sharp decline around year end but apparently made up about half of that over February and March.

Getting More and Paying Less: The Terms of Trade Improve and Correct

“Looking ahead, with commodity prices at present levels, Canada’s terms of trade look like they are still somewhat above the average for the preceding couple of decades. Australian resource producers have accepted lower prices for the year ahead, and this is likely to contribute to a decline in the terms of trade by the end of 2009 of about 25 per cent from the peak, as shown in the chart [above] Yet even with that, at this stage Australia’s terms of trade over the coming year look like they will still be around 40 per cent above the two decade average up to 2000.”

Hmm. Well, Stevens is right that the terms of trade are still well above the two-decade average. And when you are paying less for your imports but receiving more for your exports, that is not a bad position to be in. But where will they go from here? Would Australia benefit or suffer from a bi-lateral currency swap with China? More on this subject later.

Finally, we feel compelled to point out that Housing Industry Association Chris Lamont has said, “There has never been a better time to enter into home ownership,” in Australia. Someday he’s going to regret saying that.

Dan Denning
for Markets and Money

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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10 Comments on "China Performs a Kind of Financial Alchemy"

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chris lamont

Dear Mr Denning,

I note the quote that you attribute to me in the last sentence of your article entitled, ‘China Peforms a Kind of Financial Alchemy’. You have abbreviated my actual quote.

In a HIA press release issued 18 May 2009 I stated as follows, “notwithstanding current economic conditions for many aspiring home buyers there has never been a better time to enter home ownership”.

My comments were made in the context of an improvement in housing affordability, which is now at a seven year high.

Assessments of housing affordability do not provide any assessment of future price movements.

Yours sincerely

Chris Lamont

Greg Atkinson
Bloomberg reports today that, “China is stockpiling commodities such as copper and iron ore as part of a reallocation of its sovereign wealth amid concern that the value of its dollar assets may decline.” In the interests of accuracy, Bloomberg was reporting the views of “one” analyst from the Royal Bank of Canada. See: Good old analyst thinking, the Chinese say they are buying up resources because they are cheap but an analyst reckons it is all part of a wider cunning economic plan. Perhaps the Chinese are also buying up a lot of resources because they have committed… Read more »

Chris: You obviously don’t regret saying it yet. Although you didn’t apparently imply that your statement that “there has never been a better time” to buy a house had anything to do with future price changes, everybody else will be thinking that it does. Typical sales pitch.

I would say “there never has been a worse time” to take out a mortgage – for many people, at least.


USD looking very sad in near term.

chris lamont


It is disappointing that you have chosen not to correct your article which provides a false quotation. I have advised you of the error and the fact that you have chosen not to correct reflects poorly on what would have otherwise would have been a sound article.


China has a 200 year plan, Aus has one that extends all the way out to the next election.

And yes, there could not be a worse time to buy a house. The $21,000 FHO Bribe is a very thin barrier against negative equity.


Interesting if that is the ‘real’ Chris Lamont.

I wonder if a few years down the track they will be exposing him and others (esp. the REIA) for the liars they are. I certainly hope so.


Spot on Barry

David Hannaford

“Would Australia benefit or suffer from a bi-lateral currency swap with China? More on this subject later.”
I look forward to reading this article. We have a situation wherein the three largest banks in the world are in China; where our main customer is China, where our main supplier of domestic goods is China, where our export rivals have done direct currency deals with China, while we continue to bank and denominate trade in a failing currency.

Biker Pete

China’s new Yuan Carry Trade may effectively accomplish what you’re suggesting, David.

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