China’s Pivotal Role in the Future of the U.S. Dollar

This is the time of year we would normally spend investigating the share market in detail. What technical levels will it dash to by the end of year? What sectors have performed the best…the worst? Where can we find bargains and what will the forecast for 2007 look like?

Those are all questions we promise to undertake in the coming weeks, but can’t help bashing our knuckles into the door frame one more time…which is another way of saying we would rather talk about the future of the U.S. dollar.

As a child, we remember seeing our dad stand in the door-frame and slowly, in a controlled manner, punch the door frame repeatedly with subdued violence. It impressed us and, we admit, scared us a little too. But when you have twelve children (a big Catholic family), there are probably plenty of good reasons to unleash what left-over energy you have on a solid wood door frame, and not, say, on your youngest child and seventh son (your editor.) We have no idea what the old man was hoping to accomplish. He usually ended up with bruised and sometimes bloodied knuckles. But afterwards, he was always a lot more relaxed…even if he hadn’t made any…breakthroughs.

The U.S. dollar is our proverbial door-frame. We bashed our neural knuckles against the buck all weekend, trying to punch through the fog of its abstract existence. We searched articles and data to get at what really matters about the greenback and why it demands our attention. And then we read on a blog somewhere about the sock puppet of and it all made sense.

The U.S. dollar, this blog post suggested (we can’t remember where we found it) is like an Internet stock circa 1999. Specifically it’s like was one of the last Internet concept stocks to go public before the Internet bubble burst in 2000. Its concept was to sell pet owners…pet things…on the Internet. It was a pretty simple business model, made famous by its sock puppet spokesman…er…spokespuppet.

Why buy pet supplies on line, the company asked? “Because pets can’t drive!” Flush with IPO cash, the company shelled out $1.2 million for an ad during the Super Bowl. The ad was rated most memorable in a survey by USA Today. It’s about all people remember about the company today. That and the puppet.

Then the Internet bubble burst. We can’t say that the sock puppet was responsible for bursting the Internet bubble. But some concepts are better left on the drawing board and out of the sock drawer. Perhaps having a sock as the symbol of your business acumen isn’t the best strategy to inspire confidence.

In any event, investors shed the sock and shed the stock, the ones that could. And here is how Pets.Com of yesteryear is like China Inc. today: Any one with a large and noticeable position in the stock, any institution, would be reluctant to sell first.

By selling, you admit what you own ought to be sold, and cause other people to sell. Once the absurd spell which induced to you but too much of a stupid thing in the first place is broken, all hell breaks loose and panicked, undisciplined, disorderly, deeply de-stabilizing selling begins.

If the U.S. dollar is like an Internet stock, then the sell-off that’s coming is going to make the bust look a tea party. Everyone in the world who owns dollar-denominated assets owns a drawer full of U.S. dollars. That is one reason why the individual fate of share market indices ranks second to the dollar in terms of importance. If the buck goes, many global stocks will go with it. And so might a certain rising economic power just west of Japan….

Today’s Forbes reports that, “The Chinese central bank warned that international holders of US dollar assets may start to adjust their foreign exchange holdings to reduce risk. If the US current account deficit growth continues to be higher than GDP growth, the investment value of US assets will be questioned by global investors, and the willingness of investors to continue holding and buying US financial products may weaken, the central bank said.’ ”

China owns a lot of U.S. dollars. And perhaps that’s beginning to make them nervous, as nervous as a long-tailed cat in a room full of rocking chairs, as the Southern saying goes. Forbes continues, “China has been cautious in its statements about the dollar. It now has over one trillion dollars in foreign exchange reserves, the world’s biggest, and about 70% of that is believed to be held in dollar-denominated assets.”

The Chinese have every reason to preach caution on the falling dollar without stirring a panic. But in today’s Moscow Times comes a sober analysis of what we may witness in 2007. A political crisis in China could spell the end of the U.S. dollar, writes Alexei Bayer:

“So far, China has avoided the kind of financial crises and political upheavals that have repeatedly blindsided smaller exporting nations around the Pacific Rim over the past two decades. The Beijing government has used carrots and sticks to keep its vast and rapidly changing society quiescent.

“Past success, however, does not mean that China will be able to keep the lid on this cauldron forever. Economic growth has unleashed tremendous energy and creativity in the Chinese population. But it has also created severe pressures – – social, political, economic and demographic. Hundreds of millions of peasants have abandoned their centuries-old way of life and migrated to urban centers. The gap between the rich and the poor has widened…These pressures — or other problems that cannot be currently predicted — could plunge China into a crisis that could be quite severe.

“During the Cold War, the Soviet Union could annihilate the United States with its nuclear weapons — and face instant annihilation in return — but it could not make a serious impact on its economy. China has emerged as probably the only nation in the world that can single-handedly undermine the U.S. economy. If China suffers an economic or political crisis, the United States will likely be plunged into a severe recession — if not an outright depression.

“This scenario is ominously similar to that of the Great Depression of the 1930s, which was largely a U.S. crisis taking place after a decade of breakneck economic growth. The stock market crash occurred on Wall Street, but its shockwaves promptly spread around the world. Ultimately, the Depression marked the demise of British economic dominance and the end of the pound as a global currency. While the next global economic crisis is likely to originate in China, it will almost certainly mark the end of the dollar as the linchpin of the global financial system and a substantial diminution of the central role of the United States.”

So far, only knuckle-bashing investors like your editor see the looming threat of a forced Chinese dollar liquidation, and what it might mean for stocks (very bad) and for gold (very good.) But according to a New York Times article, the wisdom of individual investors is trickling up to the boardrooms of the world’s central banks.

“Central banks will eventually take the same cue…if they continue to see the value of their dollar-denominated reserves plummet,” says Professor Richard Portes, who teaches economics at the London School of Business. “People say central banks don’t care if they lose money. That’s just not true. I’ve talked to central bankers who have said, ‘I’m not going to be the last one out of this room if a fire breaks out.’ ”

No one wanted to be the last one out of either. But the problem wasn’t deciding when to get out. The problem was being “in” in the first place. Such is the problem for today’s dollar-based financial world. And the bigger problem is that there really is no “out” in the sense of escaping dollar risk. There is owning resource stocks denominated in Aussie dollars. And there is gold, which, as the anti-U.S. dollar, should rise as the dollars fall.

Beyond that…there is a whole lot of pain. Banging your knuckles against the door won’t prevent that. But it might help focus the mind to buy gold, while it’s still cheap.

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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