US DOLLAR IMPLOSION - PART II

By Alf field         December 03, 2003

As Winston Churchill might have put it, in regard to the US Dollar : “We have reached the End of the Beginning and are about to enter the Beginning of the End”. What has taken place during the past 17 months has been no more than Part I of the US$ implosion. We are set to start Part II.

During the past 17 months the US Dollar has declined moderately against most European currencies, and by even more against the currencies of commodity producers such as South Africa, Australia, Canada, and New Zealand. Elementary economics teaches that when a country’s currency depreciates, that country’s trade deficit will gradually diminish. Yet, despite a two year slide in the Dollar, there has so far been no decline in the US trade deficit. Why the exception?

The answer lies in the countervailing actions adopted by some of America’s Asian trading partners. Those with the largest surpluses, mainly Japan and China, have been intervening in the markets to slow the appreciation of their currencies against the Dollar in an effort to protect their export industries. China, which today enjoys the largest surplus of all America’s trading partners, linked its currency directly to the US Dollar. Despite rising opposition from the US Government, China’s currency strategy continues unabated.

Before condemning the Chinese, it is important to understand what is happening in their country. The Industrial Revolution in the UK and Europe in the 18th and 19th centuries totally transformed their economies from agricultural dependency to economies reliant on industry and commerce. People moved off the land into the towns. Jobs in the new industries were poorly paid, but they at least provided a living.

China appears to be going through a similar experience. They are enjoying their own Industrial Revolution that is rapidly transforming what was previously an agrarian economy into one witnessing a massive build up in its industrial and commercial infrastructure. China currently has the lowest cost labour force in the world. They are therefore being inundated with an influx of US manufacturers. Some transfer existing operations, lock, stock and barrel. Others have closed down out-of-date facilities back home only to establish brand new plants in China. To this growing pool may be added factories controlled by indigenous Chinese entrepreneurs.

With wages in Asia being a tiny fraction of those paid to workers in western countries, the trend of moving manufacturing and services to Asia – especially to China and India – is bound to accelerate. Adding to America’s nightmare is a Chinese cultural and business strategy that places great emphasis on the distant future. This persuades the nation to endure short-term pain in the interests of achieving long-term goals.

What seems to be happening is the following. The Chinese view the US as their main export market, hence the solid link between their own currency and the Dollar. China has been earning massive Dollar surpluses from its trade with the US. They re-invest those surpluses back into US Treasury Bonds. By recycling their dollars back into the system, they play a key role in keeping US interest rates artificially low. This in turn holds America’s economic recovery on track.

China must know that it is selling real goods to the USA and being paid in pieces of paper that will ultimately be worth a lot less.

The Chinese understand they will one day have to take a loss on their dollar reserves, but this is the price that they are willing to pay to maintain the existing order. The longer they perpetuate the system, the faster their industrial infrastructure will grow and the greater the number of Chinese finding jobs. A fall in the value of their accumulated foreign reserves is a price they are prepared to pay in the interests of laying a foundation for their country’s long-term growth.

China is happy to see the status quo continue. It will only change if the US takes unilateral action when the US tires of losing jobs and services to Asia. The political pressure is certainly building. American voters are becoming increasingly aware jobs are disappearing as factories close. The subcontracting of service work is going to India where there is a culture of speaking English.

A sign that groundswell opposition is having an impact was evidenced by President Bush’s recent tour of Asia. He requested Asian countries to allow their currencies to appreciate against the Dollar. Unsurprisingly his appeals went unheard. Back in Washington, the Democrats have been pushing to levy a 27.5% tariff on Chinese goods imported into the US “to protect our jobs”.

These are all signs in the wind that this particular trade arrangement is coming to an end. Sooner or later the USA will be forced to take some form of unilateral action to terminate the relationship. The side effects will be extremely damaging. Their action will signal that the game is over. It will also confirm the end of the US Dollar as a reserve currency, triggering Part II of the US Dollar Implosion.

When China understands that the game is over, the time will have arrived for them to dispose of their US Treasury Bonds, effectively switching out of Dollars into something safer like the Euro (the only viable paper reserve asset) – and into gold, which will soon become the reserve asset of choice. In recent years China has steadily been building up the gold component of their country’s foreign reserves. This trend will soon accelerate.

It is possible that China may eventually revalue their currency, the Remnimbi. In the meantime, the result of confrontation will be to tip the US, and therefore the world economy, into recession. US interest rates will rise rapidly as the Chinese dump their Treasury Bonds, causing havoc in the US real estate market. The Chinese economy will not be unaffected and may well dip into recession simultaneously. Recently constructed factories in China may fall on hard times. Those that have been financed through debt could go to the wall. Chinese entrepreneurs will pick up these factories for cents in the dollar.

Part II of the Dollar implosion will differ substantially from Part I. If the US-China economic relationship changes or ceases, the effect on commodity prices could be immediate and dramatic. “Commodity” currencies may then no longer look quite as attractive as they do at present. In the face of spreading recession, the prices of most commodities would decline, severely denting the attractiveness of the currencies of commodity producers. This could cause a severe reaction to events of the past two years in which the Australian dollar has risen 50%, from 48c to 72c; the South African Rand that is up almost 100%, from 8c to 15.5c; and the New Zealand dollar that has risen 60%, from 40c to 64c.

The feature of Part II of the US Dollar Implosion will be a recognition that even presently popular commodity currencies are mere paper, ultimately no different to the Dollar itself. There will be an awareness that, unlike the 1930’s when competitive currency devaluations were made “by decree”; we are now in an era of competitive currency creation or printing. The country with the fastest growth of currency creation will have a short term trade advantage as their currency depreciates against competitive nations. As investors withdraw from the erstwhile favoured currencies, they will have a problem deciding where to invest their funds. This is when gold will be seen as a viable alternative.

There will therefore be a growing awareness and recognition of the vastly more attractive reserve asset role that gold must and will play in the future. This recognition is the fuel that will fire a rocket under the price of gold, driving it to substantial new highs in terms of ALL currencies.

SILVER

In past crises, the wealthy have protected themselves buy purchasing gold and gold related assets. Ordinary people, by far the greater number, could rarely afford to buy gold. Being far cheaper, they have previously had to buy silver. This metal became the poor man’s choice as an asset to protect their savings. Silver has so far lagged gold in the early stages of this bull market, but that situation seems about to change.

Throughout recorded history the average relationship between silver and gold has been 15oz silver to 1oz gold. The ratio at present is a far higher 75:1 ($400/$5.30). This is massively out of line. If gold were to double to $800 per oz, it would not be unreasonable to expect the silver/gold ratio to decline sharply, possibly as low as 40:1. With gold at $800, this would position silver at $20.

Thus a 100% increase in the price of gold could possibly be accompanied by a simultaneous 400% increase (perhaps more) in the price of silver. This offers significant opportunities both in silver bullion and silver mining shares .

The above graph of the price of silver has been borrowed from an excellent recent article by Dan Norcini entitled “A Technical Look at Silver – Update”.

What is quite clear from the graph is that silver’s 22-year bear market down trend has come to an end. As Dan Norcini says, a new bull market in silver has been born. It is difficult to argue against this contention and I have no intention of doing so. A silver price above $6.80 would complete a fabulous head-and-shoulders base formation. With this as a foundation, it would be possible to project a very large rise in the price of silver for the future.

Alf Field
3 December 2003

Comments may be sent to the author at: ajfield@attglobal.net

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Disclosure Statement: The author has personal investments in JCI Ltd (JCD), in the JCI Redeemable Convertible Debentures (JCDD) and in Randgold Exploration Ltd (RNG). The author has not been paid to write this article nor has he received any other inducement to do so. The author will benefit from any appreciation in the market prices of these securities.

Disclaimer: The author’s objective in writing this article is to invoke an interest on the part of potential investors in these securities to the point where they are encouraged to conduct their own further diligent research. Neither the information nor the opinions expressed should be construed as a solicitation to buy or sell these securities. Investors are recommended to obtain the advice of a qualified investment advisor before entering into transactions in any of these securities.