China Sees the Writing on the Wall
December 16, 2005

The US trade deficit increased to $68.9 billion in October with China's net exports to the US at $20.5 billion for the month. This year's annualized deficit with China is now the largest ever recorded in the history of the US. It is almost twice as large as the deficit with Europe and almost three times as large as the deficit with Japan.

Earlier this year, before I started harping on the impact a downturn in the real estate market would have on the US economy, I said that the dollar would weaken when either China or Japan decided to stop supporting it by keeping their trade dollar reserves off the foreign exchange market. I also discussed how China and Japan could use their foreign reserves to stimulate their own economies once the marginal benefit of supporting the US dollar has diminished. Well, there was an interesting article in a Chinese newspaper, called The Standard, on Tuesday. The newspaper quoted Mr. Yu Yongding, who is a member of the monetary policy advisory committee to the People's Bank of China, as saying that China should weaken the link between the yuan (renminbi) and the US dollar, to make the exchange rate more flexible and improve the government's ability to manage the economy. Yu suggested that the weighting of the US dollar in the basket of currencies against which the renminbi is set should be reduced, reducing the impact that changes in the US dollar would have on the value of the renminbi. The market read this as a prelude to China allowing the dollar to weaken and its own currency to strengthen.

On Wednesday Mr. Yu Yongding was quoted by the same newspaper as saying that Chinese firms should get ready for a strengthening of the yuan (renminbi) in the next one to two years. The "fuller the preparations, the better," he said. He went on to say that China's current account surplus and America's current account deficit are reflections of savings and investment imbalances in the two countries. He also said that the dollar would probably weaken unless the United States tackles its current account deficit.

The same article mentions a research paper obtained by Reuters, wherein Mr. Yu Yongding suggested China could reduce the growth in its foreign reserves by running expansionary fiscal policies and invest in infrastructure and research and development.

The gold price has been volatile this past week, and I suspect that much of that volatility can be attributed to Yu's comments. The rise in the gold price was in anticipation of dollar weakness, and the subsequent decline was due to a comment on the 14th by the Chinese Central Bank chief, Zhou Xiaochuan, that he does not see the need for the yuan to appreciate next year if the country's trade surplus shrinks. Damage control.

The very witty Bill Bonner and Addison Wiggin have written a new book, called "Empire of Debt". Bill Bonner has phenomenal insight, and while many authors have belabored the debt-ridden state we find ourselves in, perhaps it is Bill's assigned role to make us more aware of how absurd today's common sense really is.

Here is a short quote from the book:

"I read in the Figaro that the American economy has become completely dependent on China," said a friend at a dinner party recently. "But I guess the Chinese have no choice. They need Americans to continue buying their products."

We are alarmed. Even chemists and shoe clerks have taken up macroeconomics. Everyone thinks he understands how the world economy works.

"Well, it is a little like that," we began to explain. "The Chinese do sell to the U.S. and they do lend money back to the U.S. But there's no law that says this has to continue."

"Imagine a shopkeeper whose biggest customer was having a hard time paying his bills. He extends credit . . . hoping the man will get his finances in order. But the more credit he gives him, the worse the man's finances are. It would be very nice if that could work out. But it rarely does. Instead, it eventually blows up. The customer has to stop buying and the shopkeeper has to stop lending. There's going to be hell to pay, in other words."

"What should an investor do to protect himself?" our friend asked.

"Buy gold."

Happy Holidays,

Paul van Eeden

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