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Buy America II: The First Shoe Drops
Dr Richard Appel
The featured article of my February 2004 issue of Financial Insights was entitled: "Will 'Buy America' Become the World's New Mantra?"
In that essay I discussed the various options available to foreigners, to manage the mountain of U.S. dollar credits that rested in their coffers. Further, I compared today's condition with that existing during the late 1970's through late1980's. During that period alien governments and individuals, led by the Japanese, began to dis-hoard their vast dollar holdings. The latter part of that era was hallmarked by the purchase of numerous prized American treasures, and the threatened acquisition of untold others.
Under current conditions, given the enormous increase in dollars that have since been amassed by our trading partners, the U.S. now finds itself in a far more precarious state. When the world's major economies finally decide to divest themselves of their U.S. dollar hoards, rather than continue to accumulate them, our nation's citizens will be forced to bear the brunt of the fall-out from the trend reversal.
It was recently announced that Minmetals, a large Chinese government controlled corporation, is in the process of acquiring Noranda, Canada's foremost mining company. In addition to the other metals that it mines, Noranda is the world's ninth largest copper and the number three zinc producer. Additionally, Noranda controls a 59% interest in Falconbridge, which is a major nickel and copper miner in its own right. Of similar note is the concurrent announcement that Sinopec, another massive Chinese government sanctioned company, is attempting to purchase a large lease-holding covering an important segment of Alberta's rich oil sands. A combination of today's high oil price and recent advancements in technology, have thrust these heretofore uneconomic hydrocarbon bearing sands into a position where they can now be economically exploited.
In essence, if these acquisitions are consummated China, which is rich in U.S. dollar credits and is commodity poor, will essentially be able to "kill two birds with one stone". It will find a home for some of the U.S. dollars that it has accumulated, and it will simultaneously secure some of the resources that they desperately require to satisfy their insatiable mineral thirst. The price tag for Noranda is currently about $5.5 U.S. billion, and that of the oil sands also runs into the billions of dollars. While both acquisitions may primarily require Canadian dollars, U.S. dollars will first be exchanged for those of our northern neighbor, which in turn will be used to complete the purchases. As an aside, this will benefit the already strong Canadian Dollar and will help drive it to even greater heights against its U.S. counterpart.
China is presently accumulating dollar credits at the mind-blowing monthly pace of over $10 U.S. billion. This is in addition to the reported one half trillion plus dollars that they currently possess. This incredible cache of U.S. credits is acting as both a boon to China and an Albatross around it's neck. On the positive side it is utilized to fund the purchase of massive amounts of raw materials that are direly needed by their industries. Negatively, it forces the government to generate a substantial and undesirable increase in their local currency, the yuan. This is fostering inflation in their domestic price structure which is threatening to undermine their economy's future growth and health.
When a Chinese business acquires U.S. dollars they exchanged them for yuan through their banking system. The yuan are created by the Chinese central bank. By significantly inflating their money supply inflation is generated. Additionally, this greatly expanded availability of capital is stimulating poor investment decisions and an overexpansion of projects which may outpace the markets that they hope to service. This too can do long-term harm to their economy.
Further damage accrues to China as the result of the ongoing decline of the dollar. The dollar's fall is generating currency exchange losses for all of the United States' trading partners, including the Chinese. This threatens China's dollar holdings with further depreciation, and gives them an additional reason to find avenues to rid themselves of their dollars, before they lose even more of their value.
Most of the dollar credits that leave the United States to fund our balance of payments deficits return, and are invested in U.S. Treasury paper. This results because foreign states have only a few primary fashions to utilize their amassed dollars. They can use them to acquire other currencies, American products or assets, or they can invest them in U.S. Treasuries where they will bear interest.
This circumstance has worked exceptionally well for the U.S.. First, the dollars leave our domestic monetary system and therefore are no longer counted in our money supply. Next, it allows our government to run budget deficits, and fund them through the issuance of Treasury paper which our trading partners largely purchase. In effect, the dollars that leave our nation, only soon to return, are invested in our Treasuries, thus restraining an increase in our monetary aggregates. Had these dollars remained within our monetary system they would have fostered inflation. Unfortunately, recent events may be aligning to create a condition where this situation may be in a state of change.
Foreign entities own nearly 50% of all outstanding U.S. Treasury debt. Further, from the dollar's peak at the end of 2001, it's international value as measured by the U.S. Dollar Index has eroded by 33%. This places all external dollar holders in a very difficult position. They have already lost one-third of the value of their holdings, and are likely becoming frightened that they will lose more. The recent action by the Chinese in their effort to acquire Noranda and the Alberta oil sands, may be the first obvious sign that one of the world's two largest dollar holders, may have reached their limit.
Importantly, this may be the first indication that the Chinese have struck upon a method where they can solve two problems. They can acquire needed mineral and hydrocarbon resources, while simultaneously ridding themselves of some of their unwanted dollars.
As I stated in the precursor to this essay, "If you will recall, during the latter half of the 1980's, a wave of foreign purchases occurred of American real estate and businesses as well as irreplaceable works of art and other items ....This 'buying of America' was led by the Japanese, and at times a certain amount of U.S. outrage occurred as asset after asset was being gobbled up by our foreign trading partners. During this era, landmarks such as Rockefeller Center, Pebble Beach as well as Universal Pictures were acquired by the Japanese."
It remains to be seen if we are experiencing the first in a series of similar Chinese acquisitions. However, I believe that this is only one of numerous ideas that China is considering to divest themselves of their mountain of U.S. dollar credits. China's government is likely already directing their efforts to make purchases in other areas, and in different asset classes, using their dollars. In any event, it is my contention that we are witnessing the early stage of a flight from the U.S. dollar, as visibly depicted by the recent actions of the Chinese. When a widespread movement out of the dollar occurs with a vengeance, this time it will be different, and it will likely be far worse than our 1970's experience.
WHEN THE DOLLARS COME HOME TO ROOST
A major problem will result when foreigners begin to dis-hoard their dollar stockpiles. It has the potential to generate a U.S. inflationary episode that will make the one that occurred during the latter part of the1970's pale by comparison. To my mind, it is not a question of if, but of when! At some point foreigners will become terrified of holding our currency. They will become fed up with watching our hemorrhaging balance of payments deficits, and the dollar's seemingly endless deterioration in value.
When that time arrives we will likely be subjected to a flood of dollars entering our monetary system and markets. As I have described, the dollar credits that were exported to "pay" for our balance of payment deficits, actually temporarily mitigated any inflationary impact on our economy. However, a very different set of circumstances will occur when these earlier expatriated dollars return to U.S. shores and enter our money supply.
Heretofore, U.S. budget deficits were largely funded by foreigners in their effort to at least achieve some benefit from holding dollars; they bought and received interest on U.S. Treasuries. These hundreds of billions of U.S. dollars circumvented entering our domestic money supply. The dollar credits were instead acquired by the Federal Reserve and exchanged for Treasury bills, notes and bonds. This greatly benefitted all Americans and allowed our citizenry to increase our standard of living while simultaneously reducing the inflationary effects. Unfortunately, the reverse will result when foreigners ultimately jettison a substantial amount of their U.S. Treasury holdings.
When foreigners sell their U.S. Treasuries some will take the received U.S. currency and purchase other currencies. This will further weaken the dollar's value on the international market, and will trigger a further liquidation of foreign held dollars. Others will use their dollar proceeds to acquire U.S. dollar denominated goods and assets.
This is where the problem arises! A flood of dollars that are issued when foreigners sell their Treasuries will enter the U.S. monetary system and dramatically inflate it. The resultant exploding money supply will have the potential to foster a serious inflationary event.
A balance occurs in a country between the size of its money supply and the value of the goods and services offered on their markets. When this is in a state of equilibrium, prices are stable. Throughout history whenever a nation fostered an increase in their money stock, without a similar rise in the quantity of their offered goods and services, prices rose. In effect, a condition results, called inflation, where too many monetary units are chasing the same number of goods. An extreme case would be the German hyperinflation of the early 1920's, of which we have all heard. In that event, their government was creating so many deutschemarks that in the end, before the currency and the country collapsed, it required a wheel barrel full of currency to purchase a loaf of bread.
I sincerely hope that this is not the state of affairs that awaits our future. True, gold will benefit and may trade at monstrous heights. However, we and our family and friends will have to live in our great country. No amount of gold profits can compensate for the misery that the ultimate return of our expatriated dollars can and likely will produce.
October 14. 2004
Dr Richard Appel
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I publish Financial Insights. It is a monthly newsletter in which I discuss gold, the financial markets, as well as various junior resource stocks that I believe offer great price appreciation potential.
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CAVEAT
I expect to have positions in many of the stocks that I discuss in these letters, and I will always disclose them to you. In essence, I will be putting my money where my mouth is! However, if this troubles you please avoid those that I own! I will attempt wherever possible, to offer stocks that I believe will allow my subscribers to participate without unduly affecting the stock price. It is my desire for my subscribers to purchase their stock as cheaply as possible. I would also suggest to beginning purchasers of these stocks, the following: always place limit orders when making purchases. If you don't, you run the risk of paying too much because you may inadvertently and unnecessarily raise the price. It may take a little patience, but in the long run you will save yourself a significant sum of money. In order to have a chance for success in this market, you must spread your risk among several companies. To that end, you should divide your available risk money into equal increments. These are all specula-tions! Never invest any money in these stocks that you could not afford to lose all of.
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