Since 1978, China has been exporting more goods than it has imported. That's allowed the nation to stockpile trillions of Dollars. What to do with so much money?
The way it works is simple to understand. When a Chinese business earns Dollars by selling overseas, the law requires the company to hand those Dollars over to the country's central bank, the People's Bank of China (PBOC). In return, the business gets Chinese currency (called either the "Yuan" or the "Renminbi") at a fixed rate.
There's nothing fair about this. The Chinese people do all the work, and the Chinese government keeps all of the money. But that's the way it goes.
At first, the Dollar inflow was small because trade between the two countries was tiny. In 1980, for example, China's foreign currency reserves stood at approximately $2.5 billion. But since then, the amount of foreign currency reserves held by the Chinese government has gone up nearly every year...and now stands at $3.2 TRILLION. That's a 127,900% increase. It's simply astonishing to look at the chart of the increase in currency reserves...
As I mentioned yesterday, the group in China that manages these foreign reserves is called the State Administration of Foreign Exchange (SAFE). This group is engaged in a full-fledged currency war with the United States. The ultimate goal – as the Chinese have publicly stated – is to create a new dominant world currency and dislodge the US Dollar from its current reserve role.
And for the past few years, SAFE has had one big problem, where to put the money.
SAFE decided to use most of these reserves to buy US government securities. As a result, the Chinese have now accumulated a massive pile of US government debt. In fact, about two-thirds of China's reserves remain invested in US Treasury bills, notes, and bonds. The next biggest chunk is in Euro. Of course, all this money is basically earning nothing to speak of in terms of interest...because interest rates around the world are close to zero.
And while the Chinese would love to diversify and ditch a significant portion of their US Dollar holdings, they are essentially stuck. You see, if the Chinese start selling large amounts of their US government bonds, it would push the value of those bonds (and their remaining holdings) way down. It would be like owning 10 houses on the same block in your neighborhood...and deciding to put five of them up for sale at the same time. Imagine how much that would depress the value of all the properties with so much for sale at one time.
One thing China tried to do in recent years was speculate in the US stock market. But that did not go well...The Chinese government bought large amounts of US equities just before the market began to crash in late 2007. It purchased a nearly 10% stake in the Blackstone Group (an investment firm)...and a similar stake in Morgan Stanley. Blackstone's shares are down about 46% since the middle of 2007, and Morgan Stanley is down about 70% since the Chinese purchase.
The Chinese authorities got burned big time by the US equities markets and received a lot of heat back home. They are not eager to return to the US stock market in a meaningful way. So China's US Dollar reserves just keep piling up in various forms of fixed income – US Treasury bonds, Fannie and Freddie mortgage bonds, and other forms of debt backed by the US government. These investments are considered totally safe – except that they're subject to the risk of inflation.
According to a statement by the government: "SAFE will never be a speculator. It mainly seeks to protect the safety of China's foreign exchange reserves and ensure a stable investment return."
If the Chinese won't buy stocks and the only real risk to their existing portfolio is inflation, what do you think they will do to hedge that risk?
They will Buy Gold...lots and lots of gold.
The Chinese are now clearly on a path to accumulate so much gold that one day soon, they will be able to restore the convertibility of their currency into a precious metal...just as they were able to do a century ago when the country was on the silver standard.
The West wasn't kind to China back then. The country was repeatedly looted and humiliated by Russia, Japan, Britain, and the United States. But today, it is a different story...
Now, China is the fastest-growing country on Earth, with the largest cash reserves on the planet. And as befits a first-rate power, China's currency is on the path to being backed by gold.
China desperately wants to return to its status as one of the world's great powers...with one of the world's great currencies. And China knows that in this day and age – when nearly all governments around the globe are printing massive amounts of currency backed by nothing but an empty promise – it can gain a huge advantage by backing its currency with a precious metal.
As the great financial historian Richard Russell wrote recently: "China wants the Renminbi to be backed with a huge percentage of gold, thereby making the Renminbi the world's best and most trusted currency."
I know this will all sound crazy to most folks. But most folks don't understand gold, or why it represents real, timeless wealth. The Chinese do.
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