Thinking outside the box

I think I'm going to talk about something a little different today. As we know, China has often been listed as America's most likely adversary in the future. I have often regarded military technology as the least of America's problems when considering China's new found economic strength.

The one threat that people have always brought up as China's leverage against America is the vast holding of gov't and agency bonds that China has invested in America. I think we've also heard about their investment into Black Rock (which has been a horrible investment) and Morgan Stanley. And with the currency appreciation being far more than the coupon rates, the actual rate of return is actually in the negatives. So, there is no question that Chinese sovereign fund would do a lot better buying Euros, Yens, minerals and other assets that are relatively liquid. People have called the threat of selling the holdings as a "financial/money nuke" against America as the biggest economic threat. Some have even advocated the idea of just voiding any of the holdings that China has in America. I disagree with both ideas and I will explain why. As anyone that deals with Fixed Income would know, there is a rating system by S&P and Moody for all bonds. US Treasury bonds is rated as AAA, because it is thought to be the safest of all investments. Consider this, UK treasury is AA rated despite also being considered risk free (I could be wrong on this). Either way, such a huge cancellation of bonds will certainly drop the rating of US Treasury bonds. With such a move, any financial firm in America that deals with bonds would have to re-engineer many models of programs that are predicated on the assumption US Treasury is AAA rated. A trouble in the ratings of US treasury bonds would immediately hit the values of any currently held US treasuries. The largest problem probably resides in the fact that the coupon rates for US Treasury would have to be raised (in general, yield is determined by the liquidity and risk factor of a bond) due to the higher risk factor. At the same time, with the loss of one of the biggest holders, the liquidity of US Treasury would also go down by a bit. The net result of cancellation of 300 billion USD worth of bond would be having to offer higher coupon rates (by maybe 50 to 100 basis point?) for the near future. Considering how much Treasury is in circulation to cover the US national debt (10 trillion). having to pay 4.5 or 5% instead of 4% would increase the value of coupon payments by over 10%. That would be an extra 50 to 100 billion in coupon payments per year. Over the long run, it's simply a loosing proposition to make such a move. Having covered that, let's look at the even bigger issue.

I know a lot of people think Ron Paul is crazy, but working in the financial field for the past year and half have made me realize a lot of stuff he says is actually valid. I think we all know about the huge national debt and the operating deficit of America. A typical excuse I often hear is that America was okay in the Regan years despite having higher operating deficit to GDP ratio. However, there is also the problem of paying for the social security program and retired gov't workers that people seem to ignore. If you divide that cost amongst average American families, you'd know how much money we each owe. So, the only way to possibly get past this is further debasing the currency by injecting more liquidity (printing money out of the thin air as Ron Paul calls). What people don't realize is that the money supply in America is expanding at a much faster rate than the productivity. So, that's why you see this huge devaluation in the currency and the inflation in food and gas. US Dollar became the dominant currency after WWII because it was the only currency tied to Gold. All the European countries also tied their currency to USD, so it would in effect also be tied to gold. Let's face it, how do you trust a piece of paper that your gov't forces you to use if there is nothing behind it? As a side note, if you collect all of your wealth in Nickels and melt that, you would actually end up with more money from selling the metals making up the nickels. (yep, each nickel is worth around 7 cent. So the treasury is spending more money to make less money, go figure that out) Aside from my snide comments, the strength of a currency is always weakened when the good/mineral backing the currency is weakened. This normally happens in wartime when the gov't needs to deflate the money to pay for debts. So, what happened to the link to the gold standard? Up until 1971, central banks traded gold amongst themselves at the value of $35 an ounce. Since this was not market based (not traded amongst the public), we got a problem where the liquidity in market far exceeded the amount of Fed holdings of gold x $35/ounce. So when the French came in 1971 and demanded gold for $35/ounce, Nixon simply said we don't have that much gold. The gold standard was dropped, so there really is nothing behind USD at the moment. Now, we can see from the history that many countries rose to prominence with the usage of gold or other rare-mineral to back their currency. This was true in the case of Persian empire, Alexander the Great, the Romans, British Empire and America. So, you might have asked by now how this has anything to do with China? Well, the reason is that some people are speculating a move by China toward gold standard. Of course, it doesn't seem to conform with the official policy of keeping currency lower for more exports. We do know that China has been a huge buyer of gold recently and that it has also become the world's top producer of gold (even more than South Africa). One might think that China is doing this as a better investment (and that's true), but you cannot think about what might happen if an economy as influential as the Chinese one is linked to the gold standard. Of note, it's generally believed that the official gold reserves reported by China is vastly less than what it actually has. Then, it would not be too much of a surprise that Yuan might surpass USD and Euro as the dominant currency in the future. I don't think one can underestimate such financial power.

I know this is an interesting change of topic for this blog, but I thought it might be a good time to change the focus a little bit and look at things from different angle. Of course, I'm not a financial expert by any stretch of imagination, so I'm sure a lot of you would disagree with what I wrote. Well, I will go back to my regular military stuff in the near future.