One of the most significant changes in the world of investing has been quietly unveiled by China in recent weeks. Even as its details are being finalized, and agencies determined, impact on the rest of the world is already coming through, be it in stock markets or the prices of commodities.

Proposed versus old regime

The old regime of investing by China was in essence the classical one that is recommended for all developing countries by the luminaries at the International Monetary Fund (IMF) or other such multilateral agencies. This involves the purchase of high-quality securities issued by Organization for Economic Cooperation and Development countries, but mainly the United States and Germany (and now a broader group of Eurozone members including France and Italy) as part of foreign-exchange reserves, which should be sufficient to pay for at least six months’ worth of imports.

The IMF and its policies have been out of touch with market realities since the mid-1990s. Indeed, it was the agency’s proposals for Latin America-type reforms that helped to perpetuate the Asian financial crisis of 1997, and has in turn set off the most significant imbalance in economic history, namely the US current-account deficit. While the IMF cannot be blamed for all the consequences, it can certainly bear the blame for proposing a lopsided arrangement.

In any event, the idea of foreign-exchange-reserves management has failed precisely because of what the IMF designed. Think about it like this: in an environment where oil prices are at US$25 a barrel, and country X has $100 million in reserves, it can purchase about 4 million barrels, which we will assume is four months’ supply. Now, when oil prices go to $50 a barrel, it automatically reduces the country’s “reserves” to two months’ supply. In this case, to have the same four months’ coverage, the country either needs to add $100 million to its reserves or else earn enough on its reserves to make a $100 million profit that can be used to purchase the extra oil.

It is in this dynamic that today’s low returns in global bonds and equities affect the management of various countries’ external requirements. Even as the significant weakening of Asian currencies against the US dollar produced a marked increase in trade competitiveness, and thus accentuated the US trade deficit (as its local producers could no longer compete with imports), the excess of money at hand also helped to increase the value of physical goods and, in particular, inputs such as commodities.

Thus a new problem confronts developing countries, which is that instead of a lack of capital that used to pose physical capacity constraints on their exports, it is the rising prices of imports that presents the greatest threat to continued growth.

Therefore, it becomes important for countries to protect their future growth with current cash, and that is why increasingly the focus is not so much on how many dollars of reserves a country has, but more about what has been done with those dollars.

Financial-market implications

One of the easiest changes to foreign-exchange reserve management is for central banks to sell their dollar holdings, substituting them with other global currencies such as the euro, sterling and the yen. [1] Notably, bond yields in all three of these markets have declined in real terms (ie, compared with economic growth) over the past few years. Alongside this, prices of equities have also gone up, as some central banks are allocating money away from bonds altogether.

Second, prices of commodities have increased sharply, but speculative activity has grown even more. China has a stated goal of building a strategic petroleum reserve, like the United States and reportedly Russia.

Third, any slowdown in the US economy such as being indicated by the decline in employment growth in the January payrolls will cause fewer dollars to flow into the coffers of developing countries. In turn, this will cause their purchases of US securities to fall, thereby pushing up US bond yields. This is a new “conundrum” for financial markets, when an economy heading into a recession sees its bond yields rising.

The art of war

As I wrote in previous articles, [2] China needs to increase its say in global affairs to guarantee growth for its citizens. This means that rather than focusing on its humongous $1 trillion in reserves, China needs to buy physical goods such as oil, copper and iron ore that form the backbone of its economy.

Inevitably, this forces China to deal with the world’s rogue governments such as nasty Middle Eastern regimes and cruel African despots. There is no reason to criticize China because the greater good, ie the development of its own people, overwhelms other concerns such as human rights and nuclear proliferation.

In any event, Western regimes are hardly in a position to criticize China, given their backing of the self-same nasty Arab governments, and their historic support for apartheid South Africa.

Second, it is normal evolution for China to use its reserves to its advantage. When American politicians do not give enough respect to its role in the world, it is quite easy for China to go and sell a few billion US bonds, thereby pushing up interest costs for all US companies and residents. In the terminology of war, China is upstream from the US, imagining money like a flowing river. The US uses the river to irrigate its economy and keep its residents happy, but only so long as China decides not to open up its dams that could flood the whole region and cause havoc.

Third, China is not yet in a position where it can wield its power wantonly. This is because it continues to import oil from the Middle East, and needs North America and Europe to buy its products. As its own domestic demand increases, China will need the rest of the world less. That is why I believe that, using US pressure as an excuse, China will let its currency rise against the US dollar sharply this year, perhaps as soon as April. This will produce high costs initially for China’s exporters and banks, [3] but eventually will provide a stronger basis for China to dominate foreign policy around the world.

As for the Islamic powers of the Middle East, they will sell oil to China if only to spite Europe and the US. In doing so, they will also invite more unwanted attention from the US, which is reeling from its lost campaign in Iraq. The main scenario of the US trying to consolidate its hold over the Middle East continues, and argues for getting more desperate in the light of China’s growing self-sufficiency in commodities. Thus, to preserve its role, the US has no option but to attack Iran. [4] The consequences will be horrifying for both parties, and push both combatants toward an inexorable decline. About time, too.

1. The thief and the scorpion, Asia Times Online, January 13.
2. China’s four-play, ATol, November 11, 2006.
3. Chinese and Indian banks plunge at different rates.
4. Garfield with guns, ATol, September 2, 2006.