China's Strategic Resource Accumulation Continues

China's insatiable appetite for strategic resource accumulations runs unabated.

The latest buyout activities as reported by the Wall Street Journal (all bold emphasis mine)

``China National Petroleum Corp. and Cnooc Ltd. have proposed paying at least $17 billion for all of Repsol YPF SA's stake in YPF, its Argentine unit, two people close to the talks said.

``The potential deal, which could be the biggest overseas investment by China, highlights the country's growing thirst for energy resources globally and its willingness to offer big money for access. It also underlines the ambition of CNPC to build its presence in South America and elsewhere.

``A deal would be another example of how Chinese companies are now working together to buy foreign energy assets after years of working alone.

``But the potential acquisition faces significant hurdles. A deal could be politically sensitive in Argentina, where YPF is the country's leader in both upstream operations -- the exploration for and production of oil -- and downstream operations involving oil refining and marketing...

``China's resource majors have snapped up foreign oil and other assets recently, as the country seeks to lock in energy supplies.

``China Petrochemical Corp., the Chinese state-owned oil company known as Sinopec, in June acquired Switzerland-based oil explorer Addax Petroleum Corp. for $7.2 billion. In April, CNPC purchased Kazakh oil producer MangistauMunaiGas jointly with Kazakhstan's state-owned KazMunaiGas for $3.3 billion.

``China's state energy companies are also showing more teamwork in chasing foreign deals than previously. This year Sinopec and Cnooc have together struck deals for oil and natural-gas assets in Angola and the Caribbean. In July they agreed to buy jointly a 20% stake held by U.S. oil producer Marathon Oil Corp. in an oil block off Angola for $1.3 billion.

``Chinese oil companies have also signed oil-for-loans agreements with Russia and Brazil.

``But not all of China's efforts have been successful. In June, a $19.5 billion bid by Aluminum Corp. of China, or Chinalco, to raise its stake in Anglo-Australian mining-giant Rio Tinto collapsed amid shareholder and political concerns. An earlier, successful deal by Chinalco, in which it paid $14 billion for an initial 9% stake in Rio in February 2008, is China's largest foreign investment in the resources sector.

Read the rest here

My take.

China's aggressive resource accumulation has the following implications:

1. Economic-it has been amassing resources for its industrialization and rapidly progressing middle class.

2. Political-it has been using their immense foreign reserves as leverage to expand its geopolitical influence overseas, which could have some possible bearing on its desire to become a military and economic powerhouse.

This could be manifested by its thrust to elevate the yuan as an eligible international reserve currency and as possible candidate to the replacement of the embattled US dollar.

3. Security-it has been insuring itself from US government's policy to debase the US dollar.

Moreover, by expanding access to resources coupled with a build up in military and commercial logistics and expanding her sphere of global political influence, all these could also be interpreted as an insurance policy against future military conflict.

The apparent transition of the geopolitical order from unipolar to a multipolar framework cannot be guaranteed as orderly and peaceful.

World's Largest Companies As Investing Roadmap?

Here is an interesting chart depicting the world's largest companies by market capitalization from the Economist.

According to the Economist, ``THE market capitalisation of PetroChina may have fallen by almost half in the past year, but it remains the world’s most valuable company. Chinese firms now occupy three of the top four slots. (The state’s large non-traded holdings are valued at market prices.) Seven of the 12 most valuable companies are either banks or oil producers. Wal-Mart, Johnson & Johnson and Procter & Gamble have all climbed the table in the past year; their industries tend to weather recessions better than others. Market capitalisation does not necessarily tally with other measures of size. Microsoft is worth more than Royal Dutch Shell, which has nearly eight times the revenue of the software company and 10,000 more employees." (emphasis added)

Given the sustainability of the present trends where Asia outperforms, the rankings will likely be skewed towards the inclusion of more Chinese or Asian companies, especially if the prediction of Templeton's Mark Mobius, where China's market value might overtake the US, would be anywhere accurate.

While past performance may not be indicative of the future, the evolution of global corporatism has been striking. The underlying themes being that of China-Asia, oil, global banking and consumer products and retailing.

Could this serve as our roadmap for investing?

Copper Market: The Growing Role of China and Emerging Markets

This is just an example of how the past hasn't been the future or how the present environment has been evolving.

Frank Holmes of US global funds notes of the changes in the seasonal patterns of copper prices due to the growing influences of China.

Here is Frank Holmes, (bold highlight mine)

``The 30-year pattern shows what used to be a rule of thumb when I first got into this business—buy in November and sell in March. This was because of seasonal stockpiling during winter months leading into major building and construction projects in the spring and summer months.

``In contrast, the 15-year pattern is dramatically different. This pattern shows copper prices rising from January through May and then trading pretty much sideways for the rest of the year, with modest peaks and valleys along the way. A similar pattern is drawn to represent the past five years.

``The reason for the trend shift is China.

``According to research from Dundee Wealth Economics, China’s copper consumption grew from about 1.8 million metric tons in 2000 to nearly 5 million metric tons in 2008. This pushed China’s share of global consumption from 13 percent in 2000 to 28.5 percent last year. In the first quarter of 2009, Dundee estimates, China accounted for 38 percent of the world’s copper usage.

``Demand for copper from the other BRIC countries (Brazil, Russia, India and China) has also increased, but none nearly on the same scale as China."

``For instance, Russia’s copper demand increased 300 percent from 2000 to 2008, but its overall share of global demand is still just 4 percent. India and Brazil both saw smaller consumption growth over the eight years, and in 2008 they accounted for 3 percent and 2 percent of global use, respectively."

``Copper isn’t the only metal where China is king. China also lead global consumption growth for aluminum, zinc, lead and nickel from 2000 to 2008."

In sum, China's role in the commodities market have been gaining significant weight in terms of overall global demand, and will most likely increase its role.

To add, we should also expect other Emerging Markets to equally gain market share. At present the BRIC, according to the estimates above, accounts for 49% of the copper market demand.

And as we pointed in Decoupling in Oil Markets: The Centre of Gravity in Energy Markets Has Shifted To Emerging Markets, BP's Tony Hayward observed that the ``centre of gravity in the energy market tilted sharply and permanently towards the emerging nations of the world."

Copper prices has so far reflected the activities in the Baltic Dry Index and the Shanghai Index (albeit the latter continues to zoom).

Chinese Are Fishing in Troubled Waters

In every crisis there are always opportunities.

And Chinese companies have made good use of this truism to snare iconic landmarks in the US amidst today's crisis.

Last night news wires reported that a Chinese company was reportedly buying into GM's Hummer lines...

Picture from New York Times

According to the New York Times (bold highlight mine), ``General Motors has reached a preliminary agreement for the sale of its Hummer brand of large sport utility vehicles and pickup trucks to a machinery company in western China with ambitions to become a carmaker.

``The buyer is the Sichuan Tengzhong Heavy Industrial Machinery Company, based in Chengdu, G.M. said Tuesday. The price was not disclosed, but industry analysts had estimated that the Hummer division would sell for less than $500 million.

``The deal, expected to close in the third quarter, would make Tengzhong the first Chinese company to sell vehicles in North America, though Hummer’s operations would remain in the United States.

``“The Hummer brand is synonymous with adventure, freedom and exhilaration, and we plan to continue that heritage by investing in the business, allowing Hummer to innovate and grow in exciting new ways under the leadership and continuity of its current management team,” Yang Yi, the chief executive of Tengzhong, said in a statement released by G.M. “We will be investing in the Hummer brand and its research and development capabilities, which will allow Hummer to better meet demand for new products such as more fuel-efficient vehicles in the U.S.”

``Hummer is one of four brands that G.M., which filed for bankruptcy protection Monday, plans to drop. The company also plans to close or sell Saturn and Saab later this year and to eliminate Pontiac in 2010. G.M. revealed Tuesday that it had 16 bidders for Saturn and three for Saab."

Last week, the NBA team Cleveland Cavaliers also sold a minority stake to Chinese investors.

Picture From New York Times

Again according to the New York Times (emphasis mine), ``The deal that may give a group of Chinese investors a minority stake in the Cleveland Cavaliers and its arena signals the first significant investment in a major American sports franchise by investors from China.

``The Cavaliers, who are led by LeBron James, the N.B.A.’s most valuable player this season and perhaps its biggest star, said they agreed over the weekend to sell a 15 percent stake in the franchise and its Quicken Loans Arena to the group, which is led by Kenny Huang, a Chinese-born investor who has also brokered marketing deals with the Yankees and the Houston Rockets, and a Hong Kong conglomerate.

``The deal must be approved by the league’s board of governors.

``If the sale is approved, it may be the most ambitious move yet in an American sports landscape full of leagues, teams and players striving for a foothold in the expansive and largely untapped Chinese marketplace. The N.B.A. has been aggressively expanding its presence in China with exhibition games and a joint venture that aims to develop a Chinese basketball league and professional arenas.

``Major League Baseball and the National Football League have also been seeking talent and business prospects in China. Nike and Adidas are doing the same. Prominent athletes like Kobe Bryant and Serena Williams have tried to capture part of the Chinese audience with endorsement deals.

``The N.B.A. is already enormously popular in China. N.B.A. games are telecast here and there are at least a half-dozen magazines devoted to the N.B.A. and its stars. Part of the popularity is attributed to the Rockets’ Yao Ming. Last summer, James and Yao appeared in an advertisement for Coke that ran on Chinese television during the Olympics. But other players, like the Los Angeles Lakers' Bryant, are just as popular among Chinese youngsters"

My comment:

Aside from US treasuries, here we see that the Chinese aren't just buying conventional companies, they are buying into hallmark American brands.

They are buying into America's pride and prestige.

And they are buying at the most opportune moment when Americans are direly in need of moolah.

In a classic Chinese military handbook depicting the 36 strategems of war, one of the recommended tactic to achieve superiority against the adversary is to employ maneuvers for confused situations or To Fish In Troubled Waters. These actions exemplify the execution of such maneuvers.

Nonetheless the Chinese has been steadily working to expand their influence overseas.

Chart from Heritage Foundation

Although, officially the Chinese government has done more political and economic deals with Africa and Arab compared to the rest, including East Asia.

But this could change-depending on the political winds.

Bond Vigilantes Are Waiting At The Corner!

``Inflation will do it. But how much? To bring the debt-to-GDP ratio down to the same level as at the end of 2008 would take a doubling of prices. That 100 per cent increase would make nominal GDP twice as high and thus cut the debt-to-GDP ratio in half, back to 41 from 82 per cent. A 100 per cent increase in the price level means about 10 per cent inflation for 10 years. But it would not be that smooth – probably more like the great inflation of the late 1960s and 1970s with boom followed by bust and recession every three or four years, and a successively higher inflation rate after each recession. The fact that the Federal Reserve is now buying longer-term Treasuries in an effort to keep Treasury yields low adds credibility to this scary story, because it suggests that the debt will be monetised. That the Fed may have a difficult task reducing its own ballooning balance sheet to prevent inflation increases the risks considerably. And 100 per cent inflation would, of course, mean a 100 per cent depreciation of the dollar. Americans would have to pay $2.80 for a euro; the Japanese could buy a dollar for Y50; and gold would be $2,000 per ounce. This is not a forecast, because policy can change; rather it is an indication of how much systemic risk the government is now creating.”- John Taylor Exploding debt threatens America

The Bonds Vigilantes are back! That’s according to the newswires and the opinion pages.

Bond vigilantes are supposedly a class of bond investors who serve as disciplinarians against government overspending. Sensing the perpetuation of profligacy, these market enforcers would sell sovereigns which would translate to rising interest rates and which effectively functions as a kibosh on the extravagancies of government.

The recent volatility in the long dated US treasuries markets (see figure 1) apparently breathed life on such market persona after more than two decades long of hibernation.

Figure 1: Bloomberg: UST 10 year yields (orange), Freddie Mac Mortgage Rates (green), Bankrate 30 year mortgages (yellow)

The recent surge in yields has prompted for concerns on the marketplace over the sustainability of stock market gains. Rising interest rates, as interpreted by the mainstream, may yet foil government measures to resuscitate the housing market and US consumers. As you will notice in the chart above, long dated treasuries often serve as benchmark to bank lending rates-so rising Treasury yields means higher mortgage rates.

But often doesn’t mean always. And with US government’s severe scale of marketplace interventions, mortgage rates and treasury yields departed earlier, as we noted in early May, see US Mortgage Rates versus Treasury Yields: Does Divergence Signal An Anomaly or A New Trend?

Yet the dynamics of the bond markets of the yesteryears haven’t been the same as today; foreigners have been pinpointed as the potential source of rising yields, through liquidations.

According to this report from Bloomberg, ``The bond vigilantes are being led by international investors, who own about 51 percent of the $6.36 trillion in marketable Treasuries outstanding, up from 35 percent in 2000, according to data compiled by the Treasury.”

Unfortunately, the classic definition of the bond vigilantes doesn’t hold true today, because rising long dated yields doesn’t automatically equate to investor selling YET see figure 2.

Figure 2: Yardeni.com: Foreign Buying of US Treasury Bills Have Surged!

As noted in last week’s $200 Per Barrel Oil, Here We Come!, the composition of the ownership of US treasuries held by foreigners, mostly by China, has dramatically shifted. In the face of declining foreign currency surpluses, foreigners have sold US agencies and reallocated their holdings mostly into short term bills.

This, we argued, has been primarily politically motivated. China doesn’t want to seen as ruffling the feathers of the US leadership and instead would like to be perceived as in “cooperation” and “collaboration” with them, despite expressing displeasure over the direction of present policies. This essentially places the responsibility of the repercussions from US policies entirely on US policymakers. So in contrast to bond vigilante actions of liquidations, foreigners have continued to buttress the US treasuries market, however yields continue to climb.

As example, Thursday’s US Treasury issuance of $26 billion in 7 year notes had been fully subscribed and this adds to the week’s total of $101 billion. While demand for the 7 year notes have been ample, ``the Treasury was forced to raise the yield by nearly 0.03 percentage points to entice buyers” reports the Associated Press.

In other words, rising yields hasn’t been due to foreign investor liquidations YET, but from oversupply or overissuance of US sovereigns relative to available capital, where the markets has been pricing a premium (through higher yields) for scarce capital to fund US government expenditures.

Nevertheless, events seem to be unfolding in an extremely fluid mode, such that we can’t count on the persistence of foreign support on US treasuries, especially if markets do turn disorderly.

Although the news report cited above, didn’t account for the category of buyers of the recently issued 7 year treasury notes, the US Federal Reserve can pose as the “buyer of last resort” as it can simply “monetize” debts through its digital or printing presses, since an “auction failure” can be highly disruptive to the financial markets, especially to the US dollar.

Bond Vigilantes Ahoy!

Nonetheless the bond vigilantes appear to have indeed surfaced in select US debt markets, concentrating on areas where governments have intervened to favor “political classes”. Here, comparable spreads have ostensibly widened between companies or industries affected by state intrusion relative to those without.

According to the Reuters (bold emphasis mine), ``To gauge whether those cases have made debtholders wary of other companies with so-called favored political classes, Garman compared spreads, or bonds' extra yields over U.S. Treasury yields, for companies with collective bargaining agreements with the high-yield bond market as a whole…

``Apart from automakers, sectors heavily influenced by collective bargaining agreements include supermarkets, construction, wired telecommunications, delivery and healthcare, Garman found. Gaming, select media and publishing companies and paper and textile companies also made his list.”

Uncertainty over the arbitrary selection of winners by the US government, the clash of objectives or priorities between management and government and the fickleness, changeability or instability of policies has translated to investor aversion or bond vigilantism.

Decoupling In Global Bond Markets?, Monetary Forces Gains Momentum

And as almost every government in the world have massively applied “stimulus” to their respective economies to provide for “cushion” from recession and to “jumpstart” economic growth, as discussed in Ignoble Deficits And The $33 Trillion Global Government Debt Bubble?, they will be competing with the private sector for access to funding in the capital markets which implies for “higher yields”.

Moreover, the capital markets will likely be the primary conduit for these fund raising activities as the banking system remains substantially dysfunctional, particularly in the bubble bust affected areas.

Evidences of such dynamics have begun to emerge, according to this Wall Street Journal report (all bold highlights mine),

``In the first quarter of the year, the value of corporate investment-grade bond issuance globally rocketed to $875.1 billion -- a 124% increase from the same period last year. That boom stands in sharp relief to a fall in the market for syndicated loans, in which a syndicate of banks makes a loan to a corporation, spreading the risk of the corporation's default between them.

``The value of banks' new corporate investment-grade lending fell 40% to $349.3 billion compared to the same period last year, according to financial data from Dealogic….

``There are two main reasons why loans from banks are stuttering: banks' available capital and banks' cost of funding. Both have made the interest terms that banks are offering corporations relatively high, making the bond market a preferable route to financing…

``Bank lending to the corporate sector has shrunk dramatically. In the nine months to December last year, global cross-border bank lending shrank almost $5 trillion -- the sharpest fall on record -- according to research out this month by the Bank for International Settlements.”

In other words, the current operating dynamics as seen in the US treasury markets will likely be applied elsewhere, but to a lesser degree on Emerging Markets and in Asia as the latter’s banking system have largely been unimpaired.

Proof?

The US bond market volatility in conjunction with a falling US dollar have prompted for a divergence or “decoupling” in bond activities see Figure 3.

Figure 3: stockcharts.com: Emerging Market-US Sovereigns “decouple”

The Morgan Stanley’s fund of investment in US treasuries as represented by the USGAX (red-black line), which according to Google, “normally invests at least 80% of net assets in U.S. government securities, which may include U.S. treasury bills, notes and bonds as well as securities issued by agencies and instrumentalities of the U.S. government” has been diverging with the JP Morgan’s benchmark for Emerging Debt JEMDX (black line) which according to Google invests in ``a portfolio of fixed-income securities of emerging-markets issuers. The fund normally invests at least 80% of assets in emerging-market debt investments. These emerging-market securities may be denominated in foreign currencies or the U.S. dollar.”

Last week, emerging market bonds posted their best week since 2002 (Bloomberg) in spite of the turmoil in the US sovereign markets as US bond yields rose to nearly a 6 year high (Bloomberg). If this isn’t decoupling, I don’t know what is.

Yet the falling US dollar (USD- lower window in the chart) has easily been made as a scapegoat for the actions in the volatility in the US treasury markets. The simplified explanation is this- a weaker US dollar extrapolates to higher value of emerging market currencies, ergo high bond prices for Emerging Market Bonds.

But this dynamic hasn’t been in place when the US dollar index fell from its peak in 2002 until its trough in early 2008!

In other words, the languid performance of US dollar index and the divergences in emerging markets sovereign relative to the US sovereign hasn’t likely been the underlying cause and effect. Instead, we suggest that it has been monetary forces that has accounted for as the principal driver of this rapidly evolving phenomenon-globally.

In short, monetary inflation has been getting a far bigger pie of the activities in the financial markets as well as in the real economy.

All told, as capital markets takes on a bigger role in the distribution of limited capital over banking system, in the choice of either funding government expenditures or private investment, the resurgent function of bond vigilantism will likely be accentuated as time goes by.

$200 Per Barrel Oil, Here We Come!

``This gets back to the disagreement I’ve had with the “inflationists” for years now: In the name of Keynesian economics, inflation proponents have repeatedly called for massive stimulus in response to the bursting of THE Bubble, while in reality this activist policymaking was instrumental in only extending and worsening a systemic Credit Bubble. This was especially the case after the bursting of the technology Bubble and is again true today following the bursting of the Wall Street finance/mortgage finance Bubble. Now, more than ever before, “Keynesian” inflationism is THE Bubble. When it eventually bursts Washington policymakers will have little left to offer.” Doug Noland Inflationism’s Seductive Battle Cry

For us, $200 oil is not an issue of IF, but rather an issue of WHEN. This will be highly dependent on the course of actions undertaken by global policymakers.

Here, we won’t deal with demand and supply imbalances of oil, as we had made our case late last year in Reflexivity Theory And $60 Oil: Fairy Tales or Great Depression?, instead we will deal with the rapidly evolving market signals and prospective political actions by policymakers

Growing Disconnect Between Markets And Real Economy

“World oil demand to hit 28-year low” screams the headline from the National.

So one must be wondering: Why has oil impetuously shot beyond $60? Has the oil market been pricing an abrupt global recovery?

The Economist instead finds justification on widening supply constraints, ``The explanation is simple. Oilmen are worried because they believe that many of the factors behind the record-breaking ascent last year remain in place. Much of the world’s “easy” oil has already been extracted, or is in the hands of nationalist governments that will not allow foreigners to exploit it…So when demand begins to revive, a sharp rise in prices is inevitable. That does not mean that a price spike is just around the corner, however. The speed with which it arrives will depend on the strength of the global recovery.”

While the article mainly underscores the geographical access limitations posed by governmental restrictions, falling demand and high inventories, as discussed in Seeds of Hyperinflation Have Been Sown have reflected on an egregious disconnect between fundamentals and the marketplace. The Economist article appears more like an attempt to explain away or to rationalize on the market activity than vet from the causality angle.

The highly reputed independent research outfit the BCA Research has a fabulous chart manifesting this phenomenon, see figure 1.

Figure 1: BCA Research: Oil Breaks Out: Is It Sustainable?

According to the BCA, ``The higher price of oil reflects in part the upturn in Chinese oil imports and car sales at a time when oil production is lagging. Russia continues to have difficulty boosting output and oil production has been flat for most OPEC countries. Saudi Arabia has cut production sharply. As with other commodities, oil should benefit from both a weaker U.S. dollar and a shift in investor portfolio preference toward real assets as a hedge against inflation. The upturn in our global leading economic indicators is another positive sign for the commodity complex.” (bold highlight mine)

True, China has been massively acquiring oil and other commodities.

And we won’t dismiss some veritable evidences of economic and financial “recovery” following the “banking meltdown” late last year, of which has functioned as a psychological “shock” (Posttraumatic Stress Disorder-PTSD) that has buffeted world financial markets and global economy.

But China has been buying way beyond its needs. It has been buying to shore up its strategic reserves.

Analysts at Sanford Bernstein reported that Google Images reveal on how China has been intensively constructing depots to hold oil. ``Bernstein says satellite images show a marked increase in oil-storage construction over the past few years and estimates that China’s number of days of forward demand–a gauge of oil storage–amount to just 28 days of imports and 14 days of total demand. China is targeting storage capacity that will hold demand cover of around 90 days,” wrote the Wall Street Journal,

Yet according to another researcher as excerpted by the Guardian, China plans to amass 3 million tonnes (about 22.5 million barrels) of oil, ``China wants to set up a 3 million tonne reserve of oil products this year, which is practically impossible, a researcher at a think-tank run by the country's top oil refiner, Sinopec Group, was quoted as saying on Saturday.”

Moreover, China’s huge appetite for commodities registered record imports for Copper and Aluminum this April. However many experts say that China’s buying activities for these commodities may have probably peaked since targets may have been met. According to Bloomberg, ``Refined copper imports by China will slow over the rest of this year as scrap supplies improve, said Ma Xiaoqin, deputy- general manager of the copper department at Minmetals Nonferrous Metals Co., the country’s largest trader, on May 8. The State Reserve Bureau has mostly completed its buying and stockpiling by manufacturers has ended, said Edward Fang, an analyst at China International Futures (Shanghai) Co.”

If such buying activities have indeed culminated then copper and aluminum prices should be expected to meaningfully correct, see figure 2. But we have our doubts.

Figure 2: stockcharts.com: Copper and Aluminum

So far only Aluminum has been showing signs of relative weakness. Although copper seems to be in a consolidation phase where a “pennant” pattern (blue converging lines) may suggest a continuation of the present uptrend.

China Attempts To Balance Political Rhetoric With Market Actions And Political Goals

This isn’t about China believing its own “bullish” tale of vigorous economic recovery, where the supposed “conventional” view equates China’s economic growth to commodity bullishness. Instead the above dynamics reflects the ongoing inflation phenomenon.

The fact that China’s officials have raised the furor over possible losses of its US asset portfolio holdings from the current US policies appears to dovetail with the activities in the commodities market.

China’s Premier Wen Jiabao, as quoted by the Financial Times recently said, ``We have lent a huge amount of money to the United States,” Mr Wen said. “Of course we are concerned about the safety of our assets. To be honest, I am a little bit worried. I request the US to maintain its good credit, to honour its promises and to guarantee the safety of China’s assets.” (bold emphasis mine)

Of course one may argue that China’s acquisition of US assets hasn’t slowed.

In contrast to Premier Wen’s statement, China has even increased its acquisition of US treasuries see Figure 3. And this would seem like a conflict between China’s intentions and actions. But this view myopically glosses over the geopolitical implication. There’s more than meets the eye.

Figure 3: New York Times: China’s Changing Role

It would be tantamount to political suicide if China decides to naively “sell” US treasuries to support its concerns, especially under the present environment which has been a fertile ground for engendering protectionist policies. For instance, recently some US lawmakers have revived efforts to brand China as a currency manipulator. Hence mass liquidations of treasuries would only fuel bilateral antagonism. And a trade war isn’t in the interest of China.

Another, it isn’t also a certainty that the underlying motivation behind China’s purchases of US assets reflects on the same paradigm of “promoting exports” as it had been in the past. Past performance doesn’t guarantee future results-that’s because the incentives behind today’s conditions have radically changed. The US consumer model as the world’s growth engine has apparently been broken. And China appears to be well cognizant of this.

Moreover, since China holds massive amount of US dollar assets- estimated at an astounding 82% of foreign currency reserves (Standard Chartered/New York Times)-any mass liquidation will most likely impact the markets extensively and stoke disorder. Where such actions will likely be mutually destructive, such policy directions will likely be avoided.

Hence, China’s political actions should also be seen from a different prism- China may want to be seen in good light with the US, where she would continually support the US even at the risks of incurring substantial losses in its portfolio of US dollar assets.

As Luo Ping, a director-general at the China Banking Regulatory Commission recently justified, ``Except for U.S. Treasuries, what can you hold?”

Moreover, China may want to project that in case a possible mayhem emerges in the financial markets this isn’t going be due to her doing. In other words, China seems to be placing the onus of the consequences from policy choices squarely on US shoulders.

Nevertheless, actions demonstrate preferences. While China remains supportive of the US in terms of buying assets, the composition of its acquisitions has materially changed.

According to the Keith Bradsher of the New York Times, ``China has also changed which Treasuries it buys. It has done so in ways calculated to reduce its exposure to inflation or other problems in the United States. As recently as a year ago, China actively bought long-dated bonds, seeking the extra yield they could bring compared to Treasury securities with short maturities, of which China bought virtually none.

``But in each month since November, China has been buying more Treasury bills, with a maturity of a year or less, than Treasuries with longer maturities. This gives China the option of cashing out its positions in a hurry, by not rolling over its investments into new Treasury bills as they come due should inflation in the United States start rising and make Treasury securities less attractive.” (bold emphasis mine)

So yes, China has been increasing its purchases of US treasuries to appease the US government, but has been concentrating these activities towards short term maturities. And by doing so she has been acting to reduce her risk exposure as well as balancing political rhetoric (bleating about US policies, announcement of past ‘covert’ gold purchases) with market actions (diversifying portfolio holdings into commodities) and political goals.

And aside from heavily buying into commodities, as previously discussed in The Nonsense About Current Account Imbalances And Super-Sovereign Reserve Currency, China has been utilizing its currency as an instrument to expand its political and economic influence across the globe by increasing swap agreements, by providing project financing and conducting trade in the remimbi or ex-US dollar currencies. Recently Brazil and China concluded an accord to conduct transactions using their national currencies instead of the US dollar.

In all, China could be working to insure herself from the risks of substantial US inflation, to expand its influence globally with its currency and possibly to challenge the US hegemony in terms of having the remimbi as a global currency reserve sometime in the future.

The Global Inflation Train Speeds Faster

And as we keep repeating, in the world of unprecedented scale of government intervention in the marketplace combined with unparalleled degree of applied inflationary measures, the repercussions intended or unintended will be vented on the currency markets.

And we agree with Professor Steve Hanke where he wrote in a Forbes article ``There are tectonic moves afoot in the currency markets these days.”

Tectonic moves afoot in the currency markets will also be parlayed in the Oil Market see Figure 4.

Figure 4: stockcharts.com: Inverse Correlation of Oil and the US Dollar

Visibly, oil in the past has moved in consonance with the US dollar, albeit in an inverse scale (see blue trend lines).

This dynamic seems to be a classic rerun as the recent weakness of the US dollar index (USD) has equally coincided with rising oil prices (WTIC-main window).

Alongside this development has been the rise of 10-year US Treasury yields (TNX) in spite of the recent activities from the US Federal Reserve where the ``Fed bought $18.277 billion of U.S. debt in three purchase operations this week and minutes of the central bank’s April 28-29.” (Bloomberg).

The US Federal Reserve in its March 18^th press release has earmarked $300 billion to purchase long term Treasury securities.

But there seems to be one missing ingredient. In the past, the falling US dollar had been accompanied by falling treasury yields-perhaps reflecting what Former Fed Chair Alan Greenspan’s calls as a conundrum of low bond yields. And this phenomenon was suspected to have been influenced by foreign purchases of US treasuries that have kept yields low.

But since recent treasury issuance to fund US government deficits has surged far more than what foreigners or China has recently bought as shown in the chart earlier, where according to the same Bloomberg report, ``President Barack Obama has pushed the nation’s marketable debt to an unprecedented $6.36 trillion. [bold highlight--mine] His administration raised on May 11 its estimate for the deficit this year to a record $1.84 trillion, up 5 percent from the February estimate, and equal to about 13 percent of the nation’s GDP”, yields have materially risen!

And as we have previously discussed in Ignoble Deficits And The $33 Trillion Global Government Debt Bubble?, the colossal government spending by the US and elsewhere and the prospective surges of government treasury issuance are posing as risks towards hefty inflation or national bankruptcies.

Hence, today’s rapidly deteriorating US Dollar, rising treasury yields and rising oil prices seem to be solidifying the manifestations of inflation gaining traction globally.

Credit Rating Downgrades Amidst Exploding Deficits

Figure 5: Washington Post: Projected Deficits

The recent spate of massive waves of deficit spending in many crisis havocked economies has put pressure on their respective credit rating standings.

The S&P recently issued a downgrade from “stable” to “negative” on UK’s outlook which means the country is at risk of losing its coveted AAA status.

Concerns over the same predicament has apparently spilled over to the US considering the huge planned dosages of government spending aimed at jumpstarting the economy as shown in Figure 5.

Well the impact of concerns over these deficits, aside from rising treasury yields, has been deterioration in credit default swaps, which function as insurance against the risks of credit default.

According to Bloomberg, ``The cost to hedge against losses on U.S. government bonds for five years climbed to a three-week high, indicating perceptions the nation’s credit quality is deteriorating. Credit-default swaps on U.S. debt rose 3.5 basis points to 41, the highest since April 29, according to prices from CMA Datavision in New York. An investor would have to pay $41,000 a year to protect $10 million of debt from default.” (bold highlight mine)

Mainstream Calls For More Inflation Ensures Oil at $200!

These credit rating warnings should serve as call to action on governments to limit overspending. Remember there is no free lunch. Ultimately taxpayers will pay for government profligacy.

But will these warnings be heeded? Apparently not.

On the contrary the mainstream has vociferously been desiring for more inflation.

The Bond King, PIMCO’s William Gross, recently predicted that the US will eventually lose its AAA rating according to Bloomberg.

Yet his prescriptions to support the economy account for the same factors that would ensure the US will likely lose its prime credit rating.

It’s because Mr. Gross subscribes to the Keynesian methodology of printing money as a cure, where the same report quotes Mr. Gross, ``We need more than that,” Gross said at the time. The Fed’s balance sheet “will probably have to grow to about $5 trillion or $6 trillion,” he said.”

And the policy prescriptions of Mr. Gross have been joined by the similar calls from well known Harvard experts-Kenneth Rogoff and Greg Mankiw.

``I’m advocating 6 percent inflation for at least a couple of years,” says Rogoff, 56, who’s now a professor at Harvard University. “It would ameliorate the debt bomb and help us work through the deleveraging process.” (Bloomberg)

Meanwhile, Mr. Mankiw former chairman of the Council of Economic Advisors under President George W. Bush said ``Faster inflation might be preferable to increased unemployment, or to further budget stimulus packages that push up the national debt” (Bloomberg)

So in the face of rising risks of default, these mainstream experts sporting a good clout over at the officialdom may be reflective of the policy directions of the present administration.

Of course inflation can be achieved through massive credit expansion (through public or private channels) or via the government spending route or both.

And if Mr. Bond King’s suggestion will be adhered to and if it’ll likewise be copied elsewhere the risk of a runaway inflation will be tremendous.Figure 6: BIS: Balance Sheets of the Central Banks of the US, UK and ECB

Since the advent of the crisis the balance sheets of the US Federal Reserve, the ECB and the Bank of England have surged see figure 6.

So policymakers have made sure that inflation will likely take hold; inflation is what they ask for hence inflation is what we will get.

As Dr. John Hussman admonished in his latest weekly outlook (bold highlight mine),

``The bottom line is that the attempt to save bank bondholders from losses – to provide monetary compensation without economic production – is not sound economic policy but is instead a grand monetary experiment that has never been tried in the developed world except in Germany circa 1921. This policy can only have one of two effects: either it will crowd out over $1 trillion of gross domestic investment that would otherwise have occurred if the appropriate losses had been wiped off the ledger (instead of making bank bondholders whole), or it will result in a stunning and durable increase in the quantity of base money, which will ultimately be accompanied not by a year or two of 5-6% inflation, but most probably by a near-doubling of the U.S. price level over the next decade. As I've noted previously, the growth rate of government spending is better correlated with subsequent inflation than even growth in money supply itself, particularly at 4-year intervals. Regardless of near-term deflation pressures from a continued mortgage crisis, our present course is consistent with double digit inflation once any incipient recovery emerges.”

Even Yale’s David Swenson told Bloomberg that everyone must own inflation protected securities in the face of substantial inflation, ``We’ve had this massive fiscal stimulus, massive monetary stimulus, and it’s hard to see how that doesn’t translate into pretty substantial inflation, or at least pretty substantial risk of inflation,” Swensen, Yale University’s investment chief, said in an interview on the “Consuelo Mack WealthTrack” television show that aired yesterday. Treasury Inflation- Protected Securities “should be in every investor’s portfolio," he said.”

Finally fund manager David Dreman has another unorthodox suggestion for the US government.

He posits that the US stimulus package be directed at the commodity markets.

According to Mr. Dreman, ``My idea is that we accumulate useful resources, such as crude for our strategic oil reserve. This would create new jobs, halt a deflationary spiral and give us some protection against the next international oil crisis. If the government allocated $500 billion at current prices, it would add 10 billion barrels of oil, which amounts to 17 months' consumption. The government could undertake similar purchase programs for copper, aluminum, lead and other essential industrial commodities now trading at very depressed prices.

``An oil-buying binge would be a win for taxpayers as well. Oil bought today below $60 a barrel can be released back into the market at $120 after economic activity has picked up and inflation has resumed.”

Mr. Dreman’s suggestion implies that the US government should engage with China and the rest of the world in a bidding war over oil and other commodities. The idea is to directly stoke inflation by means of direct intervention in the commodity markets.

However, high commodity prices reduce the purchasing power of consumers or the taxpayers, so it is a contradiction how taxpayers/consumers would benefit from high commodity prices. Put differently, the US government may earn from a spread alright, but the world in general will be poorer because of the lesser amount of goods the Americans and people around the world can acquire.

Moreover he seems to suggest that the US government should be transformed into a proprietary trading desk. Governments don’t work for profit but for social concerns.

Besides a policy directed at a race to own commodities could serve as a casus belli for a world war at war or a world resource war.

What have these “inflationists” have been smoking, anyway?

Overall, the inflationary policies of global governments are key drivers to oil prices at over $200 per barrel!

Has China Begun Preparing For The Crack-Up Boom?

We came across a thought provoking article by Telegraph’s Ambrose Evans-Pritchard where he suggests that perhaps China’s diversification from US assets might already be happening.

But instead of accumulating gold, which most observers have been expecting her to do, the diversification process could have been channeled through unexpected assets….copper and other base metals.

We quote Mr. Pritchard in “A Copper Standard' for the world's currency system?” (bold highlight mine)

``China's State Reserves Bureau (SRB) has instead been buying copper and other industrial metals over recent months on a scale that appears to go beyond the usual rebuilding of stocks for commercial reasons.

``Nobu Su, head of Taiwan's TMT group, which ships commodities to China, said Beijing is trying to extricate itself from dollar dependency as fast as it can.

``"China has woken up. The West is a black hole with all this money being printed. The Chinese are buying raw materials because it is a much better way to use their $1.9 trillion of reserves. They get ten times the impact, and can cover their infrastructure for 50 years."

``"The next industrial revolution is going to be led by hybrid cars, and that needs copper. You can see the subtle way that China is moving into 30 or 40 countries with resources," he said.

``The SRB has also been accumulating aluminium, zinc, nickel, and rarer metals such as titanium, indium (thin-film technology), rhodium (catalytic converters) and praseodymium (glass).

Circumstantial evidence seem to corroborate such hypothesis.

One, China’s purchases of US treasuries appears to have slowed.

According to the New York Times, ``China’s foreign reserves grew in the first quarter of this year at the slowest pace in nearly eight years, edging up $7.7 billion, compared with a record increase of $153.9 billion in the same quarter last year.

While others suggests that China’s apparent moderation in acquiring of US assets could be a function of diminishing forex reserve accumulation, the alternative is that China could indeed be massively accumulating base metals including copper.

Next, copper prices have been on a rampage since hitting a low last December.

And if Mr. Pritchard’s account of China’s accumulation is accurate then the rise in base metal prices could also be reflective of the Middle Kingdom’s tacit diversification…

Moreover, Mr. Pritchard seems to connect these activities to China’s recent call for a global currency system.

From Mr. Pritchard, ``Zhou Xiaochuan, the central bank governor, piqued the interest of metal buffs last month by calling for a world currency modelled on the "Bancor", floated by John Maynard Keynes at Bretton Woods in 1944.

``The Bancor was to be anchored on 30 commodities - a broader base than the Gold Standard, which had caused so much grief in the 1930s. Mr Zhou said such a currency would prevent the sort of "credit-based" excess that has brought the global finance to its knees.

``If his thoughts reflect Communist Party thinking, it would explain the bizarre moves in commodity markets over recent weeks. Copper prices have surged 49pc this year to $4,925 a tonne despite estimates by the CRU copper group that world demand will fall 15pc to 20pc this year as construction wilts…

``The beauty of recycling China's surplus into metals instead of US bonds is that it kills so many birds with one stone: it stops the yuan rising, without provoking complaints of currency manipulation by Washington; metals are easily stored in warehouses, unlike oil; the holdings are likely to rise in value over time since the earth's crust is gradually depleting its accessible ores. Above all, such a policy safeguards China's industrial revolution, while the West may one day face a supply crisis.”

Mr. Pritchard’s essay reminds us of Ludwig von Mises' admonition in Interventionism: An Economic Analysis, Inflation and Credit Expansion of the harmful effects of persistent inflationary policies…

``But on the other hand inflation cannot continue indefinitely. As soon as the public realizes that the government does not intend to stop inflation, that the quantity of money will continue to increase with no end in sight, and that consequently the money prices of all goods and services will continue to soar with no possibility of stopping them, everybody will tend to buy as much as possible and to keep his ready cash at a minimum. The keeping of cash under such conditions involves not only the costs usually called interest, but also considerable losses due to the decrease in the money’s purchasing power. The advantages of holding cash must be bought at sacrifices which appear so high that everybody restricts more and more his ready cash. During the great inflations of World War I, this development was termed “a flight to commodities” and the “crack-up boom.” The monetary system is then bound to collapse; a panic ensues; it ends in a complete devaluation of money Barter is substituted or a new kind of money is resorted to. Examples are the Continental Currency in 1781, the French Assignats in 1796, and the German Mark in 1923.”

While China has spoken of the need for a global currency, our thought is in acquiescence to Mr. Pritchard's supposition that China could indeed be seeking insurance with massive purchases of metals which could eventually back their currency.

Maybe China's is doing a flanking approach with accumulation centered mostly in base metal and copper first, agriculture and energy next and lastly gold.