Monday, March 26, 2007

>China & Dollar

Zhou was quoted as saying: "... many people say that foreign exchange reserves in China are large enough. We do not intend to go further and accumulate reserves.”

China's vast and rapidly growing foreign exchange reserves accumulate because China does not sell the surplus US dollars that it receives from its trade surplus with the United States into foreign exchange markets, but buys US debt with them instead. Under normal circumstances China would have sold its surplus US dollars and not accumulated such a vast foreign exchange reserve; however, the United States' trade deficit is so large that if China, Japan and Europe were to sell their trade dollars into foreign exchange markets the dollar exchange rate would collapse.

Last year the Organization for Economic Co-operation and Development (OECD) determined that the dollar had to fall by 35% to 50% in order to balance the US current account gap. My calculations of the dollar's over-valuation based on the gold price also suggest that the dollar has to fall by about 35%.

China does not have to sell any of its existing dollar reserves to precipitate a decline in the dollar -- all it has to do is stop accumulating dollars. The current US trade deficit with that country alone is running over $20 billion per month, and that is not an insignificant amount. If China stopped accumulating foreign reserves those dollars would be sold and I expect that when that happens, the dollar will fall.

Other Asian countries that helped prop up the dollar by accumulating foreign reserves may follow China and start selling their surplus trade dollars as well.

The ramifications are that there will subsequently be less demand for US Treasuries and agency debt. That will push US interest rates higher regardless of what the Fed says, and higher interest rates will be detrimental to US economic growth and US equities. One would expect that higher US interest rates would be positive for the dollar, but with surplus trade dollars hitting foreign exchange markets we can expect to see the dollar fall in tandem with rising interest rates. A falling US dollar in the face of rising US interest rates is the key event that I am waiting for to indicate that a significant and sustainable rise in the gold price is occurring. Until then the gold price should continue to creep upwards as a result of fiat money inflation.

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