Peter Schiff: China''s peg was America''s crutch

Section:

A Golden Solution to the China Syndrome?

By Richard Lehmann
Forbes.com
Wednesday, July 27, 2005

http://www.forbes.com/investmentnewsletters/2005/07/27/china-gold-
lehmann-cz_rl_0727soapbox_inl.html?

Put yourself in China's shoes. Your economy is heavily dependent
for its economic growth and well being on exports to the United
States, long its least-favorite country. It has to accept payment
for its exports in U.S. dollars,a currency over which it has no
control other than to cause it to depreciate by trading out of the
dollars it holds and into another currency. (Note: This is something
the United States is trying to get China to do to itself by
revaluing the yuan.)

To add insult to injury, it has accumulated a staggering $700
billion of such dollar reserves and sees no other investment option
besides the U.S. Treasury market.

Hence, they not only supply cheap goods to this least-favored
country, they then lend it back the proceeds of their labor --
lending which makes them vulnerable to a freezing of these reserves
by the U.S. should serious enough policy differences arise, la
Iran. Welcome, China, to the World Trade Organization, or should I
say, "Welcome to the Hotel California."

Fairly recent history offers two examples of countries who have
dealt with this problem with mixed success. In the 1970s, when OPEC
managed to take control of the oil market and more than double
prices, their foreign reserves quickly built up as they had not yet
figured out how to spend these vast sums. Their solution was to
invest in CDs with large international banks, thereby providing the
funds necessary for oil-importing countries to fund their higher oil
import bills. This dubious arrangement lead to an international
banking crisis, as the debtor nations defaulted nearly causing some
major international banks to fail.

The 1980s saw a replay of the reserve problem, only this time the
country with the excess reserves was Japan. Their attempt to
diversify out of dollars led to an organized spending spree
involving the purchase of hotel properties, signature office
buildings and golf courses. The problem with this strategy was that
it was premised on the notion that property values overseas were
cheap in comparison to those in Japan. The flaw in that thinking was
that it was the Japanese values that were out of line, not those in
the rest of the world. Bottom line, the Japanese overpaid. As for
their infatuation with buying and building golf courses around the
world, leave this to a psychologist to explain.

The recent purchase attempt of Unocal by CNOOC, the state-controlled
China oil company, exemplifies an attempt to pursue yet a different
route for diversifying out of dollars. China appears to be trying to
spend its foreign reserves to buy entire U.S. companies. From a
Chinese strategic point of view, this is definitely the right
policy: Buy the means of producing the raw materials you need or
alternatively, buy the companies that have the technology and
distribution channels for the products you produce or want to
produce.

For the United States, however, this strategy is a serious threat
that goes beyond trade rivalry. Let no one kid himself.

International trade and capitalism is a form of warfare where
domination is the objective. A country such as China is playing a
different game from most WTO members -- they are mercantilists. That
means they are not interested in creating a level playing field and
letting private enterprises compete. They want state involvement to
a much greater degree than is practiced in the United States. This
means direct ownership of key enterprises, setting economic
priorities, controlling foreign ownership participation, rule-making
that favors national enterprises, and using commerce to achieve
foreign policy ends.

The United States has allowed foreign ownership of domestic
companies except in cases involving national security. This usually
means protecting against foreign control of sensitive technology,
defense companies or vital sources of supply. Even excluding these
types of companies, China could make major inroads in dominating key
industries in this country.

Such dominance by a country that is fundamentally hostile to U.S.
interests will not be tolerated by the U.S. government. We already
see this with the protests over the CNOOC tender for Unocal, the
acquisition of which is, at best, peripheral to U.S. interests. That
protest, however, should be a clear signal to China that acquisition
of U.S. operating companies is a non-starter that can only lead to
further strained relations.

How, then, can China reduce its subordination to U.S. interests and
use its dollar reserves to strengthen its role in world affairs?

I believe China will eventually find gold as a partial solution to
its foreign-exchange problem.

While an immediate reaction may be to think this is nonsense, a
closer examination may provide some food for thought. Gold was the
world reserve standard for centuries until former President Richard
Nixon closed the "gold window" on Aug. 15, 1971. What he did, in
effect, was end the exchangeability of gold for dollars at the fixed
rate of $35 per ounce. In effect, the U.S. stopped being a sponsor
of gold under a system whereby it set the price and became the buyer
and seller of last resort.

The change was necessitated by the fact that foreign holdings of
dollars had gotten well beyond the U.S. reserves for gold. Even a
steep rise in the pegged gold price would not have solved the
problem for long and would have rewarded Russia and South Africa,
two countries not then in favor with Washington. Also, the United
States stood to gain tremendously from the new world order in which
the U.S. dollar became the world's reserve currency by default. It
would be no exaggeration to say that Nixon's action was one of the
keys to America's subsequent world economic dominance.

When America abandoned gold, no one was inclined to step in and
continue the gold standard. And since gold earned no interest,
nations around the world began to systematically reduce or eliminate
their gold holdings. Time has shown that such gold holdings would,
through subsequent appreciation, have served quite well as an
alternative to U.S. Treasurys. However, in today's world of
multibillion-dollar reserves, the gold market is too illiquid to
serve its former role.

To revive gold's role as a reserve currency, it again would need a
sponsor -- a buyer and seller of last resort who dictated the
support price. That price could increase each year, per government
policy, by a set amount. China, with its $700 billion in reserves
has the clout to assume this role. Keep in mind that gold is still a
scarce resource that has not kept up in supply with the growth of
world economic activity. It is insufficient in quantity to serve as
the main world reserve currency unless its price was vastly higher.
It could, however, be a close second or third. More importantly,
like the De Beers diamond cartel, it can be extremely profitable for
its sponsor.

Dominating the gold market would offer a number of benefits to
China. It offers a viable alternative to buying more U.S. Treasury
debt. It allows them to set the rate of return on their gold
investment, much as De Beers sets the price of diamonds. However,
their control of prices would be even stronger since a net buyer
role is much stronger than the De Beers role as a seller. In fact,
once China let its newly assumed role in gold become known, a
worldwide gold rush would commence, driving prices well above
current levels. China will not be able to take control until well
into this initial rush. Over time, other nations would join China in
again holding gold as a way to reduce their dollar exposure.

Holding large gold reserves can serve China's domestic economic
policy, as well. China does not want to see its citizens investing
abroad. Allowing Chinese citizens to buy gold would help satisfy
domestic saving and investment desires while also giving the
government a means of regulating the money supply. Gold has a long
history with individual Chinese as a way to hide and preserve
wealth -- a way made no less attractive by the mistrust that is
always present with an autocratic central government.

The ultimate attraction of such a policy for China is that it allows
them to reduce their vulnerability to the United States. Even more
so, it allows them to play a dominant role in international affairs,
clearly a high priority with current Chinese leadership.

While it is not in the U.S. interest to strengthen China's role in
world affairs, it is a better alternative than letting pressures
build inside China's government over a perceived, if not actual,
threat to their sovereignty. Also, other solutions to the dollar
reserve problem may be dreamed up that prove to be far more
dangerous to the current international order. Forecasts are for
China' reserves to grow to $1 trillion dollars by June 2006.
Such an accumulation only puts more pressure on the Chinese to find
an alternative solution.

--------------

Richard Lehmann is editor of Forbes/Lehmann Income Securities
Investor.

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