Wednesday, October 29, 2008

The Greatest Trade EVER!

There has been a considerable uproar over a story in the overseas version of the Chinese newspaper The People’s Daily. The story suggested the Chinese are very unhappy with the low value of the US dollar. The most quoted line from the story is,


The United States has plundered global wealth by exploiting the dollar's dominance, and the world urgently needs other currencies to take its place.


Clearly the Chinese have a beef with the greenback and the way the US has treated it.


However, the Chinese anger seems misplaced, they are massive holders of US dollars and dollar denominated assets, why would they want to trash the dollar? Doing so would only hurt their dollar positions. I spent a good portion of yesterday pondering this exact question, and then, over a bowl of cookie dough ice cream it came to me….the Chinese have figured out the greatest trade EVER!


If the Chinese decide to transfer their dollars into another dollar denominated asset, besides US Treasury debt, they have a few choices. Several of these options include: US equities, private equity stakes, agricultural commodities, oil and gold.


If they choose gold they have a significant advantage. Since gold roughly trades inversely to the US dollar, the Chinese could buy gold with some of their dollar reserves and use the rest of the dollar reserves to keep a cap on a rising dollar. In this way they create the exact scenario that would cause the price of gold to rise, i.e., increased investment demand and a weak dollar. With this trade they could convert a depreciating asset into an appreciating asset and have some control over the appreciation. The Chinese government is one of the only sovereigns that have the resources to have a significant impact on both these markets.


Chinese dollar holdings are estimated to be more than $1 trillion. Using this figure as the estimated “dollar portfolio” we can get a little perspective on China’s ability to influence the gold market.


According to the World Gold Council, as of June 2008, the total amount of gold held in reserve was $894 billion or 29,813 tons. Immediately it is clear to see that, if it wanted to, China could buy all the gold in the world. Of course, that is all but impossible since the gold reserves are held by central banks and is not for sale.


A more realistic (and mathematically simple) scenario may be that China wants to spend $89 billion of its $1 trillion on gold, using the World Gold Council statistics that would buy China about 2900 tons. The following chart shows tonnage statistics for the last two years.


Gold Supply and Demand

In Tons

In tons

2006

2007

Supply



Mine Production

2485

2475

Central Bank Gold Sales

370

501

Total Gold Supply

3573

3496

Demand



Jewelry

2284

2400

Bar and Coin Investment

424

445

Total Demand

3405

3518

Source: World Gold Council


It is clear from the table that if China spent less than 10% of its dollar reserves to buy gold, they would overwhelm the market. They would be able to buy all the mine production and all the gold the central banks wanted to sell. They would also double the total demand for gold.


Of course I have no proof that the Chinese are doing this or are even contemplating buying gold with their dollars. But if I was running the dollar reserve portfolio and my bosses were talking tough about the dollar, I would look for alternative investments.


Disclosure: I am long GLD and DGP

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