Chinese Checkerboard of Effects

August 23, 2005

Mark July 21, 2005 down as an historic day in the financial world. Few people among the public will fully appreciate its importance. In fact, even among the investment community, the date might not stand tall in significance aside other key dates. The 1987 Black Monday, the 1997 Asian Meltdown, the 1998 Russian Default, the 2000 Tech Stock Bust, these dates will stand out. On the July 21-st date, the Chinese announced a delink from the USDollar, began to enforce a new tie from their yuan to a basket of currencys, and finally permitted more liberal hedging practices for both banks and commercial entities. In my Hat Trick Letter August issue, subscribers were shown no less than 20 effects of the currency regime change exercised by China. Some are significant and somewhat immediate. Some are clear but behind the scenes in nature. Some have the capability of shaking the entire world financial system. In my analysis, the Chinese yuan revaluation decision manages to poke a hole with widening cracks in the grand USDollar world currency dam. The hidden damage might be better seen with the US$-based trading system for commodities. Such is the underwater pressure building forces behind the dam structure.

In the last few months, each continent has had a major event. Europe voted NO on centralized power backed by a constitution. That put a sudden halt to the expansion of the European Union, and retained member nation sovereignty. The euro currency was shaken. Asia saw the end of the fixed Chinese yuan currency regime. The United States and Canada blocked acquisition attempts by China for Noranda and Unocal, with Maytag collateral damage. China might have learned that Anglo-Saxon mergers and acquisitions are peachy keen, but not Asian. See British Petroleum and their merger with Amoco. The Chinese will move in earnest on foreign reserves diversification, even as Asia follows. These are tectonic shifts which have collectively forced the cracks wider in the USDollar world currency system.

Let's touch on two key effects among the 20. My effort during a North Carolina beach vacation was to read about the Chinese currency decision, note a couple overlooked analytic points, and produce a listed litany of effects in leisure on a spiral notebook while observing waves and other walking scenery. A couple valued friends actually assessed the decision to be trivial, since the 2.1% amount is so small. Well, so is a crack in a dam small, whereas its existence is the important fact. The spread of the crack is unavoidable, inescapable, certain to cause unfortunate problems. The stress from colossal world imbalance exerts continual pressure.

#5) China will be indirectly granted a price discount in commodity imports (oil, gas, copper, iron, aluminum, zinc, lumber, cement, grains, soybeans). Look for commodity demand to be buffeted by with each yuan upgrade.

Each time China upgrades their yuan currency, they grant themselves an immediate discount on all commodity imports. Apart from delivery costs, the discount is one for one, 2.1% from the July decision. Notice how copper broke out to hit 1.70 on the August contract in the wake of the yuan upward revaluation. China can continue to grant commodity price discounts, as a short-term offset to the erosion to their foreign reserve assets. Each threat of economic slowdown within China can be met with a reduction in the cost of commodities via the yuan floated exchange rate and the next yuan lift announced officially. The USA in the face of a threatening recession cuts the price of money (interest rates). Watch China cut the price of commodities by means of a slight upgrade in its own yuan currency in order to sustain its economy.

Over the course of the last thirty years, the United States has managed its economic slowdowns by reducing short-term interest rates. The US Economy in the process grew in its reliance upon monetary inflation for its main engine thrust, and became dependent on cheap money. A reduced interest rate has the effect of cutting the price of the most important commodity in the world's largest economy, namely the money to borrow in a debt dependent society operating inflationary machinery. Usually the USFed has been late to cut, relying upon coincident indicators (same time) rather than leading indicators (imminent future). That is another matter, attesting to their amateurish incompetence which is difficult to refute on a professional level.

With China the most important prices to them are for the vast array of commodities. Of course, their housing market is important. However, as strange as it sounds, China is new to introducing interest rates. The Chinese public is only beginning to react to the price of money, to use policy on rates to manage borrowing generally. They have yet to discover the concept of borrowing against asset value. Without question, the most important price to China is for tangible things, like building materials and industrial metals. If within the next few months, the Chinese economy slows its pace of growth another couple percent, look for their leaders to execute the next yuan upgrade. The result will be to render commodity prices cheaper once more, enough to offer some relief to their burgeoning economy. Each quantum jump will be the expense of the United States. As commodity prices are rendered less expensive to the Chinese, they will rise in US$ terms.

#20) China might gradually undermine the entire petro-dollar system, a financial superstructure designed to facilitate oil purchase in USDollars. Look for warning signals from OPEC, which might someday announce oil priced in terms of a basket of currencys also.

Last week, in "Energy Alliance & US Isolation" a premise was put forth that the timing of the Chinese currency revaluation with the new petroleum exchange in Iran coming online in several months. A challenge of the petro-dollar system lies directly ahead. If the sale of oil in euro currency practiced by Saddam Hussein had spread widely to all oil producers in the Persian Gulf, the effect would have been severe. In fact, we do not know what the effect would be, since it would have overthrown a financial system which has stood for over 30 years. The ability for the USGovt to run hefty federal deficits, the ability for the US Economy to run hefty trade deficits, both twin towers would have suffered a teetering from a shifted foundation. It would have grown into a dangerous situation.

An enormous test comes over the horizon with the Iranian Oil Bourse. The sale of oil & natural gas is without question to be conducted in a currency besides the USDollar, namely the euro. That will surely tweak the US leadership noses. Upcoming competition is heralded between this new bourse and the International Petroleum Exchange in London, and the New York Mercantile Exchange. The world's Petro-Dollar system will soon be directly challenged. Anyone who thinks the Chinese yuan currency basket announcement is not somehow centrally important to the Iranian oil bourse creation, is sadly clueless. The Chinese currency delink to the USDollar next will undermine the Petro-Dollar system itself.

China is the #2 world oil purchaser, behind the United States. More importantly, China is the biggest marginal purchaser, responsible for most of the pervasive growth. Any change to their link with the USDollar might easily result in a change to their payment system for commodities on the world market. It is a natural consequence since oil is the most important commercial commodity. Oil is already tightly linked to the US Treasury credit market, the basis of the name "petro-dollar."

Bear in mind that Iran has very powerful defenses, complete with missiles aimed at ships, deployed on several strategic islands. By comparison, Iraq was a sitting duck, made lame from humiliating defeat during the Gulf War in 1991. Their lack of air force, lack of air defense, lack of missile strongholds, these made Iraq more than vulnerable. Taking Baghdad was the military equivalent of stealing a little kid's lunch at school. Iran is not Iraq, with over three times the population and far more entrenched defensive systems. Iran can very capably defend, if not shut down, the Strait of Hormutz in the Persian Gulf where so much oil tanker traffic passes. Meanwhile, China is actively building defense emplacements for other important strategic straits in east Asia, such as the Malacca Strait off Indonesia. More importantly, nobody stood by Saddam's side. The Iraqi nation owed money to France, Germany, and Russia. At Iran's side is both Russia and China with clear military commitment to fortify clear energy contractual partnerships and obligations. Their alliance is unquestionably important to defend the upcoming Iranian initiative to challenge the petro-dollar, with an alternative oil trading currency, the euro. Military force might soon defend the challenge to the petro-dollar !!!

The US Congress is certain to resume trade tariff legislation in late September. The 2.1% lift in the Chinese yuan in no way met the Congressional requirement to sidetrack the 27.5% tariff to be imposed. The Senate bill supported by both political parties calls for a 40% yuan lift. The major impetus behind protectionism is job loss, reserve asset buildup, energy supply access, property acquisition, lost intellectual property royalty, brand capture, and industry kills.

The process of Chinese policy incrementalism in no way satisfies the quantum change in remedy required and called for. One very ugly fact is that an estimated 92% of software is pirated inside China, without due royalty paid for intellectual property. In fact, IP is probably the biggest rankled issue behind lost jobs on the political front. Leading the list, job loss from outsourcing is a big thick thorn in the side of both workers and politicians. Close behind is the massive loss in royalty revenue from IP in software, music, movies, books, and patents generally. Most informed sources are well aware that the perpetrator for pirate production is the Chinese Army Corp.

These and other topics with bearing on energy and financial world are covered and analyzed in the Hat Trick Letter for subscribers. The petro-dollar system is under siege, quietly but effectively, with the assault sure to gather force. Implications to interest rates and sovereign power cannot be minimized. The major US media networks are strangely silent. Perhaps they do not understand the issues. More than likely, they take the current system as the status quo, never to be altered. Such is a mistake.

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Jim Willie CB is a statistical analyst in marketing research and retail forecasting. He holds a PhD in Statistics. His career has stretched over 23 years. He aspires to thrive in the financial editor world, unencumbered by the limitations of economic credentials. Visit his free website to find articles from topflight authors at

Jim Willie

Jim Willie

Jim Willie CB, also known as the “Golden Jackass”, is an insightful and forward-thinking writer and analyst of today's events, the economy and markets. In 2004 he launched the popular website that offers his articles of original “out of the box” thinking as well as content from top analysts and authors. He also has a popular and affordable subscription-based newsletter service, The Hat Trick Letter, which you can learn more about here.  

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Jim Willie has experience in three fields of statistical practice during 23 industry years after earning a Statistics PhD at Carnegie Mellon University. The career began at Digital Equipment Corp in Metro Boston, where two positions involved quality control procedures used worldwide and marketing research for the computer industry. An engineering spec was authored, and my group worked through a transition with UNIX. The next post was at Staples HQ in Metro Boston, where work focused on forecasting and sales analysis for their retail business amidst tremendous growth.

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