DOLLAR CRISIS IN THE MAKING, Part 2

With regard to whether Chinese advisors and experts think the US government is creating a dangerous and unstable Treasuries bubble, note this statement:
"Buying US government bonds amid an economic downturn, [a purchase] that is not based on the sound performance of the US economy itself, indicates a huge bubble," said Zuo Xiaolei, chief economist of China Galaxy Securities.

Chinese officials exChinese officials express mounting alarm at the likely negativepress mounting alarm at the likely negativenear-to-medium term effects upon the dollar, and upon their huge reserves, of the spend-spend-spend policy emanating from Washington:

The huge deficit would not immediately lead to inflation, since banks were likely to curb lending as the financial system remained weak, Zuo said. "It might be two or three years before the huge deficit leads to serious inflation." Analysts noted that if the stimulus plan didn't accomplish its goal of restarting growth, the US government would have to ease its large fiscal burden by borrowing more and issuing more dollars, instead of relying on economic growth.

Huge Treasury bond issues would exacerbate the depreciation of the US dollar and world wealth. Such developments would be more catastrophic than the global financial crisis, according to Zhang Yansheng, head of the International Economic Research Institute under the National Development and Reform Commission, the chief economic planning body in China.

A weaker US dollar would hurt that currency's international status, he said, which would "not be in the interests of the United States and other countries and would exacerbate the crisis." Said Zuo: "US dollar depreciation is inevitable in the long run. China should prepare and reduce its holdings of US Treasuries to a proper size."

In a strong hint that China's central bank won't be adding to its holdings of Treasuries at anywhere near the rate it did in 2008, that it may already have clandestinely achieved more diversification out of the dollar than is widely known, and may well find ways to further decrease its holdings without explicitly telegraphing its moves, note this statement:

Fang Shangpu, deputy director of the State Administration of Foreign Exchange, noted Wednesday that the report released by the US Treasury of the amount of government bonds held by China included not only the investment from the reserves, but also from other financial institutions. It might be a hint that Chinese government is not holding as much US government bonds.

China is managing its foreign exchange reserves with a long-term and strategic view, Fang told a press briefing. "Whether China is to purchase, and to buy how much of the US government bonds, will be decided according to China's need," Fang said. "We will make judgment based on the principle of ensuring safety and the value of the reserves," Fang said.The foregoing quotes beg the following questions:

What about the widely held view, which is even at times recited by Chinese central bank officials themselves, that says China has no choice but to maintain its holdings of Treasuries and to keep buying more, lest any significant slowdown in its rate of purchases risk triggering a global dollar panic?

Is that view correct, or does China's central bank actually have other viable options, as Luo Ping and other officials insist that it does?

What might those other options be, are they really viable, and what might happen to the dollar if China's central bank began to exercise its professed "other options"?

What kind of scenario might prompt China's central bank to attempt to do so?
Could its enactment of "other options" be carried out in a way that would be difficult to trace, so that China would avoid triggering a dollar panic while it steadily reduced its exposure to the dollar over the coming months?

Saying "goodbye!" sooner, not later

With respect to whether China will continue to purchase Treasuries at anywhere near the same rate at which it has in the recent past, a new and fundamental problem is arising. Its significantly slowing economy is causing a rapid slowing of the rate of growth of its reserves, which makes much less new reserve accumulation available, and therefore also undermines the need for the purchase of Treasuries. Experts state that even if China's central bank uses all of its new accumulation of reserves each month to purchase Treasuries, the sums it would purchase would still fall.

Additionally, China must now fund its new $585 billion domestic stimulus package, and that will only further decrease funds available for the purchase of Treasuries. Therefore, its rate of purchase of Treasuries will almost certainly decline significantly from here forward.

This potentially potent new fundamental comes into play at the most inopportune time for the US, when it intends to sell perhaps as much as $2.5 trillion in Treasuries this fiscal year alone. The question that begs an answer, and that is increasingly being asked around the globe, is who's going to buy this huge new supply of debt? Certainly not Japan, for its exports are plunging, as is its new reserve accumulation, as it suffers a severe economic contraction at an annual rate of 12.7% according to the latest figures.

It certainly appears likely that as new Treasuries flood the market, the point could soon be reached where supply outstrips demand, causing yields to rise. The Fed is trying to keep yields as low as possible so as to attract big buyers that already have large holdings of Treasuries, such as China. For such holders of Treasuries, rising yields would ravage the value of their holdings, making the purchase of yet more Treasuries distinctly unattractive. Yet, lower yields tend to be less attractive for new buyers, except in the case where such a buyer is suffering from strong risk aversion and is looking, not so much for profit, but rather for a safe haven.

Therefore, minus the environment of extreme risk aversion that still plagues the markets, the US is caught between multiple contradictory interests. On the one hand, it wants to keep yields low so as to attract buyers such as China to purchase significantly more Treasuries. On the other hand, it needs higher yields to attract many new buyers because the big buyers are becoming much less able to keep up their purchases, let alone increase them. But those higher yields would almost certainly force investors such as China's central bank to begin to more quickly divest themselves of Treasuries - or risk seeing the value of the dollar-denominated portion of their reserves eaten away.

The biggest factor that has so far prevented a destructive collision of all these conflicting interests is the persistence of extreme risk aversion in the markets, causing a global rush into Treasuries as a safe haven.

If that extreme risk aversion were to subside, then investors holding Treasuries and prospective new buyers of Treasuries would be lured instead to investments that offer greater profit potential. The yields on Treasuries would have to rise in order to attract buyers, but that would undermine the value of investors' holdings of Treasuries, which would in turn drive them to sell out in favor of better safe stores of wealth. As yields rise rapidly, prospective buyers would likely stay on the sidelines to wait for the best deal rather than jump in too soon only to see their holding ravaged by yields that continue to rise.

The yields would rise yet further on the falling demand for Treasuries, and the downward spiral would feed into itself in a stampede out of Treasuries and the dollar. What I am describing here is a bursting of the Treasuries bubble. It would most likely be disorderly and chaotic.

But such a bubble burst for Treasuries could come about even if risk aversion persists, or perhaps intensifies, in this deepening global crisis. What if investors become more worried about the safety of Treasuries, fearing, as China's central bank increasingly does, that the flooding of the market with huge new sums of US debt will inevitably inflate away the value of their Treasury holdings? Or what if the costly new US stimulus package and bank rescue fail, and the US descends into a much deeper recession or a full-blown depression and is forced to nationalize virtually the entire financial sector, stoking fears that the US government may have no choice but to default on at least a portion of its gargantuan debt?

In that case there is a real threat that investors will begin to transfer their risk aversion strategy from focusing on Treasuries and the dollar to focusing on something else that is deemed much safer - perhaps including hard assets like gold and other precious metals and commodities. If US gross domestic product (GDP) deteriorates significantly further than it has already, the dollar will become much more vulnerable and will likely fall as investors begin to value the safe haven currency more in line with the fundamentals of the US economy. Then, the same self-reinforcing downward spiral described above would likely come into play, and the Treasuries bubble would burst in chaotic fashion in an investor stampede to havens safer than the shaky dollar.

One can begin to see how very tentative is the dollar's recent appeal as a safe haven in the mounting storm. In verification of that fact, investors have been piling into short-dated Treasuries for the most part, for two reasons. First, these assets are less vulnerable to the ravages of higher yields, which tend to hit the long-dated Treasuries earliest and hardest. Second, the short-dated assets facilitate a quick exit in the event that it is deemed justified. When taken together, these two factors are not a very solid vote of confidence in Treasuries and the dollar.

Next: China Inoculating Itself against a Dollar Collapse

W Joseph Stroupe is a strategic forecasting expert and editor of Global Events Magazine online at www.globaleventsmagazine.com