October 21, 2010
Hong Kong, SAR
I’m seeing some things on the ground here in Hong Kong that are the first signs of a coming dollar crash.
We’ve talked before about how the global financial system is based on enormous flows of capital– trillions of dollars flow from one country to another, from one currency to another, and most of it is controlled by large banks, funds, and institutions.
This system requires extremely large economies with extremely large money supplies that can adequately absorb huge capital flows. If you and I go buy a few thousand dollars worth of Peruvian sols, for example, no one will notice. But if JP Morgan decides to buy $1 billion worth of Peruvian sols, the Peruvian sol is going to spike.
As such, there are really only three places in the world where the currencies can absorb huge capital flows– the US, Japan, and eurozone. Coincidentally, these are also among the three sickest developed economies.
Everyone knows that the US has the largest debt in the history of the world, that the eurozone’s supranational challenges are beyond repair, and that Japan’s 2-decade long recession shows no signs of abating… but frankly there aren’t any other options out there.
Trillions of dollars of institutional money need to be parked somewhere, and as much as institutions might like to hold their cash in a better store of value like, say, the Chilean peso, there simply aren’t enough Chilean pesos in existence to absorb trillions of dollars.
This means that institutional investors are essentially left to judge a redneck beauty pageant: which of the three contestants is the least ugly?
The winner fluctuates. For the six months from September 2008 through March 2009, the dollar was the least ugly. Then for the next 6-months until November 2009, the dollar was the ugliest. From November 2009 through May 2010, the euro was the ugliest, and since May it appears that the dollar has once again been deemed the ugliest.
Undoubtedly, the Japanese yen will have its time in the spotlight as the ugliest, and we’ll continue to see all three of these currencies jockeying for position against the others. Their respective bureaucrats favor weak currencies, and they’re doing whatever they can to inflate and devalue.
In the meantime, little by little, some of these institutional flows are spilling into other currencies viewed as safer stores of value… hence the rapid rise of the Swiss franc, Canadian dollar, Aussie dollar, New Zealand dollar, Singapore dollar, Chilean peso, Brazilian real, and of course, precious metals.
For institutional funds, though, these currencies don’t necessary offer a long-term solution because they’re too small. The entire money supplies of Australia and Canada, for example, are each about $1.3 trillion, while the value of all the available precious metal is less than $6 trillion.
Meanwhile, the Bank for International Settlements estimates the size of the world bond market at over $80 trillion. Thus, you can see why institutions are having to play judge in such an unfortunate beauty pageant… there simply aren’t any reasonable options to hold vast amounts of currency.
As one of the world’s strongest and most dominant economies, China’s renminbi represents a long-term solution… but not yet. China’s economy is already #2 in the world and will likely overtake the United States within a decade. Its money supply is vast, and would be able to withstand significant capital flows.
The problem is that China has imposed severe exchange controls, and the financial system depends on the free flow of capital. Little by little, these controls have been gradually loosening… and the more these controls loosen, the more likely investors will be to abandon the three ugly sisters and move into the renminbi.
Years ago we saw the first signs– China loosened its exchange controls by allowing foreigners and locals to begin moving money overseas with limited restriction. Now the signs are becoming more frequent, and more obvious.
To start, many countries are beginning to build up foreign exchange reserves in renminbi instead of dollars or euro. Malaysia, for example, is buying renminbi-denominated Chinese bonds, and other countries like Argentina, Iceland, Belarus, and Singapore have swap agreements with China, allowing them to hold renminbi in reserve.
Perhaps even more interesting, though, are all the new bonds that are being issued in renminbi. Here in Hong Kong, I saw Asian Development Bank (ADB) just raise 1.2 billion renminbi ($180 million) through a bond auction. They’re moving to list the bonds on Hong Kong’s stock exchange, becoming the first exchange-traded renmimbi bond.
A few months ago, McDonald’s became the first multinational company to sell renminbi-denominated bonds, and Wal Mart has openly discussed doing the same. I’m convinced that one day soon we’ll see bankrupt cities in the US taking similar steps and auctioning off renminbi-denominated municipal bonds.
Furthermore, the Chinese government has also paved the way for instant, cross-border settlement services between the mainland and Hong Kong. In other words, banks in mainland China can settle and wire payments immediately to Hong Kong without bureaucratic approval… and then from Hong Kong, to the rest of the world.
Effectively, Chinese policymakers have dropped most of the exchange controls with Hong Kong, and they’re using Hong Kong’s financial system as a middle man to have a free flow of capital between China and the rest of the world.
As the Chinese government continues down this path of monetary deregulation, you can be sure that institutional funds will dump their dollars, yen, and euro and head to the dim sum market for a better store of value.
This is not a cause for panic, but merely preparation. We can see the signs of the long-term trend… and if you haven’t done so already, you should be taking steps to preserve the value of your capital. Consider holding stronger currencies in a foreign bank account, buying precious metals, or purchasing well-located foreign property.
If you wait until your broker calls to offer you renminbi-denominated muni’s, it will be too late.