MineFund Independent Natural Resources Analysis & Analytics

China’s Commodity Strategy & Displacement of the Dollar

ST. LOUIS (MineFund.com) -- We expect Robert B. Zoellick to be the last American president of the World Bank for some time. His pending departure presages much greater changes for the international financial system that will not just be a product of the financial crisis.

Speaking last year at Johns Hopkins University’s School for Advanced International Studies in Washington, Zoellick said: “Bretton Woods is being overhauled before our eyes”. Whilst the media is emphasizing his comments on the displacement of the dollar as numeraire, we believe he is signaling a more profound change that could culminate in the eventual emigration of the global financial institutions away from Washington.

Physical relocation is a long way off, but Zoellick’s term is drawing to a close quite soon. He was heavily supported by the Europeans as a compromise candidate to replace Paul Wolfowitz who was drummed out after a hysterical campaign by antagonists. It is quite possible that the Europeans, back by any number of anti-American factions, is waiting in the wings to install the quid pro quo for Zoellick. And the timing is ripe given the current Administration’s post-modern multilateral sceances.

Part of the deal may have involved Zoellick working within the Washington elite to soften them up to accept parallel reserve currencies that might be more regionally based, but almost certainly reduces American discretion in international monetary affairs.

Notably, in March of last year, Zoellick told Reuters that although a strong dollar was important and should remain the principal reserve currency, “The question will be whether you have complementary measures“. Zoellick’s position continues to develop and he has been talking about the dollar as a “major currency” rather than the “principal reserve currency.”

The tearing of Europe’s fiscal wallpaper, otherwise known as the euro, has been inconvenient, but it doesn’t change the long-range thrust.

Zoellick’s use of the word “measures” is significant. He should have been asked to clarify that statement, but we can infer that the Group of Twenty (G20) has commenced the process of developing policies and mechanisms that constrain American power to abuse the dollar as the world’s principal reserve currency.

In the absence of a gold standard, alternative mechanisms must be developed to prevent a recurrence of the 1960s tension and 1970s malaise. That process is now underway.

Quo Vadis China?

Whilst there is a great deal of concern about China’s leverage over the United States because of the dollar assets it has accumulated, we should not forget that the purpose of dollar hoarding has been to prevent an inflation of the yuan – especially relative to the dollar. Asia holds nearly $5 trillion in forex reserves; primarily in dollars.

The problem for China and its Asian peers is that there is no credible alternative to the dollar yet. They are also acutely aware that they may be left holding depreciating or devalued dollars so they cannot afford to be passive. None of them will trust the other to manage a reserve currency, and nor would they trust and of the G20 countries for that matter. Consequently, the intermediate effect is likely to be a continued conversion into hard assets like commodities.

It then becomes obvious that the coterminous major challenge is the re-denomination of commodities. For as long as major commodities are priced in dollars, the dollar will remain the numeraire.

This is where China’s ambitions lie. A while ago, Ha Jiming, Chief Economist at China International Capital, China’s largest investment bank, noted that his country runs “a huge deficit against raw-material-producing countries.” His solution for China is obvious (emphasis ours):

It makes sense even for a deficit country to trade in its own currency due to seigniorage (the profit made between the cost of printing money and its face value), convenience and, according to International Monetary Fund studies, improved terms of trade. Since payments of an international currency are frequently processed through the banking system of the issuing country, Chinese domestic financial institutions would also benefit from the wider global use of the yuan.

China’s economic growth has elevated it to become the primary off-take partner for most raw materials. Add that to America’s current financial and ballooning fiscal crisis, and it becomes plausible that China could force commodities it buys to be priced in yuan.

It would be a reserve currency coup – a relatively stealthy, non-confrontational, market-driven resolution to the dollar “problem”.

Meanwhile, Ha is also a strong proponent of a global super-currency. However, he is opposed to floating exchange rates and is an advocate of managed rates. No prizes for guessing why if you’re China. Ha favors a New Special Drawing Right – IMF funny money – as the super-currency. However, it’s doomed to failure since the IMF would be responsible for liquidity and settlement.

Repricing commodities by, for and in China

Broadly framed, China’s commodity strategy looks something like this:

1. Incentivize domestic production and beneficiation.
   • Support infrastructure investments to move product efficiently and cheaply beyond the coastal zones.
   • Protect commodity industries from international treaties and obligations that raise costs (e.g. Kyoto, ILO).
2. Where domestic output cannot fill domestic demand, incentivize development and control of offshore supply chains.
   • Invest in bilateral trade diplomacy in frontier markets.
   • Own or control development of projects to lock up the offtake for China.
   • Own or control infrastructure whose primary beneficiary is the mineral or agriculture project.
   • Own or control export terminals.
   • Own or control bulk tonnage shipping units and infrastructure.
3. Encourage the removal of products from conventional 'Anglo-Saxon' market pricing, especially the spot market.
4. Develop price settlement in renminbi
   • Pursue dollar alternative diplomacy through multilateral institutions.
   • Provide incentives for clearing, settlement, and warehousing in China, in renminbi.
   • Redonominate commodity prices away from the dollar.
5. Progressively out flank cartels and dominated markets such as those for oil and iron ore.

Recently, the Wall Street Journal led with a crucial story about the final point. Entitled 'China Nurtures Futures Markets in Bid to Sway Commodity Prices'. "Government officials say the country is positioning its futures markets to be major players in setting world prices for metal, energy and farm commodities. By letting the world know how much its companies and investors think goods are worth, China hopes to be less at the mercy of markets elsewhere."No doubt that will draw plenty of scoffers who cannot imagine Chicago, New York or London being displaced. That would be a serious and short-sighted mistake.

China has proven extremely patient in its commodity strategies and tactics.

Lest anyone forget, Chicago and New York are relatively recent entrants to the world of commodities trading. Both ascended and dominated based on open societies that vacuumed up much of the world's hard commodity output, or sold a large proportion of the world's soft commodity needs. Only London, because of its vibrant capital markets, has been able to retain its commodity pre-eminence despite a declining consumption and production stature.

The trends are unmistakable if you monitor the data from the Futures Industry Association.

The Shanghai, Dalian, and Zhengzhou markets have steadily increased the volume and value of contracts being traded. We expect them to break into the top ten exchanges by volume shortly after this decade ends.

The challenge for China is to end its suspicion of foreign activity in its markets. That will happen, but China must first navigate its own confusion between sovereign independence and global integration. The two are not mutually exclusive, as the United States discovered by becoming and remaining an open society.

We would bet that China's futures market ambitions would be met in short order if it allowed the LME or CME an unrestricted right to set up shop there.

The WSJ insightfully observes: "Beijing believes hosting big futures markets will enhance the country's economic security by essentially advertising what the world's biggest customer for some commodities considers a fair price. For the rest of the world, the exchanges could mean less guesswork about China's buying habits, possibly reducing volatility in the global market."

Indeed. China must be encouraged to pursue its commodity futures markets strategy. The world has more to gain from the transparency of liquid commodities markets near the source of consumption. The worst alternative is the quasi military desire for state companies to bypass conventional markets using closed channels that they develop and own.

As Bloomberg noted in a story about London's LME mating season: "Competition from the Shanghai Futures Exchange is limited because foreign investors can’t trade on the Chinese exchange."

Before it can get there though China faces an uncomfortable adjustment - it can no longer rely on the US Federal Reserve to manage its monetary policy. It is going to have to allow the renminbi to appreciate. Now would be a good time to do it as America's consumers largely remain on debt strike, preventing them from buying all those trinkets that employ millions of factory workers.

© 2010, MineFund.com.

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