Can China and Japan save the US dollar?

Gold was around $570 an ounce when I wrote the last commentary two weeks ago. Since then it has dropped to $540 an ounce and is now back up to $555 an ounce. The theme in many prior commentaries has been that we should expect an increase in volatility; we have certainly started to see that happen although I don't think we have seen the last of it. I would not be surprised to see even more volatility ahead.

For most part these commentaries reflect my views and opinions of current events as they relate to the gold market and the macro economic environment in which we find ourselves. But every now and then I get the chance to write an article that I think is quite fundamental, and certainly important to my own investment paradigm. The previous commentary: 'Change is upon us', is one of them. If you have not read it you can find it on my website in the Commentary Section (www.paulvaneeden.com).

In that article I made the point that both China and Japan seem to be re-evaluating their positions towards the US dollar. More specifically, I believe we have seen the beginning of the end of unquestionable dollar-support from those two countries. The repercussions for us in North America are higher interest rates, a lower US dollar exchange rate - which means higher costs of imports, including fuel - and, as a result of higher interest rates, slower economic growth.

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After last week's commentary I received several emails from readers who suggested that China and Japan would not allow the dollar to fall, since they each have about one trillion dollars in their foreign reserve accounts and the losses they would incur due to a declining dollar would be too great. Not only would they realize losses in their foreign reserve accounts, a weaker US dollar would also make their exports more expensive to US consumers and that could in turn hurt their export-driven economies. Those are good points, but completely irrelevant. Here's why.

The argument that China and Japan would not let the dollar fall assumes first of all that they have a choice in the matter. Up until now it has taken a concerted effort by both China and Japan, as well as an enormous demand for US assets from private international investors such as pension funds, mutual funds and hedge funds, to keep the dollar afloat. When all these players together desire US financial assets then the dollar can stay afloat. But when appetite for US financial assets starts waning, the house of cards implodes. So you have to ask yourself, will international demand for US financial assets remain as strong going forward, as it has been in the past?

The US economic expansion - if there currently is one - has only been made possible during the past several years by rapidly rising real estate prices that have injected large amounts of money into the US economy through cash-out refinancings, etc. Take away rising real estate prices and you will be hard pressed to find a stimulus for US economic growth. Now consider that inventories of homes for sale in the US are at a 19-year high, affordability is at a 14-year low, home prices have started falling and home ownership has begun to decline. Home starts in February were down 7.9% from a year earlier and new home sales in January fell by 5%. As I said, if you take away the growth in real estate then you pretty much take away the fuel that fires US economic growth.

On March 11 the Wall Street Journal ran an article that started: 'As interest rates rise and the housing market cools, there are hints that Americans are weaning themselves off the home-equity lines of credit that have helped sustain consumer spending.' According to Federal Reserve data, the volume of home equity lines of credit, that have been growing at an annual rate of 30% to 40%, have started leveling off. There have been numerous signs during the past several months that the real estate boom is over. It is just the realization that still has to sink into the minds of Americans, and investors alike.

It may be that the US auto industry's woes are unique, but I still find it interesting that at the height of the greatest of the greatest economic expansions in American history, four multi-billion dollar auto parts makers have filed bankruptcy and just this week GM announced that it expects its loss for last year will be more than $10 billion! Does this sound like a healthy economy?

Okay, so that's the auto industry and we all know that higher gasoline prices knocked them hard, so let's look at computers. Intel warned earlier this month that its first-quarter revenue would miss estimates on weaker-than-expected demand. The company also warned that its operating margins are being squeezed by lower revenues. Even Dell, the largest PC seller in the world, is starting to show signs of strain in the US. While its revenues were up strongly in the fourth quarter of last year, most of the growth came from outside the US and the company's forecast for first quarter revenues this year was below expectations when released.

What about retailers? Radio Shack posted a 62% decline in fourth-quarter net income as weakness in wireless sales and other high-margin (read higher-end) product lines hurt the company's profitability. The company announced that it may close as many as 700 stores.

Let's look at durable goods orders: The Commerce Department announced that durable goods orders decreased by 10.2% in January - the largest decline in more than five years. This is not necessarily as bad as it sounds, since the data is heavily skewed by orders for new aircraft, which can be volatile, and defense spending. But even if we look at non-defense capital goods, excluding aircraft, we still see a decline.

The Commerce Department put on a brave face and announced that the US economy expanded at a slightly stronger pace in 2005 than suggested by earlier estimates, but that a slump in consumer spending held growth to its slowest pace in three years. Now, let's get back to answering the question about whether China and Japan will allow the dollar to fall.

The reason that China and Japan have been supporting the dollar is that they both run export-driven economies and with a strong US dollar, US consumers had great appetite for their products. But, if US consumption has reached its limits, and the growth of US consumer spending is nearing an end, then the marginal benefit to China and Japan for supporting the US dollar has also come to an end.

There is nothing they can do about the losses they will suffer in their foreign reserve accounts but there is also no need for them to add more dollars to those reserve accounts. Also, as I mentioned, China and Japan are unlikely to be able to support the US dollar if private investment funds lose their appetite for dollar-investments. Given the state of the US economy, do you think that the biggest and best pension fund, mutual fund and hedge fund managers are going to continue scrambling to buy US assets?

My guess is that as more and more bad news comes out of the US, the demand for US assets is going to decline and either China and Japan are going to have to buy more US dollar assets than ever before, or the dollar will fall. Each of them would have to add almost 40% to their US dollar reserves this year if they had to support the US dollar alone. Since both China and Japan have in recent years clearly demonstrated that their demand for US assets is diminishing, and given the announcements they have made of late (see previous commentary), I suspect that they know the game is up.

So, you see, it is not that China and Japan want to lose money on the US assets they hold in their foreign reserve accounts, it is more a question of, what can they do about it? The one thing they can do to mitigate the effect of a slowing US economy on their own economies is to reinvest some of those dollars into their own local economies. Watch for that to happen, because doing so would also entail selling US dollars and that would put further pressure on the US dollar.

When you're having a wild party and the police bang on the front door everyone rushes to get out the back door. They will leave their jackets, coats and drinks behind without even thinking twice about them. Don't let the large dollar reserves that China and Japan hold fool you, there is a much bigger picture here than just their reserves.

First published on Kitco.com (www.kitco.com)

By Paul van Eeden

Paul van Eeden works primarily to find investments for his own portfolio and shares his investment ideas with subscribers to his weekly investment publication. For more information please visit his website (www.paulvaneeden.com). If you would like to read more from Paul, you can sign up to get his weekly commentary at https://www.paulvaneeden.com/commentary.php.