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China, Blackstone & gold

China's $1 trillion in currency reserves has to find a home somewhere...

Is China diversifying into equities and into gold? Here is a snippet from the latest weekly issue from

THE CHINESE GOVERNMENT last year decided to change how it manages the composition of its currency reserves to better reflect the importance – by weight – of its trading partners.

   This was an effort to hold enough cash to cover 'rainy days' with these countries. But as China's currency reserves are already at levels way above those needed for such a 'rainy day', the Chinese government finds itself holding well over $1 trillion more than it needs – and this amount is rising by $250 billion a year.

   So what can Beijing do with these 'excess' funds? It can't enter the foreign exchange market to sell the US Dollar portion of its reserves. That would certainly hammer the value of the Dollar itself and probably start a run against the US currency. So that option's out.

  Invest in gold? Here at we believe they will, but the sheer size of China's reserves makes it impossible for Beijing to go into the open market to buy gold. After all, one tonne of gold only costs $20 million today. Fifty tonnes would only soak up $1 billion of China's $1 trillion in currency reserves.

   What would be easy for China to do instead would be to buy gold for their reserves via the purchase of local gold mining output – now around 250 tonnes a year.

   A mere $5 billion per year, this gold will be paid for with Yuan, the Chinese currency.

   Beijing wants to keep the surplus reserves away from the Chinese economy, avoiding the inflationary pressures which the torrent of Dollars could unleash. So the authorities will be cautious when doing this. Such caution will, of course, be tempered by a continuous expansion of the local money supply to accommodate the larger economy and its consequential demand for more money.

   Hence the purchase of local gold mining production is certainly on the table of choices in front of the Bank of China.

   A more appropriate way to ensure that there is gold in China is to expand the size of the local Chinese gold market through the widening of the gold market and direct encouragement to Chinese citizens to buy gold. We believe they want to do this. After all, the holding of gold by its citizens still leaves that gold within its reach of the Chinese government.

   What about other investments – such as bonds and equities? To date the Beijing authorities have parked their Dollars in US Treasuries, as most international surplus funds are parked in there, a sound situation it seems on the surface and from a risk point of view. But only if they're holding reasonable and not excessive amounts of the Dollar, the most liquid of markets in the world.

   They are under no illusions though, as all they have in their hand is a set of US government IOUs in very large quantities. This is not wise, as tensions arise against China from the US Congress, who watch from a distance as China's cheaper prices and goods are sapping US global economic power.

   Indeed, China must realize that the US government has the capability of exerting control over the value of its paper promises – and there's little that they, the owners of that paper, can do about it.

   The States could retain control over this paper by even imposing Capital Controls such as the following:

  • Impose controls over the excessive selling of these instruments – much as other nations, including South Africa, did in the past. They placed a moratorium over the repayment of debt when there was a run on the Rand.
  • Institute a dual currency system – as Britain did in 1971, whereby capital had a different rate on the foreign exchange markets to that given to commercial transactions. This ensured investors suffered if they withdrew their capital from the country, but it rewarded those who introduced new capital to the country.

   Either way the States can keep a grip on China's and all other Dollar investors' money, justifying it in the national interests of the US. China's immediate problem is that it is stuck with a currency that is likely to fall and vulnerable to government control if the global reserve currency status of the Dollar is rattled.

   What other options are open to China? It has to move away from holding excess Dollars and Dollar derivatives, so as to lower the risk from these holdings. And there is one certain way, which has worked in the past, but it could meet obstacles if the politicians get excited – a near certainty on this matter.

   It is to convert the excess paper currency and its derivatives into real assets. This means China must move its money out of the 'parking bay' of US Treasuries and buy equities – and more solid assets as well – instead.

   No, we're not talking about across the board minority shareholder stakes in a sound, well-spread equity portfolio. That would see China immersed in the US economy, still under the control of the US authorities, but in a worse situation than when they held Treasuries.

   In the position of non-controlling equity holders, the Chinese would now find they faced far greater risks, ones that no central bank could countenance. Instead, China would have to buy majority positions in companies or even in their entirety, so that it controlled them.

   Ideally strategic companies would be the targets too, companies who could help China develop itself – as well as retaining value and growing inside the United States. Expect huge development contracts to go to companies with a majority Chinese shareholding, enhancing their value even more. Such companies can be listed in the US or even on foreign stock markets, just so long as the Chinese pay for them with their US Dollars.

   Such a policy would pose no risk to the Dollar exchange rate; even foreigners will be happy to be paid in the US Dollar at present. China would then find itself under the same legislated protections as US companies are today. It would also be free from US influence in the case of foreign companies in whom it's bought majority stakes.

   The damage caused by the flight from Treasuries would be ameliorated by the actions of the Fed to some extent. It would be more than compensated by the potential increasing value of China's new equity investments.

   After all, if US Treasury rates rose strongly, they would pull the US equity market down and cheapen the purchase prices of the shares the Chinese sought – a fair quid pro quo?

   Such policies would be the 'spoils' of the economic battle the Chinese are winning. Their selective conquest of the US economy and its expertise would thereby enhance Chinese growth, and ease its way into the position as the top global economy.

   What would be the first step on such a road? Buy into a company that will get you the majority positions in your target companies. Last week saw the announcement of China's intention to use $3 billion of its foreign exchange reserves to buy a 9.9% stake in Blackstone, the US buy-out fund.

   The investment will coincide with Blackstone's landmark $40 billion stock market listing, expected in the next few months. Quite rightly, Stephen Schwarzman, Blackstone's chief executive, hailed the deal as an "historic event that changes the paradigm in global capital flows."

   Cleverly, under the terms of the deal, the Chinese government has given up its voting rights associated with the stake in Blackstone. Wisely, the move is aimed at defusing any US political opposition to the deal. In its prospectus, Blackstone warned that its priority was to return cash to the private investors in its funds, rather than to pay dividends to shareholders. After all the Chinese want more valuable assets not dividends.

   The investment will come through a new Chinese agency charged with managing part of the country's $1,200 billion in foreign reserves. The price of the stake to be sold to Beijing will be at a slight discount to the one paid by investors in the initial public offering. It is understood that China's foreign reserve agency has agreed not to invest in rival private equity groups for 12 months. We are sure Blackstone had to pay a heavy price for looking after China's interests to get this 'monopoly'.

   This is the start of a new and likely perspicacious policy by Beijing. The first obstacle in its way will be when politicians see the buyouts as a threat to the US. This could be well down the road.

   And now Saudi Arabia is diversifying from the Dollar into real assets, and for similar motives, too. Riyadh-based chemicals company Saudi Basic Industries Corp. is in the lead to buy General Electric Co.'s plastics business. It looks like bidding for the business could approach $11 billion. But the Saudi government is under the thumb of the US and would never pose a threat to the US as they are wholly dependent upon the US for their power.

   The Chinese are not under the influence of the US. Such a takeover would be seen as tame foreign direct investment into the US.

   GE, the world's second-largest company by market capitalization behind Exxon Mobil Corp., has close ties to the Saudi government. In December and January alone the company received about $2 billion in orders for Saudi infrastructure projects.

   China is to follow this thinking. But with $1.2 trillion to spend, so far, they are able to impact on the US economy heavily. This will make the companies it buys extremely attractive, as they will be backed by the Chinese government with a whole nation to develop.

   Don't be naïve enough to think that the US economy is going to benefit, however, as a whole. The purpose of the investments will be to benefit the Chinese economy first. Any US benefit will be incidental!

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JULIAN PHILLIPS – one half of the highly respected team at – began his career in the financial markets back in 1970, when he left the British Army after serving as an Officer in the Light Infantry in Malaya, Mauritius, and Belfast.

First he worked in Timber Management and then joined the London Stock Exchange, qualifying as a member and specializing from the beginning in currencies, gold and the "Dollar Premium". On moving to South Africa, Julian was appointed a macro-economist for the Electricity Supply Commission – guiding currency decisions on the multi-billion foreign Loan Portfolio – before joining Chase Manhattan and the UK Merchant Bank, Hill Samuel, in Johannesburg.

There he specialized in gold, before moving to Capetown, where he established the Fund Management department of the Board of Executors. Julian returned to the "Gold World" over two years ago, contributing his exceptional experience and insights to Global Watch: The Gold Forecaster.

Legal Notice/Disclaimer: This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment. Gold Forecaster/Julian D.W. Phillips have based this document on information obtained from sources they believe to be reliable but which it has not independently verified; they make no guarantee, representation or warranty and accepts no responsibility or liability as to its accuracy or completeness. Expressions of opinion are those of Gold Forecaster/Julian D.W. Phillips only and are subject to change without notice. They assume no warranty, liability or guarantee for the current relevance, correctness or completeness of any information provided within this report and will not be held liable for the consequence of reliance upon any opinion or statement contained herein or any omission. Furthermore, they assume no liability for any direct or indirect loss or damage or, in particular, for lost profit, which you may incur as a result of the use and existence of the information, provided within this report.

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