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By: Costas Bocelli — January 19, 2011

"Hu's" Your Daddy Now?

Editor's Note:  Currencies are one of the hottest asset classes around, and many of you have written in and asked us to provide you with education and guidance in that area.  Today we're pleased to welcome Guest Contributor Tom Putney, who will be writing a series of articles for you on currency investing.  Tom brings more than 20 years of trading experience, including 6 trading the Forex market, where he traded $250 million in volume per month as a Certified Trading Advisor.  You'll find his first article immediately following Costas' contribution for the week.  We hope you enjoy his articles, and hope you'll welcome him to the Tycoon Report family.

The last time Chinese President Hu Jintao visited the United States, in April of 2006, President George W. Bush was the main man in charge.  U.S. economic confidence was high, and the "take it or leave it" approach was the common theme in dealing with foreign policy.

Nearly five years later, the global economic balance of power looks much different.  Although the United States continues to be the world's economic and military superpower, emerging markets are gaining at a rapid pace.

Last year, China finally surpassed Japan as the world's second largest economy by GDP, and although the U.S. economy is currently 3 times larger than China's, their rate of growth could actually see them vault to number one in the world by 2025, according to leading economists (China's economy is growing at 10% annually, while the U.S. is projected to grow by 3.5% in 2011).

The economic imbalances between the two trading partners have always been evident.  But the system seemed to work pretty well -- China would export goods that Americans needed at attractive prices, while investing their current account surpluses directly back into the U.S. by purchasing Treasury bonds, which in turn funded U.S. government spending.

Although China is still the largest foreign holder of U.S. Treasuries -- currently just under $900 Billion -- their appetite seems to be waning for Uncle Sam's finest paper.  This shift in how China appropriates its surpluses is becoming a serious issue.

China's foreign exchange reserves now total $2.85 Trillion, up another $200 Billion in 2010.  China's trade surplus with the Unites States has grown to over $270 Billion.  (The U.S. imported roughly $370 Billion from China, while exporting $100 Billion to the communist nation.)  The record trade deficit is approaching levels that are unsustainable, and is a huge drag on GDP.

The red flag is the divergence of China's surpluses being reinvested into U.S. Treasuries -- they're simply not keeping pace with the rising trade imbalance.

So What's Changed?

China has made it perfectly clear that they are unhappy with current U.S. monetary and fiscal policy, and with the direction the US dollar is heading.  There are two main problems, from China's perspective:  First, a weakening dollar has a negative effect on their Treasury portfolio value.  Second, the Federal Reserve's quantitative easing strategy to reignite growth domestically is putting huge inflationary pressures on other economies around the globe, particularly in China.

To combat these effects, China has begun to diversify their foreign exchange reserves by tweaking their investment allocation.  This shift is the main driver that makes this issue vitally important.  But if they're not buying Treasuries, what are they buying?

China is very active in Brazil, Russia and Venezuela.  All of these emerging countries have a common element -- Natural resources.  China is a major consumer of oil, iron ore, and base metals like copper.  They are redirecting a greater portion of their foreign exchange reserves to these investments, circumventing funds that would generally be used to buy U.S. Treasuries.

China's foreign exchange reserves have grown so large that they eclipsed the World Bank in total global lending in 2010.  Once upon a time, China was the biggest borrower of funds from the World Bank -- now they ARE the "Bank".

Many of the loans are cleverly tied to oil production and other resources that would be directed straight back to China.  China is also lending to emerging markets that are denominated in Yuan, which are in turn used to purchase Chinese goods and equipment.  China is clearly finding ways to diversify their exports and have less reliance on developed economies like the U.S. and Europe.

Is China Still an Opportunity, or a Growing Threat?

As the economic imbalances between the two countries have now hit dangerous levels, the United States must halt this growing divergence if they want to maintain the edge as the global superpower before it's too late.

This week's historic summit between President Obama and President Hu brought many of the issues to the forefront.

The U.S. administration is making it very clear that things must change, and bringing the trade imbalances more in line is an urgent priority.  China is under intense pressure to let their currency "appreciate" to market levels.  Many economists believe that the Chinese Yuan is undervalued by 30-40%, which gives them a huge edge.  The Yuan valuation is strictly controlled by the Bank of China and is monitored on a daily basis with a deliberate hand.

Congress is very close to passing legislation that would officially label China a currency manipulator.  The next step would be to "revalue" their currency for them by placing appropriate tariffs and penalties on their exports coming to the U.S. -- essentially starting a trade war.

Another major issue is how business is done in China.  American businesses blame China and their bureaucratic regulations that fail to protect intellectual property rights and piracy.  Also, government sponsored subsidies in many cases practically make it impossible to compete fairly as a foreign company in China.

President Hu has renewed a promise to make sure that U.S. companies in China are protected and treated fairly.  He goes on to say ...

"All Foreign companies in China are Chinese enterprises.  Their innovation, production and business operations in China enjoy the same treatment as Chinese enterprises."

Being that practically every major business is state owned in China, this statement is not very assuring.  This issue is very damaging to company trade secrets, patent infringements, and outright cannibalism of U.S. innovation.

The bottom line is that the trading relationship with China is not on a level playing field.  The reality is that it never really was, but the United States let it fester and ignored that this issue could someday get out of control, to the point that national economic and global security is threatened.

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