Risk and Reward: China's Golden Hammer

Tue, Dec 3, 2013 - 8:32am

Game Theory is the study of mathematical models of conflict and cooperation between rational strategic decision makers, which is essentially a fancy way of saying “Think about something from the standpoint of your opponent, and try to figure out what their most logical move is”. So I started thinking, which is admittedly a dangerous thing, about Game Theory in relation to China’s now considerable gold hoard. What follows is merely my attempt to stimulate a conversation on one of the most significant potential economic shifts any of us are likely to see. Please be warned that I claim no special training in or understanding of international currency flows, monetary policy strategy or implementation, or pretty much anything else. But since the financial press and others within the mainstream investing world seem intent on pretending that none of this is happening, well… somebody should talk about it.

Let’s do some crude, back-of-the-napkin calculations and see where this train of thought leads:

There are 35,274 ounces in a metric ton of gold. Let’s say that China’s actual total gold holdings are now around 5,000mt as reported in this Reuters article. Five thousand metric tons would be about 176 million ounces. As I type, the price of gold is roughly $1,250 per oz, meaning that China’s 176 million ounces would have a current market value in US Dollars of $220 billion dollars. Meh. No biggie.

But what would happen if the Chinese prominently announced their gold holdings publicly? Surely such an announcement would shock the financial world, and even more so if they then publicly called into question the status of US gold reserves (unaudited since 1952, probably for good reason). What if China made the claim that they now have the largest amount of gold reserves of any nation on earth, and dared the US to prove them wrong with a fully public audit? What if they announced this fact while at the same time prominently noting all of the separate trade agreements they have signed in the last two years that cut out the US Dollar from trade settlement- you know, the agreements they have signed with Russia, India, Japan, France, Australia, Brazil, and others? It seems quite probable, in such a scenario, that gold priced in USD would reset quickly some multiples higher.

I do not think that, in the resulting turmoil that would surely be caused by this scenario, a revaluation of gold to $10,000 per oz would be an unreasonable outcome. If so, what would/could this mean?

A revaluation of gold to 10,000$ per oz would make China’s “stack” worth 1.76 trillion in USD- a gain of 1.5 trillion dollars over its present worth. Not too shabby, but wait- there’s more. Let’s say that this gold was then used to “back” the Chinese Renmimbi in some sort of international trade settlement system… and really, what else are you going to do with a stack of gold that size? Let’s posit a realistic “gold backing” figure that most markets would accept- say a 20% backing. This leverages the value of the current Chinese gold hoard to 8.8 trillion dollars. Now we are talking some serious cheddar.

But wait, there’s more!

China has become the world's biggest trading nation in goods, ending the post-war dominance of the US, according to official figures. China's customs administration said the combined total for imports and exports in Chinese goods reached $3.87tn (£2.4tn) in 2012, edging past the $3.82tn trade in goods registed by the US commerce department… US total trade amounted to $4.93tn in 2012, according to the US Bureau of Economic Analysis (BEA) with a surplus of $195.3bn. But like most western nations, the US deficit in the trade of goods weighs heavily and is only expected to get larger. The deficit in goods was more than $700bn compared with China's 2012 trade surplus, measured in goods, which totalled $231.1bn. https://www.theguardian.com/business/2013/feb/11/china-worlds-largest-trading-nation

A scenario like this would mean that these figures would skew even more heavily to China and away from the US, thus leveraging the value of such a move even more in terms of future trade and “controlling interest” in the world economy. Suffice it to say that, even if the estimates given in this exercise are incorrect (and they almost surely are), it is still reasonable to suppose that some combination of these, centered on this now formidable gold hoard and coupled with various other stratagems at their disposal (use of their 1.3 trillion in US Treasury bonds, for example), could be used to accomplish essentially the same thing.

The bottom line is that China holds all the cards now: they are the largest export economy in the world, have the biggest concentration of manufacturing infrastructure and expertise in the world, and they now possess an enormous gold reserve (augmented by the largest gold mining output of any nation in the world, set to exceed a whopping 400 tons this year alone). They truly possess a Golden Hammer, and with one blow they could choose to establish themselves as the new economic Hegemon of the 21st century. They likely have the ability to do this right now, as we speak.

So why don’t they do it?

Aside from the obvious fact that the longer they wait the more powerful their position becomes, I suspect there are two interrelated reasons. One is the still formidable power of the US military (and particularly the nuclear weapons arsenal), and two is the irascible and “quick to anger” nature of the US public. The last thing China wants is for a hard crash to engulf the US economy and have a hot-tempered US public placing the blame squarely on China. Things could get out of control quickly, and this would not be in their long-term interests. In order for China to swing their Golden Hammer, it is imperative for them to be certain that the US public will be pointing fingers at Washington, not Beijing. They simply cannot afford to be the scapegoat for the inevitable destruction of the current US standard of living and the seething anger this will inevitably engender.

So it seems the most logical strategy for China is to 1. Quietly move pieces around the board, putting agreements, infrastructure, and resources in place to be ready to assert their position as Hegemon when the time is right, and 2. Wait patiently for a meltdown (of banks, markets, or the US economy as a whole) that will give them the cover to THEN make their big move without fear of provoking the US public and therefore risking a destructive military confrontation.

In the meantime, they continue to flex their geopolitical muscles in various places, such as unilaterally proclaiming a huge “no-fly without our permission” zone over international waters. They continue to sign trade agreements and have second-tier functionaries make public pronouncements about the weakness of the US dollar or about no longer accumulating US dollar currency reserves. They may even quietly work to hasten the process of western fiat crisis a bit in various markets, possibly using those 1.3 trillion dollars in treasuries, once they feel more confident of their position.

Regardless, what will really get my attention will be what China does in the aftermath of the next 2008-style western financial crisis. My suspicion is that they will wait until the self-inflicted wounds of the west finally result in a debacle the politicians and central planners cannot control or hide from the public. In the aftermath of such a crisis, they will wait until US public attention (and blame) is squarely directed at Washington, then they will swing their Golden Hammer.

And from that point on, the world will be a very different place.

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