Wednesday, August 24, 2005

Chasing China

Blue Sky is correct in calling China's over-spending on oil assets The Winner’s Curse.

Chasing China to absurd prices is plain silly. It betrays a profound failure of understanding what's really going on.

Chinese currency is deliberately undervalued versus the Dollar -- by as much as 30-40%. Consequently, China's trade surplus is basically Dollar denominated, hence overvalued in local currency terms.

Why this matters is because Chinese liabilities are its people's savings denominated in local currency, hence undervalued in Dollar terms.

Running a financial system with overvalued assets financed with undervalued liabilities is a fool's game. China knows this but has few options to get out of the mess it has made. It's in this context that it's trying to swap its hoard of Dollars for real assets -- e.g., overseas oil reserves.

The notion that a large unrealized currency losses can be resolved by bidding up physical assets (even assets like oil reserves) is laughable. But that is China's new game. They think that their newly acquired assets will appreciate sufficiently to hedge some of the unrealized currency losses they have already incurred. In other words, they are trying to trade out of a gigantic mess. Likely, they'll turn up snake eyes.

When this happens and the currency corrects (as it absolutely will), the peasants will ask for their money back -- from bank's who won't have enough assets to make them whole. Then, one of two things will happen. Either China will dump physical assets at throwaway prices to generate liquidity, or Chinese domestic economy will stand destroyed. Either way, oil prices will tumble.

Given all this, is there any sense in chasing China up a foolish price ladder? Think about a similar dynamic with Japan buying up all manner of assets in the 80s at absurd prices -- only to sell them at much lower prices when the bubble collapsed.

When there's a desperate buyer in the game, the smart trader sells -- he does not chase prices at market highs. Does New Delhi understand this?

1 comment:

doubtinggaurav said...


While that may well be a reason behind chinese, I think they are also doing for energy security and independence. They fear (I think rightly), that in event of a serious disagreement with US, her energy sources will feel the most threat



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