Yesterday, we had a couple of Fed Heads talking, but the Big Kahuna stood out and moved the markets with his statements… Here’s the skinny…

Big Ben was giving a speech, and said, “The Fed will monitor closely the currencies, and the Fed’s policies will ensure that the dollar is strong.” Now, when he first uttered those words, the dollar got bought and the non-dollar currencies were sold… But then, a few of us had this feeling… It was a feeling that we had heard all this before… And there – in the archives, circa June 2008 – Bernanke said, “In collaboration with our colleagues at the Treasury, we continue to carefully monitor developments in foreign exchange markets.” Wait! We won’t get fooled again!

In June 2008, his statements spooked the markets into believing the Fed was really going to do something to bolster the dollar… But when nothing came along, the dollar REALLY got sold until the financial meltdown of August 2008… I mean… What has the Fed done in the past 1 1/2 years to “bolster the dollar”? Near zero interest rates that will remain in place for longer than they should… Quantitative easing… A bloated balance sheet of toxic bonds.

You could see the V-8 moments on traders’ faces when they realized, yesterday, that all this had been said before, and nothing came of it, so… We won’t get fooled again!

So, then traders reversed their buying of the dollar and sent the dollar to the woodshed. You should have seen the reversal… It was amazing…

Click here to read the rest of Mr. Butler’s article.

This controversial proposal – and the support that it’s getting – also underscores China’s continued emergence as a growing global force in both the financial and political arenas. That’s a trend that successful global investors won’t be able to ignore.

The recent torrent of criticism to swirl around the dollar began with remarks by Chinese Premier Wen Jiabao.  Speaking last month at a press conference leading up to the recent Group 20 meeting in London, Premier Wen voiced his concern about the value of China’s large holdings of U.S. Treasuries.

“We have lent a huge amount of money to the United States,” he said. “Of course, we are concerned about the safety of our assets. To be honest, I am definitely a little bit worried. I request the U.S. to maintain its good credit, to honor its promises and to guarantee the safety of China’s assets.”

Of China’s $2 trillion in foreign currency holdings, about $1 trillion is invested in U.S. Treasuries and notes issued by other government affiliated agencies, such as Fannie Mae (FNM) and Freddie Mac (FRE).

“They are worried about forever-rising deficits, which may devalue Treasuries by pushing interest rates higher,” JP Morgan & Co. (JPM) analyst Frank Gong told The Associated Press. “Inside China, there has been a lot of debate about whether they should continue to buy Treasuries.”

Earlier this year, the Congressional Budget Office (CBO) projected that the U.S. budget deficit would nearly triple from last year’s $455 billion – and would reach a staggering $1.2 trillion. And that was even before U.S. President Barack Obama unveiled his $787 billion in stimulus, bank-rescue and anti-foreclosure plans. And that massive projected shortfall also doesn’t include other fix-up initiatives that are sure to surface in the months ahead.

But rather than sit idly by and watch the value of its reserves be eroded by the U.S. government’s economic policies, China is trying to lay the foundation for future change.

China and the SDR

On the eve of the G-20 summit, Zhou Xiaochuan, governor of the People’s Bank of China, released an essay entitled “Reform of the International Monetary System” on the BOC’s Web site.

Without explicitly mentioning the U.S. dollar, People’s Bank Gov. Zhou asked what kind of international reserve currency the world needs in order to secure global financial stability and facilitate economic growth.

According to Zhou, the dollar’s unique status as the world’s primary currency reserve has resulted in increasingly frequent financial crises ever since the collapse of the Bretton Woods system in 1971.

“The price [of relying solely on the dollar] is becoming increasingly higher, not only for the users, but also for the issuers of the reserve currencies,” Zhou said. “Although crisis may not necessarily be an intended result of the issuing authorities, it is an inevitable outcome of the institutional flaws.”

Zhou called for the “re-establishment of a new and widely accepted reserve currency with a stable valuation” to replace the U.S. dollar – a credit-based national currency. The central bank governor noted that the International Monetary Fund’s Special Drawing Right (SDR) should be given special consideration.

Created by the IMF in 1969 to support the Bretton Woods fixed exchange rate system, the SDR was redefined in 1973 as a basket of currencies. Today, the SDR consists of the euro, Japanese yen, pound sterling, and U.S. dollar.

“The SDR has the features and potential to act as a super-sovereign reserve currency,” said Zhou. “Moreover, an increase in SDR allocation would help the Fund address its resources problem and the difficulties in the voice and representation reform. Therefore,efforts should be made to push forward a SDR allocation.”

Zhou proposed the following actions to move the SDR in a direction that could better accommodate demand for a more stable reserve currency:

• Set up a settlement system between the SDR and other currencies. Therefore, the SDR, which is now only used between governments and international institutions, could become a widely accepted means of payment in international trade and financial transactions.

• Actively promote the use of the SDR in international trade, commodities pricing, investment and corporate bookkeeping. This will help enhance the role of the SDR, and will effectively reduce the fluctuation of prices of assets denominated in national currencies and related risks.

• Create financial assets denominated in the SDR to increase its appeal. The introduction of SDR-denominated securities, which is being studied by the IMF, will be a good start.

• Further improve the valuation and allocation of the SDR. The basket of currencies forming the basis for SDR valuation should be expanded to include currencies of all major economies, and the GDP may also be included as a weight. The allocation of the SDR can be shifted from a purely calculation-based system to one backed by real assets, such as a reserve pool, to further boost market confidence in its value.

China Rallies BRIC Allies

While China has been the most vocal proponent of a new – less-dollar-oriented – global currency system, other countries around the world have taken up the cause.

Russia, as Thursday’s videoconference illustrated, is working with China to push for an overhaul of the current currency system. In fact, the creation of a new reserve currency to be issued by international financial institutions was one of the measures Russia proposed to the G-20 on March 16.

Russia and China have also been joined by India and Brazil. Representatives from each of the four BRIC countries met in the weeks before the G-20 summit, and an unnamed source told Reuters that a shift away from the dollar was discussed.

“They (China) did not formally put forward their position for the G-20 summit but unofficially they had distributed their paper regarding the same ideas (the need for the new currency),” the source told Reuters, speaking on condition of anonymity.

Shortly after the G-20 meeting, Russia proposed that the IMF or G-20 study the creation of a new international reserve currency.

“The new global reserve currency has not been discussed at the summit. We only discussed it at several bilateral meetings,” Russian President Dmitry Medvedev’s chief economic aide, Arkady Dvorkovich, told a news briefing.

Weeks later, China agreed to a $10 billion (70 billion yuan) currency swap with Argentina.  That deal will allow China to receive yuan, instead of dollars, for its exports to the Latin American country.

Including the latest deal with Argentina, Beijing has signed about $95 billion (695 billion yuan) of currency deals with Malaysia, South Korea, Hong Kong, Belarus, and Indonesia over the past few months.

These deals undermine the status of the dollar as the world’s leading trade-and-reserve currency, but they also broaden the status of the yuan – something policymakers in Beijing see as being vital to China’s economic success, particularly in light of the current financial crisis.

“Beijing has its eye on raising the status of the yuan,” Ben Simpfendorfer, an economist at the Royal Bank of Scotland Group PLC (ADR: RBS), told The Associated Press. “They are the world’s second-largest exporter and the third-largest economy, so it is in their interest to handle trade in the yuan.”

While it continues to push for reform, China is also realistic about a timetable for achievement.

“”When a problem comes up, it’s always better to discuss it than not. But important reforms take more than one or two days,” Sun Zhongtao, a professor of international strategy at the Central Party School in Beijing, told the AFP. “Under the new system, the dominance of the dollar is set to be challenged. But it’s impossible to reach consensus on such issues overnight.”
But for many analysts, the support that China has been able to drum up in just a short matter of time is evidence of the nation’s growing economic and political clout.

“In the Asian financial crisis, China kept a relatively low profile and it didn’t assume any kind of leadership role at that stage,” Brian Bridges, a political scientist at Hong Kong’s Lingnan University, told the AFP. “Now the contrast is very significantly different in terms of China being much more open and involved in the financial system.”

For Bridges China’s determination to flex its financial muscle and expand political influence is what sets it apart from other would-be success stories, like the Japan of 1980s.

“In the case of China, you have a power which is almost simultaneously both becoming a rising economic power and also [becoming increasingly] involved in political and security issues around the world,” said Bridges. “It’s slightly different from the Japan model, because Japan was first an economic power and there was expectation it would become important in political and security issues. But it never actually fulfilled that role.”

Source:  China Flexes its Muscles and Finds Support in a Bid to Dump the Dollar as the World’s Main Reserve Currency

When China announced a new array of stimulus measures earlier this month, this very important plan was overshadowed by China Premier Wen Jiabao’s concerns about the United States’ quickly growing debt load.

“We have lent a huge amount of money to the United States,” Premier Wen said. “Of course we are concerned about the safety of our assets. To be honest, I am definitely a little bit worried. I request the U.S. to maintain its good credit, to honor its promises and to guarantee the safety of China’s assets.”

China has cause to be concerned: As of December, the most recent figures available, China held $727.4 billion in Treasuries – about 26% more than the $578 billion in U.S. government securities the Asian giant held at the end of 2007. More than half of China’s nearly $2 trillion in foreign currency reserves are tied up in U.S. Treasuries and notes issued by other affiliated agencies of the U.S. government – including beleaguered mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE).

However, the value of U.S. Treasuries has dropped steadily since the government began selling record amounts of debt to finance its economic stimulus packages. Investors have lost an average of 2.7% in 2009, according to Merrill Lynch & Co. Inc.’s U.S. Treasury Master Index.

China’s leaders “are worried about forever-rising deficits, which may devalue Treasuries by pushing interest rates higher,” JP Morgan & Co. (JPM) analyst Frank Gong told The Associated Press. “Inside China there has been a lot of debate about whether they should continue to buy Treasuries.”

And as the U.S. debt soars as the government works to halt the worst financial crisis since the Great Depression, China’s concerns about this country’s growing deficits – and its creditworthiness – are escalating in kind.

Depending upon how it did so, were China to stop buying U.S. debt – or even worse, to start dumping it – the economic fallout could be widespread, and perhaps even catastrophic:

• The U.S. dollar would drop 15%-20%.
• U.S. stocks would get hammered.
• Inflation would spike and interest rates on Treasuries would jump into the 8% range.
• And the economy would end up flat on its back – where it would stay, with no rebound on the horizon.

Detailing the Deficit

During the first five months of the 2009 fiscal year, which began Oct.1, the U.S. budget deficit hit a record $764.5 billion. Last month, President Obama outlined a $3.94 trillion budget plan that would take the deficit to $1.75 trillion by the time the fiscal year ends Sept. 30. The plan then calls for a $1.17 trillion deficit for fiscal 2010.

As currently projected, the U.S. budget deficit is forecast to run at about 12% of gross domestic product (GDP) – even worse than the perennially anemic Japan, where the deficit is running at 11%. And the debt picture is certain to get worse.

The Treasury Department has the government’s printing presses running overtime just to finance the $787 billion stimulus passed by Congress earlier this year. And in order to pay for all the stimulus, bailout and fix-it plans that are being put in place to arrest the U.S. economic decline, the U.S. government is assuming a murderous amount of debt: Over the next decade, the Congressional Budget Office projects that the White House budget will run $9.3 trillion in deficits.

That’s $2.3 trillion more than the Obama administration had forecast. But even the CBO projection could prove way too low: It assumes that the U.S. economy – after declining 1.5% this year – will turn around an advance at a racy 4.1% clip in both 2010 and 2011, a forecast that seems far too rosy, given the depths that the U.S. economy appears to have reached.

And that brings us to China.

Enter the (Red) Dragon

During the past several years, government-operated “sovereign-wealth funds” (SWFs) from virtually every major economic powerhouse around the world had been on a global shopping spree, buying up assets and bidding up prices as they did so.

China was no exception.

So when worldwide financial-asset prices began to slide – and then to nosedive – China abandoned many of its riskier holdings, choosing to boost its stockpile of U.S. Treasury securities. That underscores one marketplace truism: Despite Premier Wen’s reservations, the market for U.S. debt is the only market large enough, liquid enough, and stable enough to accommodate China’s large-scale investments.

That’s forced China to engage in a kind of global investor activism – although, so far, most of that activism has been aimed at one country: The United States.

About one-fifth of China’s currency reserves were tied up in Fannie and Freddie debt last fall when the two mortgage firms were placed under government conservatorship, The Washington Post reported.

In fact, as Money Morning detailed back in September as part of its ongoing investigation of the bailout of the U.S. banking system, that U.S. government decision to take control of Fannie and Freddie was driven not by worries about the fading U.S. housing market, but by concerns that foreign central banks in China, Japan, Europe, the Middle East and Russia might stop buying our bonds.

China clearly made its risk concerns known at that time, adding to the sense of urgency U.S. officials felt to make a move. Today, as U.S. debt continues to mount at an obscene rate, financial and economic risks also escalate. This could lead to a spike in inflation and interest rates – a double-whammy that could cause any recovery that’s under way to sputter and stall. That duo of higher inflation and interest rates could also hammer bond values, including the Treasuries held in such large quantities by China. So it’s no wonder the risk concerns China articulated back at the time of the Fannie and Freddie takeovers go double or triple now.

Indeed, when Premier Wen unveiled the spending measures earlier this month, he made the point of saying that China should seek to “fend off risks” by further diversifying its reserves.

“We have already adopted a guiding management policy of diversifying our foreign exchange reserves, and at present our foreign exchange reserves are safe overall,” Wen said. “Our first principle in managing foreign currency is averting risk. We have always adhered to the principles of foreign currency security, liquidity and maintaining value, and implemented a strategy of diversification.”

When it comes to U.S. government debt, that strategy will take one of three forms, and will have the following potential effects:

1. Quietly threatening to stop purchasing (or even threatening to “dump”) U.S. Treasuries, a form of “back-channel” communications that can generate results (just look at how China forced the U.S. government to place Fannie and Freddie in conservatorship). Because this is back channel, it stays out of the marketplace, so long as the U.S. government finds some ways to appease Chinese investors by somehow reducing risk.

2. Quietly slowing or stopping its purchases of U.S. government debt. If China does this effectively and systematically, the fact that it’s cutting back on purchases doesn’t surface until the plan is executed. If China is able to pull this off – and it faces long odds to do so – the fact that it’s cutting back on U.S. debt doesn’t roil the markets too badly, especially if it doesn’t leak out until after the fact.

3. Publicly dumping U.S. debt. Self-explanatory in nature – and also the most unlikely, if it wants to maintain its “friendly” status with the United States – this is the worst-case scenario, and is the one that ends up with the dollar and the stock market getting stomped. If China chooses this route, it’s also essentially cutting off its nose to spite its face. The reason: By publicly dumping U.S. debt, the Treasury market will also take a beating – meaning China’s remaining U.S. debt holdings would take a haircut of 20% to 30%.

The Marketplace Realities

International demand for long-term U.S. financial assets actually fell in January, reflecting China’s smallest net purchase since May, Bloomberg reported.

International investors sold a net $8.4 billion in U.S. corporate debt in January, the report showed. Net foreign purchases of Treasury notes and bonds were a net $10.7 billion in for the month, after purchases of $15 billion a month earlier.

Few analysts believe China will abandon its Treasury holdings altogether, as that would hammer the dollar, hurt the value of its debt holdings and ruin its political relationship with the United States.

Besides, it’s becoming increasingly clear that Beijing wants a voice in Washington.

Yu Yongding, a former advisor to the Bank of China said last month that China should seek guarantees from the U.S. government that its holdings won’t be diminished by “reckless policies.”

Premier Wen echoed that request last week when he called on the United States to “honor its promises and guarantee the safety of China’s assets.”

“I think what they’re trying to say right now is, ‘Don’t take any steps that would impair our ability to access your market,’” Auggie Tantillo, executive director of the American Manufacturing Trade Action Coalition, told The Post. “The Chinese are starting to flex their muscles, they are becoming more powerful commercially and economically, and they want us to know it.”

The very possibility that China and other foreign countries would stop buying U.S. bonds already was enough to prompt the U.S. government to take control of foundering mortgage giants Fannie Mae and Freddie Mac.

Source: The Three Ways China May Deal With Growing U.S. Debt

Back in 2001, the Goldman Sachs Group Inc. (GS) – eager to push its clients toward emerging markets investment – created the acronym “BRIC” to stand for Brazil, Russia, India and China, the four emerging markets the investment bank’s strategists believed would become a dominant part of the world economy in the years ahead.

Such was the case until the global financial crisis happened. Now, Russia is falling out of investor sunlight and into the pits of recession.

Russia’s Economic Development Minister Elvira Nabiullina projects a 2.2% gross domestic product (GDP) decline for 2009, according to EurasiaNet. But the current global financial crisis is making previous estimates look foolish and impossibly rosy (U.S. GDP was originally estimated to fall 3.2% for the fourth quarter. In reality, GDP plunged 6.2%).

The culprits: A falling ruble, plummeting oil prices, war with Georgia and a gas-export dispute with the Ukraine.

Russia’s economy is heavily reliant on its oil reserves, making the effects of falling oil prices easy to measure. But the silent killer of the Russian economy has yet to be full measured – the money spent in a thus-far vain attempt to prop up its falling ruble.

The ruble recently fell to a level not seen since 1998, a scary statistic because that was the year Russia experienced a nationwide banking crisis – and it was also a period during which world markets were being roiled by the Asian Financial Crisis, also known as the “Asian contagion.”

In an effort to cushion the ruble’s fall, Russia has spent $245 billion since August, as policymakers sold more than a quarter of the country’s gold and foreign-currency reserves. Russia’s reserves, the world’s third-largest, stood at $426.5 billion on Jan. 9, according to BNP Paribas SA.

That has some economists calling for a “free-float” – or a big devaluation – to avoid depleting all of the reserves.

The tactic, and the accompanying effect on investors, is nearly identical to that of 1998, when the ruble fell 71% against the dollar before finally stabilizing after the government defaulted on $40 billion of debt. Investors are fleeing Russia because the government is tapping its reserves to defend the ruble, further eroding investor confidence and undermining the currency.

Brazil, India and China are currently faring far better than Russia currently, but are still dealing with their own unique struggles. That has led analysts to question the viability of the BRIC acronym.

Milton Ezrati, a senior economist and market strategist at Lord Abbett & Co. LLC, recently published a report titled, “Broken BRIC,” in which he questions the notion of lumping those economies together – especially in view of their wealth of differences.

“We, at Lord Abbett, were always skeptical of BRIC,” Ezrati said in an interview with MarketWatch.com, noting that investors should diversify beyond emerging markets. “The whole concept behind the BRIC, that these four countries were leaders, is no longer the case today.”

Ezrati no doubt has his share of dissenters, who can quickly point out that while the stock markets of China, India and Brazil are taking their lumps, they are the only major economies in the world with positive GDP growth.

Effect on Local Elections

Looking at Russia’s recent local election results, the country’s decline into the financial red is having little effect on the popularity of United Russia, the party of former President and current Prime Minister Vladimir Putin.

Elections were held yesterday and preliminary results show United Russia racking up commanding leads in local elections around the country, The Associated Press reported. Of course, allegations of election violations abound.

But the bottom line is that those in power are keeping it. Doing so engraves their names next to the economy’s decline; but it also gives them a chance to take credit for recovery if their policies work.

Source: Russia’s Economic Demise Could Turn “BRIC” to “BIC”

The IMF will lend Iceland $2.1 billion, and Finland, Sweden, Norway and Denmark will loan $2.5 billion to help the country re-float its currency and shore up its banking sector.

The Icelandic krona, or crown, has lost about 70% of its value since the nation’s financial crisis first began. The government put restrictions on currency trade as it wrestled with the crisis, however one of the stipulations of the IMF loan is that Reykjavik once again float its currency. Once it does, it’s likely that there will be a “massive currency outflow,” Iceland’s central bank said.

The krona, which traded at 176 against the euro at a Nov.19 auction, could trade weaker than 250 per euro after the float, Lars Christensen, chief analyst at Danske Bank A/S, told Bloomberg.
“They’ll have to accept that there’ll be a pretty significant pressure on the currency when they reintroduce a free float,” Christensen said.

The IMF said that $827 million of its loan would be made available immediately and the rest in eight installments of about $155 million, subjected to quarterly reviews.

Iceland will also get about $6.3 billion from the United Kingdom, the Netherlands, and Germany to cover foreign deposits at Icesave – a unit of the failed bank Landsbanki Islands.

“Iceland is in the midst of a banking crisis of extraordinary proportions,” John Lipsky, deputy managing director of the IMF, said in a statement. The country “is facing a severe recession, given the high debt level in the economy and significant dependence of the private sector on foreign currency and inflation-indexed debt.”

The debt burden resulting from IMF, European, and Nordic loans totals nearly $11 billion, greater than the nation’s gross domestic product (GDP). The Icelandic economy is worth roughly $7.5 billion, based on 2007 GDP at current krona exchange rates, Bloomberg reported.

Divided amongst a population of 320,000, each citizen would have to come up with $34,375 to pay off the debt. But that’s only if Icelanders stick around.

Up to a third of Iceland’s population is considering leaving the island, the Financial Times reported. That kind of exodus would result in even less tax revenue and economic development and deepen a recession that is already expected to be severe.

The IMF expects Iceland’s GDP to contract 9.6% next year, while Danske Bank’s Christensen estimates the economy will contract by a full 10%.

Source: Iceland Gets $11 Billion Bailout, but Will be Saddled with Debt for Years to Come

As food and energy inflation climb to their highest levels since 1990 worldwide, central banks in Latin America, the Baltics, Balkans and South Africa are raising interest rates. And if the U.S. was fighting a toxic cocktail of both inflation and deflation, the U.S. would probably raising rates too.

But now that commodities are hitting all-time highs, investors are losing confidence that central banks can arrest inflation.

Gold hit an all-time intraday high of US$1,033 an ounce in March. And now gold is heading to breach that level over the next few weeks, if not sooner.

Gold continues to blast past all currencies since 2005 – including the mighty euro, Brazilian real and the Canadian dollar. This tells me that despite big gains for most currencies against the dollar this decade, they pale in comparison to gold and other hard assets.

Monetary reflation is now alive and kicking just about everywhere. Central bank broader monetary aggregates continue to post high single or double-digit gains over the last 12 months. Authorities are growing desperate to revive sagging growth caused by the U.S. slowdown.

The U.S. dollar is probably one of the most undervalued currencies in the world at this point following a severe decline since 2002. I would not dump dollars now. Most U.S. assets from a foreign currency perspective are absolutely dirt cheap!

But if you expect a “muddle through” economic recovery to persist over the next 12 months – and I do – then the Fed will have to stay on guard as housing attempts to establish a bottom. This doesn’t imply the dollar must fall further. But it does suggest commodities and gold will continue to rally because most central banks will continue to print credit while they try to look concerned about inflation.

The majority of central banks raising rates in 2008 are only gradually draining liquidity from the financial system. These banks are also the smaller players on the global stage. The banks that matter most in creating inflation – the Fed and the ECB, however, continue to print credit and inject funds.

Inflation is trying to win and overcome deflation. In time, I’m betting on inflation.

ERIC ROSEMAN, Investment Director

Source: The Central Bank Mirage, Part II