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June 11, 2008

Dope, Dollars and Deficits
by Adrian Ash

"...Take a gun-boat and 1,200 tonnes of opium, and America could close its trade gap with China tomorrow..."

DO DEFICITS MATTER? Right around the time that English missionaries produced the first Bible in Chinese, the British Empire found itself with a trickier kind of translation problem.

Exporting the English language to China - and a little Protestant godliness besides - was proving much easier than exporting British-made goods.

Imports from abroad, in contrast, just kept on growing as the industrial revolution steamed ahead at home, sucking in the new consumer favorites - tobacco, sugar, coffee, calicoes, porcelain and silk.

By the early 19th century, of course, Britain owned the plantations of the West Indies and the factories of Bengal. So those deficits didn't even exist, let alone matter. But "the British were spectacularly unsuccessful in finding trade goods that the Chinese wanted or needed," as Jonathan Spence, professor of history at Yale, noted in his Reith Lectures for the BBC earlier this week.

Thus "there was the problem of trade imbalances." And stuck for consumer items to ship back across the oceans, London's merchants were forced to pay in cash.

For the British, money meant gold, just as it did until the last gasp of the Gold Standard one hundred years later. But the Chinese wanted silver.

(They never did get round to using gold, in fact. And while Britain recovered early from the Great Depression by abandoning gold for credit-money in 1931, one theory holds that China side-stepped it entirely by sticking to its silver standard...)

Translating English pounds into Chinese yuan in the 1830s meant selling gold for silver, and that meant dealing on Europe's precious metals market. Paying a commission to the bullion dealers of Paris or Prussia - as well as shipping it all back and forth - only added further to the transaction costs of running up that yawning trade gap.

What to do? A little of the British Empire's raw cotton found a market in China, but it wasn't nearly enough to close the trade gap. Gold bullion continued to flow out of London, aggravating the "bullionist" school of economists and policy-makers. They feared a shortage of coin in the domestic British economy, plus a fall in the Pound Sterling's international value...as well as giving work to foreign laborers, and paying profits to their foreign masters...while leaving the London exchequer impoverished should it ever need to fund a military defense of the home front.

And so "it was this melancholy failure of the balance of trade that led to the under girding of the opium business in China," explains Prof. Spence. Opium grown in India "started to be sold to the Chinese by British traders, and later by American traders, because the West simply could not find enough products to attract the Chinese in a sort of barter exchange at the time."

Widespread dope-smoking and the social breakdown it can invite rarely chimes with government policy - not domestically, at least. Opium had long been banned by imperial decree from Nanjing. But after ten years of trying to fend off Britain's drug dealers without damaging the inflows of silver, the Qin authorities finally cracked and made a stand, seizing 20,000 chests of the drug - some 1,200 tonnes - landed in Guangzhou.

London responded first with a gun-boat, and then the all-out Opium War of 1839. It ended three years later with the Treaty of Nanjing. Britain's military might won the island of Hong Kong, plus reduced trade tariffs, freedom from Chinese law for its ex-pats, as well as "most-favored nation" status.

Whatever trading rights or concessions China would grant in future, the British Empire would also gain as well. Opium was then forced on the Chinese, and the trade gap closed without the need for hard money payments.

We still don't make much that the Chinese want to buy. The United Kingdom's trade deficit with China rose 8% in the year to April '08, as Chinese imports swelled by more than 10%.

But most clearly here in the early 21st century, it's America's turn to fumble around for a way of settling its debts with China. Yes, the value of Chinese imports to the US fell slightly during the first four months of this year compared with the first third of '07.

But US exports to China fell faster still according to the Census Bureau's latest data. So the trade gap widened again to rack up a deficit three times the size of America's debt to Canada or Mexico, the United States' No.1 and No.3 trading partners respectively.

Canada and Mexico just happen to share a land border with the States. Whereas China sits on the other side of the Pacific. As the British Empire's gun-boat diplomacy of 1839 attests, however, distance means little when consumers choose to buy luxury goods overseas.

The United States, of course, ships dollars and bonds back across the Pacific, rather than silver or Gold bullion. But are Dollar bills and Treasuries what China really wants, anymore than it wanted 1,200 tonnes of dope in 1839...?

The People's Bank of China just raised the required reserves ratio - the amount of cash which private banks must keep in reserve - to a massive 17.5%. That should drain something like $58 billion from the domestic lending markets, reckons the RGE Monitor, as the Chinese authorities set about "treating the symptoms of excess liquidity."

Spooked by the risk of a further slump in the over-heated Shanghai stock market, however, the PBoC continues to hold its key interest rate below the rate of consumer-price inflation. That makes cash a losing asset class in China today, just like it is in the US and UK, too.

Funnily enough, the Chinese would still rather buy and hold precious metals apparently. China's retail investment demand for Gold rose 63% during the first quarter of 2008, reports the GFMS consultancy, amounting to 15.1 tonnes. Gold jewelry sales grew by 9% - "one of the few examples of demand increasing over 2007 levels" during the global spike to $1,000 per ounce - reaching 86.6 tonnes.

China now represents the world's second-largest gold jewelry market after India, over-taking the United States in 2007. But even at a total of 420 tonnes last year, total demand for Gold from mainland China, Hong Kong and Taiwan combined remains almost negligible on a per capita basis.

That's not to say it's sure to keep rising; but with Chinese goods now accounting for 13% of America's imports each month - more than Mexican goods and only just less than Canada's (including petroleum) - we wouldn't be surprised to see ever more of that wealth swapped for silver and gold bullion.

Because deficits do matter after all, despite what Dick Cheney claimed back in 2002 as the Dollar's 40% decline got started.

Not least, trade deficits matter to those countries sat at the other end of the shipping route.

Adrian Ash
BullionVault.com

Head of research at BullionVault.com, the fastest growing gold bullion service online, Adrian Ash is also City correspondent for The Daily Reckoning in London, and a regular contributor to MoneyWeek magazine.

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