JPRI Working Paper No. 111, (February 2007)
China's Dollars Versus America's Guns
by Marshall Auerback

US-China relations are influenced by a wide array of issues from Taiwan to trade relations and human rights. More recently, the nexus of the relationship has centered on the so-called "Bretton Woods II" arrangement, a continuation by other means of the dollar-centered international order that prevailed in the postwar decades. This monetary status quo, based on structural current account deficits in the U.S. and structural current account surpluses in Asia, in which Asian current account surpluses are recycled to provide cheap financing for the US current account deficits, largely explains why the US dollar has not collapsed despite the country's increasingly parlous debt build-up. It has been characterized by PIMCO's Paul McCulley as a "stable disequilibrium".

But Bretton Woods II is increasingly beset with internal contradictions: the Chinese have in effect initiated a dollar reserve accumulation policy that acts as a quasi oil reserve, given that oil is priced in dollars. But in so doing, they have helped to fund an increasingly confrontational and militaristic US, which in turn threatens China's energy security. How long before this circular relationship, which underpins the stability of today's global markets, breaks down?

Historically, Beijing has recognized that its energy security was largely dependent on cooperation with the US, rather than competition with it. China would like to maintain good relations with the US and enjoy the economic benefits derived from such cooperation. But this inclination is balanced by the feeling among many Chinese leaders that the US seeks to dominate the world's energy supply routes in order to exercise control over energy resources and to counter the rising economic power of China. It is indeed one of the ironies of the early 21st century that an administration supposedly full of competent oilmen has contributed to political turbulence in energy-producing countries and inflamed a growing oil rivalry with China. Under the Bush Administration, China has increasingly come to be viewed as a "strategic competitor", while Beijing in turn now regards Washington as a major threat to its long-term energy security.

All of this leads one to question whether today's Bretton Woods II arrangement is either sustainable or desirable. Although the remninbi peg supports an economic model based on export led growth financed largely by domestic savings, it is not without cost. China's central bank continues to accumulate dollars which creates the risk of large capital losses by, in effect, financing the purchase of low yielding dollar debt with the issuance of high-yielding local currency debt. If China's currency ultimately were to appreciate relative to the US dollar, the local currency value of their dollar denominated reserve assets would fall sharply, which would argue the case for greater foreign exchange diversification. 

But is there another rationale for this apparently perverse policy? Clarium Capital's Kevin Harrington has recently argued ("The Petrodollar Illusion", Clarium Capital, September 2006) that for the large foreign exchange reserve nations, such as China, holding huge amounts of dollars is important not only because oil is priced in the US currency, but also because holding lots of dollars gives these countries the flexibility to dump the greenbacks when oil prices spike, thus allowing it to outbid the US -- the single biggest oil consumer -- for the oil. 

Therefore, Harrington argues, there is method to the apparent madness in the phenomenal accumulation of dollar reserves by East Asian states: the dollar stores are essentially strategic petroleum reserves in financial disguise: "For China in particular this is important as the Chinese now have passed Japan as the country with the largest foreign exchange reserves. It makes sense for them not only to hold dollars, but also to diversify into sterling and euros because in any energy emergency, China would need to outbid the US and also the economies of Western Europe for the oil. So the currency dumping strategy would extend for them to the euro and sterling. But in the accumulation phase of foreign exchange by the Chinese, it makes less sense to buy yen because Japan holds currency reserves equal to those of China and they have the same incentive to depress the value of the dollar. China's dumping of yen in such circumstances would simply be nullified by Japan's aggressive accumulation of yen."

Viewing China's massive forex reserve buildup as the financial equivalent of a strategic petroleum reserve is not idle theory. Already, the country has deployed its considerable war chest of dollars on an international natural resources shopping spree, making their presence increasingly felt in both Africa and the Middle East (the most recent example being a February 4th announcement of an $800 million investment package in Zambia). In a world in which depletion dynamics in oil reserves are becoming more pronounced, it is but a small conceptual leap to start buying the assets directly, especially if the US continues on its current confrontational militarized approach to energy policy.

Of course, there is a great irony here, which Harrington fails to note: China's accumulation of dollars as a quasi oil reserve in effect creates the means by which the US can perpetuate the militarization of its energy policy. If one includes America's array of privately outsourced services along with a professional permanent military, the costs run around three-quarters of a trillion dollars a year.   This cost is indirectly financed by Chinese, Japanese and other central banks of East Asia via Bretton Woods II. So we have a paradoxical situation in which the Chinese are in effect "feeding the hand that threatens to bite it".

Since the end of the Cold War, the United States has abandoned the principle of building up a defense force for the purposes of addressing the security tasks immediately at hand, and instead has embarked on a policy of maintaining military capabilities far in excess of those of any would-be adversary or combination of adversaries. Von Clausewitz once said, "War is diplomacy by other means." Under recent US administrations, however, war has become an extension, not of diplomacy, but of energy policy. 

While the Pentagon readily acknowledges it can do little to promote trade or enhance financial stability, it increasingly asserts that it can play a key role in protecting resource supplies. Resources are tangible assets that can be exposed to risk by political turmoil and conflict abroad -- and so, it is increasingly argued, they require physical protection, which in turn is used to justify the extraordinary sums now lavished on the Pentagon.

To add to the problem, we are on the verge of a collision between rising energy demand and depleting energy supplies, and a historic migration of the center of gravity of planetary energy output from the developed to developing world, with the higher attendant political risk that accompanies this move. 

The common pronouncement that at present rate of production the discovered reserves will last 40 years may well be technically true but highly misleading. It implies a scenario in which production remains flat for 40 years and then drops to zero. The more likely eventuality is that oil production will increase until depletion dynamics overwhelm production and then production will drop at some specified yearly rate until it is exhausted. When the world enters this stage, half of the original oil endowment will still be there to be extracted, but at much higher prices and attendant potential for conflict, as consuming countries faced with a diminishing supply aggressively compete (militarily or otherwise) for it. 

Watching the gyrations of the oil market so far this year, one might conclude that stories of supply shortages are nonsense. Oil has declined from a high of $78 last year to a recent price in the mid-fifties (after hitting a low of $51 in January). Of course, even at the lows, oil is already considerably in excess of what many "experts", including the International Energy Agency (IEA) forecast years ago, bringing to mind Oscar Wilde's quip about those who know the price of everything but the value of nothing. The current explanations range from unseasonably warm weather in the US to rumors that Saudi Arabia has been dumping shiploads of crude on the US Gulf coast to hurt Iran. All of these explanations probably contain some kernel of truth, but the longer term structural case for significantly higher energy prices overwhelms these short term considerations.

For now, the oil market seems to be ignoring the possibility of a US war with Iran. The Bush surge in Iraq with the prospect of fresh and heavy fighting is already old news. The news that Mexican oil production fell by half a million barrels a day last year caused not a ripple. The shutdown of most of Nigeria's refining capacity has evoked the equivalent of a mighty yawn. Likewise, the announcement in December by the Kuwaiti government that production at the world's second largest field, Burgan, had peaked and is now declining passed without comment or even a blip in the price slide.

The fact that Iran, if current trends persist, is set to become an oil importer in six or seven years has caused not the least anxiety nor altered neocon explanations as to why Iran might be acquiring nuclear power. Today, the world's cushion of crude oil has fallen to an alarmingly low level, with surplus capacity at less than 10 percent of consumption. One strategically placed natural disaster or political upheaval could create a crisis, but neither the markets, nor the IEA, seem to have noticed this fact. Only the Pentagon has, but its solution may not be viable.

Keep in mind that oil exporting nations struggle just to maintain current levels of output because of the continual need to replace depleting oil fields with new discoveries. Recent cuts in OPEC production targets made news late last year, but few articles noted that OPEC was failing to meet its targets anyway. According to a November 2006 piece by Rigzone, crude production from the 10 OPEC members bound by the cartel's output agreements fell to 27.73 million b/d last October, down 80,000 b/d from September output of 27.81 million b/d. Including Iraq, which does not participate in output pacts and whose production and exports tend to fluctuate, total OPEC output was 29.75 million b/d in October compared with 29.95 million b/d in September.

Surprisingly, because it has historically tended to overstate oil production and minimize supply/demand imbalances,the IEA has implicitly recognized this problem and expects no increase in OPEC production for many years. In pursuit of reasonable oil balances, the IEA has tended to inflate elements of supply or omit some deliveries. The large positive "balancing items" -- 0.5 mmbd in 2004 and 0.7 mmbd in 2005 -- are hypothetical increases in stocks outside the members of the OECD. Skeptics term these "missing barrels". They are still missing and there are more of them as time passes. According to independent oil analysts, Groppe, Long & Littell, the IEA overstated oil stocks by 180 million barrels in 2004 and another 250 million or so in 2005.

Even allowing for this overstatement of supply, it is striking that the IEA concedes that only Saudi Arabia can increase production, and that this will only offset declines by other OPEC members. The IEA expects the growth in oil demand to be met by major production expansions in Russia, Sudan, and Angola. Given the political instability in these nations and their lack of infrastructure, one must rate these IEA projections as very optimistic. In fact, the oil industry, with the help of modern seismic surveys and geochemistry, has now mapped the world's more promising areas and has found almost all of the giant fields within them. New discoveries are helping to offset, but not replace, the production of mega-fields such as Saudi Arabia's Ghawar and Safaniyah, or Mexico's Cantarell. PEMEX itself conceded that 2005 was the year that Cantarell began an irreversible decline in production, with a drop from 2.11 million barrel per day to 2.02 million for this year. When exploration of an area begins (whether it is a basin, state, or country), the largest reservoirs are the easiest to find. Total production rises as they are brought into production and exploration for smaller reservoirs continues. Eventually enough small reservoirs cannot be found to offset the declines in production from the large reservoirs as they are depleted. Prices and technology affect the area under the curve -- the total amount of oil and gas recovered over time -- but not the shape of the curve. It is a process similar to aging and death in living organisms.

And the non-conventional alternatives are not without problems. In regard to heavy oil, such as the Alberta tar sands, the challenge is to mobilize the resource at a useful rate. As Michael Klare has noted, it has taken until 2006 to get Canadian tar sand production to just over 1 million b/d. Of course, these volumes can be multiplied many times over but how quickly? Cost inflation for the Canadian tar sands is already spiraling. There are major challenges in terms of gas supply, water availability, environmental pollution and CO2 emissions. On current plans, oil sands production could increase by 2-2.5 million b/d by 2015 or a rate of 200,000-250,000 b/d per year. Yet, by 2015, all the richest sands will be in production and operators would have to develop leaner ones.

In Venezuela, despite numerous hopes and plans, President Chavez has yet to sanction an incremental Orinoco project (although Lukoil has just started drilling on the Junin-3 block). Venezuelan production by 2015 is therefore unlikely to even reach 1.5bn barrels/year. If production rates from Canada and Venezuela could be sustained at the optimistic 2015 levels projected by the Center for Economic Policy and Analysis (CERA, the group that has been most actively campaigning to avert an oil supply shock), it would last for nearly 300 years but the flow would amount to only 5% of this year's oil production. It goes without saying that the political context in Venezuela at this juncture is not particularly favorable to the US. Even though the Venezuelan oil industry has always been focused on exporting to the United States, Venezuelan President Hugo Chávez struck deals with the Chinese that could eventually divert crude oil from the United States to China. He also raised taxes on, and demanded renegotiated contracts from, foreign producers. Recently, he threatened to nationalize four oil ventures in the Faja region that are funded by Chevron, ConocoPhillips, and ExxonMobil.

What about coal, which it is assumed will last for hundreds of years? British Petroleum's Statistical Review of World Energy  2006 says proved coal reserves total 909 billion tons, which at the current rate of production of 5.8 billion tons per annum would presumably last 155 years. But coal has severe environmental problems. In response to growing global warming pressures, a number of coal consumers have announced their intention to use "clean coal" processes that will sequestrate carbon dioxide and compress it to push it underground in old mines and oil fields. Although its use in the latter may in some cases assist in the extraction of oil from decaying fields, the additional energy required for the separation and compression of the CO2 leads to a lower overall coal utilization efficiency. And if coal is used to replace oil (in various coal-to-liquid schemes), it will disappear much more rapidly.

Natural gas and uranium will outlast petroleum by a decade or two, but they too will eventually reach peak output and begin to decline. A recent mining mishap at Comeco Mining's Cigar Lake uranium deposit has served to highlight the unreliability of supplies for nuclear power. By the same token, power generated from waves, windmills, and solar panels is weak, intermittent, and expensive-at least twice the cost of electricity produced from coal or gas. When it is cold or dark, solar panels don't produce energy; when it is calm, wind turbines don't turn. To insure continuity of supply, renewable power plants have to budget for large amounts of overcapacity, a problem that isn't going to disappear.

In recent years, as politicians have tried to deal with high gas prices, concerns about global warming, and America's dependence on OPEC, a new savior has been found: ethanol, most recently lauded by President Bush in his 2007 State of the Union Address. Ethanol has all sorts of virtues. When it's blended with gasoline, it reduces greenhouse-gas emissions. Unlike fossil fuels, it doesn't get depleted over time, since it's made from biomass. And sources of ethanol can be found all over the world, unlike oil, which is found mostly in unstable or autocratic countries that are unfriendly to the U.S.

Unfortunately, the ethanol produced in the U.S. comes from a less-than-ideal source: corn. Corn ethanol's "net energy balance" --the amount of energy it yields in proportion to how much energy goes into its production -- is significantly lower than that of other alternatives, and modern corn farming isn't easy on the land. By contrast, ethanol distilled from sugarcane is much cheaper to produce and generates far more energy per unit of input -- eight times more, by most estimates -- than corn. In the nineteen-seventies, Brazil embarked on a program to substitute sugar ethanol for oil. Today, every gallon of gas in Brazil is blended with at least twenty per cent of ethanol, and many cars run on ethanol alone, at half the price of gasoline.

What's stopping the U.S. from doing the same? In a word, politics. The favors granted to the domestic sugar industry keep the price of sugar so high that it's not cost-effective to use it for ethanol. And the tariffs and quotas for imported sugar mean that no one can afford to turn it into ethanol, the way oil refiners import crude from the Middle East to make gasoline. Americans now import eighty per cent less sugar than they did thirty years ago. So the prospects for a domestic sugar-ethanol industry are dim at best.

The lack of a viable alternative to conventional energy sources is generating great anxiety within the United States, particularly as it lacks the economic muscle of China or Japan in terms of forex reserves and therefore cannot outbid them for supplies of crude or other forms of energy. This is one battle the US could theoretically lose, which is part of the reason the U.S. military is being transformed into a global oil-protection service. Indeed, as Michael Klare notes, "From the vantage of officers and enlisted personnel in the U.S. Central Command, the invasion of Iraq is only the latest in a series of military engagements in the Gulf proceeding from the Carter Doctrine. This history helps to explain why the very first military objective of Operation Iraqi Freedom was to secure control over the oil fields and refineries of southern Iraq."

This sort of thinking now is now governing American policy well beyond the Persian Gulf. And it is bipartisan in nature: It was former President Clinton, after all, who asserted America's right to resort to "unilateral use of military power" to ensure "uninhibited access to key markets, energy supplies, and strategic resources", and who established military ties with the governments of Azerbaijan, Georgia, Kazakhstan, Kyrgyzstan, and Uzbekistan. Likewise, it was under Clinton that the Taiwan Straits became an increasingly active area for the US Navy (since perpetuated by President Bush), leading many in Beijing to conclude that an American naval blockade against it may ultimately be in the offing. More recently, the Bush Administration has extended the reach of this policy to Nigeria, now one of America's major sources of oil. And in Colombia, where Arauca province is a petroleum rich area in northeastern Colombia near the Venezuelan border, the U.S. is intensifying its military involvement as part of efforts to diversify its oil supply.

In case the rest of the world hasn't gotten the message, the White House has increasingly warned Russia and China against monopolizing oil sources in the developing world. In May 2006, in Vilnius, Lithuania,Vice President Cheney attacked Russia's use of oil and gas as "tools of intimidation and blackmail". The next day, he traveled to Kazakhstan, where he expressed "admiration" for its authoritarian government and where Assistant Secretary of State Richard Boucher, who was traveling with Cheney, urged Kazakhstan to ship more of its natural gas to Europe through a pipeline that bypasses Russia. 

One has to question how effective this confrontational and military approach has been. According to Gal Luft, executive director of the Institute for the Analysis of Global Security, a Washington think tank that tracks energy issues, in Iraq alone, there have been 385 attacks against oil pipelines since June 2003. This in a war that was supposed to be "self financing" as a consequence of Iraq's ample oil reserves. There are similar threats in other parts of the Persian Gulf in response to the Pentagon's actions. Radical Islamists in the Persian Gulf appear to be heeding al-Qaeda second-in-command Ayman al-Zawahiri's call to target Persian Gulf oil infrastructure. U.S. and British sources believe that al-Qaeda militants have their sights set on Saudi Arabia's Ras Tanura facility. With a total loading capacity of six million barrels per day, Ras Tanura is the world's largest offshore oil export terminal ( Gulf Daily News, October 28, 2006 ). Bahrain's Bapco oil refinery is also believed to be under threat of attack. Western and regional capitals are taking these warnings seriously. U.S., British and other Western navies comprising the Italian-led Coalition Task Force 152 that patrols international waters near Ras Tanura have deployed forces in support of Saudi and Bahraini military and security forces ( al-Jazeera, October 28, 2006 ).

Washington's machinations in Central Asia have earned a comparably hostile response: In 2005, the Shanghai Cooperation Organization--a group consisting of China, Russia, Kazakhstan, Kyrgyzstan, Tajikistan, and Uzbekistan--called on the United States to withdraw its troops from Central Asia, in effect repudiating the actions of former President Clinton. This year, the countries plan to conduct joint military exercises with members of the Collective Security Treaty Organization, an alliance consisting of Russia, Belarus, Armenia, Kazakhstan, Kyrgyzstan, and Tajikistan. As Joshua Kurlantzick argued in the October 2, 2006 New Republic, these strengthened ties signal the emergence of a new alliance consisting of Central Asian energy-producing states plus China that may seek to limit Western access to its oil and gas. Rather than securing America's future energy security, its militarism is actually enhancing energy insecurity and economic instability.

The costs of these military operations will also snowball as the United States becomes more dependent on energy from the southern hemisphere, resistance to Western exploitation of foreign oil fields grows, and an energy race with newly ascendant China and India revs up. Will future administrations realize the extent to which their confrontational strategy actually fuels increased energy insecurity? From Beijing's perspective there is no doubt that China will need a great deal of energy in the years ahead, and that it will be competing with the United States for access to overseas supplies of oil and gas, especially in Africa, the Middle East, and Central Asia. Beijing has indicated a preference for competing with the US on something approaching equal economic footing, as one big consumer vs. another. This is not, however, a vision shared by America. How long, therefore, will it be before the Chinese government comes to the conclusion that its own dollar support strategy is actually helping the US to fund a defense strategy inimical to Beijing's longer term interests? It should soon become increasingly clear that the historically symbiotic relationship which has hitherto characterized "Bretton Woods II", risks running aground on the shoals of its own internal contradictions.

Marshall Auerback is a global financial strategist based in Denver, Colorado, and a frequent contributor to the Japan Policy Research Institute.  


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