The coming commodity BOOM

What coming commodity boom? The price of oil has already risen from an average of about $22 between 1986 and 2003 to almost $75 last year. For 16 years, oil was priced between the low of $9.75 in April 1986 to the high of $40 in February 2003 before it took off.

Gold flew from a low and stable level under $300 at the turn of the century to more than $700 last year. Copper was stable in the late 90s around 75 cents but hit almost $4 last year. The commodity boom is old news.

Now, however, there is a new bidder — the Chinese government, in the form of the new reserve management agency established in March 2007. The Chinese press translates the agency as the “China Foreign Exchange Investment Company” (CFXIC) and China’s central bank is going to give it about $100-$200 billion to use in the search for higher returns than can be had from U.S. government paper.

New reserves that are created by the Chinese trade surplus — probably about $200 billion per year — may go to this agency (and a sister agency that will be established to invest in domestic enterprises). China has about $700 billion of its $1.1 trillion reserves in U.S. government paper, and it is now capped at that level. If the U.S. government wants to increase issuance, it can’t count on the Chinese to soak up new paper.

The new agency can invest in foreign stocks and bonds — and in stockpiles of strategic commodities such as oil, gold, and copper. The money would stay in U.S. dollars but be siphoned off from the U.S. Treasury market. China watchers imagine the Chinese government might set up a series of benchmarks to judge the agency’s performance relative to hedge funds. It’s fascinating that the nominally communist Chinese are the ones introducing this novel concept — that states should be as financially savvy and successful as the private sector.

Other emerging market governments will likely emulate the Chinese. Norway and South Korea are two of the countries that already have a more aggressive investment policy for reserves. With China’s initiative, the entire reserve management environment has changed. Any country not embracing the new quest for maximum returns given a specific degree of riskiness can be charged with failing its fiduciary duty to its citizens.

Why put a country’s collective national savings into the dollar in the first place? The old reason was literally to have savings for a rainy day, to buy food in case the crops failed, to buy arms if war breaks out, to ensure the ability to import essential goods. But if a country has more than enough reserves to get over any particular hump of three to six months, the rest should be available for higher returns.

Luckily for governments, only a very small percentage of citizens in any country understand foreign exchange reserves. In the U.S., most of our reserves are in Fort Knox, earning nothing at all. We don’t expect a public clamor for governments to diversify away from boring old U.S. Treasuries. Still, within the rarefied atmosphere of the elite government financial managers, the clarion call of higher return can’t be ignored. A page of history has turned.