Axel Merk, June 28th 2005

The $18.5 billion bid by China's state-controlled Cnooc Ltd. to purchase the American energy company Unocal has created fear, anger and calls for intervention among U.S. politicians. As the U.S. trade deficit, currently around 6% of Gross Domestic Product (GDP), continues to climb, China has access to vast amounts of U.S. dollars that it has hoarded over the years. Until recently, Chinas has simply been buying  U.S. Treasuries. In recent months, it has become clear that China is becoming a more active investor, showing interest in natural  resources (timber, oil and gas assets)  and U.S. enterprises (IBM's personal computer business and Maytag, among others).

China, already the world's largest importer of many raw materials, anticipates dramatically higher energy and natural resource requirements in the years ahead. The world's oil production capacity, according to some estimates, is approaching its peak and there will be increased global competition for natural resources. While China is securing capacity, the United States has not built additional oil refineries since the 1970s (nor have any nuclear reactors been built since).

In the meantime, the U.S. is consuming goods imported from China at a record pace. Because of the tremendous trade deficit, the Chinese are sitting on hundreds of billions of U.S. dollars. Now, as the Chinese want to use this money wisely, U.S. politicians cry foul. The Chinese must wonder whether the U.S. dollar is worth the paper it is printed on. It is acceptable to use dollars to buy consumer goods, but if they are put to use to invest in the future, red lights go off in Washington.

Warren Buffett has long argued that the U.S. trade deficit is akin to selling out U.S. assets to foreigners. His once abstract warnings are now becoming vividly clear: With a huge trade deficit, foreigners are going  to own ever larger chunks of U.S. assets. And unlike Americans, who seem to derive great satisfaction from consuming goods frequently with a nearly insatiable appetite, the Chinese are investing in their energy needs of the future.

That is not to say that the Cnooc bid and others from China are not shocking.  The culprit, however, is not the Chinese government, but the U.S. fiscal and monetary policies that foster an environment of exploding trade imbalances and abysmal domestic savings. We believe this policy puts long-term pressure on the dollar, especially as Asian countries realize that their dollar reserves will not be honored if they are used for something of value to them.

As far as this particular transaction is concerned, Cnooc is only interested in the Asian assets of Unocal and will spin-off the U.S. assets. U.S. calls to intervene are unlikely to be successful as it is difficult to argue that U.S. "national interests" are being jeopardized  the way this offer is structured. What bugs many is that Cnooc is 70% state controlled and has access to financing at below market rate interest rates. According to Chevron, also interested in acquiring Unocal, this is unfair state intervention.

Politicians will fight over this transaction in the coming weeks and  may be able to force China to open up their markets further, so that foreigners can take control of more Chinese owned firms. But much of the discussion will miss the point: China, having become a major player  in the global market with deep pockets, will want to put its dollars to use. The Chinese have subsidized their currency to sell cheap goods to the U.S. In return, they have accumulated billions of dollars. Now they will find out whether these dollars are worth anything at all as they try to use them to secure their future natural resource needs. If disappointed, China and other Asian countries may accelerate their diversification out of the U.S. dollar and into a basket of  hard currencies.