As we predicted earlier this year, China may use its newfound economic clout to save Europe and diversify away from the US dollar. Seeing as Italy is still in favor with global investors with spreads between Italian and German bonds reasonable, the Italians could strike a formidable deal with the Chinese to push off debt concerns.

The consequences of a Chinese bailout of Italy are many for the United States:

1. Falling dollar values – Any purchase of European bonds would come as a direct play on the Euro against the US dollar. As China seeks to revalue the Renminbi to make internal consumption more affordable, a policy of mitigating overexposure to the US dollar with Euros makes sense domestically. However, for the United States, a lack of demand for long-term debt obligations could force yields higher and dollar values lower.

2. Capital flight – China remains an active investor in and around the United States. Most notably, the Chinese hold significant investments in US government debt securities, but to the north, in Canada, the Chinese are snapping up real estate holdings. Any shift of capital to Europe is in direct competition to capital investments in the US, a true short-dollar and long-Europe trade.

3. Political favors – Whereas the Chinese found little resistance to acquisitions of emerging market companies and commodity exporters like Australia and New Zealand, China faces tough EU restrictions on foreign acquisitions. Purchasing Italian debt, a relatively small portion even in its multi-trillion dollar foreign reserves account, could prove to open up the floodgates for acquisitions of European companies. Since the beginning of the year, China has used its cash hoards to negotiate massive purchases of telecommunication, real estate, and shipping companies in Europe. Any deal will only further increase merger and acquisition activity in Europe by state-run Chinese organizations, or privately-held companies.

Future Dollar Weakness Ahead

While China’s purchases of foreign securities are solidly pro-dollar, a shift to new acquisitions could change the global landscape. The dollar’s status as reserve currency remains on the brink; future inflation coupled with debt concerns makes the dollar a future falling star as the reserve currency in the world.

There is no easy exit for China, of course. The nation holds some $1.1 trillion of US debt, a figure which some estimate to be lower than the actual holdings. Any move to diversify away from the dollar will require fewer asset sales than it would purchases; China suffers from the inability to sell dollars without moving the market, which would devalue its other holdings proportionally. (It was discovered in January that state-sponsored Chinese entities use proxies to buy US Treasuries at auction without leaving a paper trail back to China. Since then, estimates have been revised up some 30% from under $1 trillion dollars.)

Going forward, silver and gold look strong, gaining from the instability fears, sovereign debt loads that have grown too large, and inflationary policies underwritten by the ECB, the Federal Reserve, and the Swiss National Bank.