The cost of borrowing money in the United States is going to increase. Not tomorrow, and likely not in the next six months, but in the foreseeable future it is going to become increasingly expensive to finance your car, home, and college education. I come to that conclusion in the wake of reports that China--our largest creditor--is now looking to significantly diversify her holdings.
This development came with a warning. In late January 2009, China's leaders began to make it quite clear they had lost faith in Washington's ability to responsibly oversee the international financial system. At the annual global gathering of economic and political leaders in Davos, Switzerland, Wen Jiabao forthrightly blamed the U.S.-led financial system for the ongoing international recession. According to China's Premier, "excessive expansion of financial institutions in blind pursuit of profit," a failure of government supervision, and an "unsustainable model of development, characterized by prolonged low savings and high consumption," were directly to blame for the crisis.
This finger-waving lecture, however, included a call for Beijing and Washington to cooperate in efforts to "fight the financial crisis and promote constructive and cooperative bilateral relations." Speaking with reporters from the Financial Times on 2 February, Wen stated, "We believe that to maintain cooperation between China and the United States serves world peace, stability, and prosperity."
As it turns out, Beijing wasn't willing to wait on Washington. In late March, Zhou Xiaochuan, the governor of the People's Bank of China, released a paper calling for the establishment of a new "super-sovereign reserve currency" to replace the dollar. Zhou argued the new currency reserve system should be controlled by the International Monetary Fund (IMF) as a means of avoiding the "inherent vulnerabilities and systemic risks in the existing international monetary system." Interestingly, despite the fact China currently holds the world's largest foreign exchange reserve--an estimated $2 trillion--the new "super-sovereign reserve currency" is to be supranational. Zhou contends the global dominance of a few currencies--the dollar, euro and yen--leaves the international financial system more volatile and vulnerable.
Zhou's solution--expand the use of "special drawing rights." The IMF created special drawing rights in the 1960s. Under this system, the supranational currency has a value determined by a basket of major currencies. Nations would gain access to--and control over--these special drawing rights through increased contributions to the International Monetary Fund. As the Wall Street Journal observed, this would increase the role and powers of the IMF--indicating "that China and other international developing nations aren't hostile to international financial systems--they just want to have more say in running them."
The Wall Street Journal is right. During the last week of March, Beijing said it would be willing to make more money available to the IMF so as to increase the institution's ability to assist nations suffering the consequences of the current financial crisis. The catch? Beijing wants greater IMF voting rights. As an economist for Deutsche Bank told the Journal, "China sees this as a good opportunity to increase [Beijing's] influence." As it turns out, it China also sees the expanded IMF holdings as a means of escaping Beijing's over-investment in American debt.
On 24 April, officials from Brazil, Russia, India and China (commonly referred to as the BRIC) met to discuss how they would contribute to the proposed $1 trillion fund. The response from IMF critics--this new fund could become competition for similar bond offerings from sovereign nations...like the United States. In order to continue drawing investors these sovereign debtors would either have to pay higher returns or curtail their deficit spending. I'm not sure the first option will work. Unlike U.S. Treasury notes, the IMF bonds have the additional allure of support from a deep-pocketed multi-national consortium. If I was a central banker in China my bet would be with the IMF bond--at this stage Washington appears intent on printing money until the dollar is worthless.
China is not just interested in this new IMF investment option. Over the last couple of years Beijing has been quietly purchasing gold--and now has $31 billion invested in the previous metal. Couple this development with reports that Beijing's sovereign wealth fund is also shopping on the commodities market and one comes to a grim conclusion...the Chinese are aggressively seeking to diversify their holdings.
Please note I am not suggesting the Chinese are preparing for a rapid flight from their $744 billion investment in our national debt. As Nouriel Roubini told the Washington Post last week, "In the short run, China has no option but to accumulate dollar reserves." A fire-sale of these holdings would cause the yuan to rapidly appreciate and further drive down exports--a development the Chinese Communist Party is currently unwilling to contemplate. But, says the economist who accurately predicted the current international crisis, the Chinese are exploring a "huge number of new initiatives" for resolving this problem in the not-so-distant future.
Why should you care? When the Chinese stop--or dramatically curtail--their purchase of U.S. Treasury notes Washington is going to have to find a new creditor. Good luck. Domestic savings won't cover the bill and other international investors are likely to follow the smart money. That is to say, other BRIC members and the Middle East are likely to follow China's lead. As a result, the average American consumer is going to pay more for a loan--anywhere from 150-300 basis points more. All of which leads me to conclude when China talks we need to listen...I sure have no faith left in the likes of EF Hutton.