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Eric C. Anderson

Eric C. Anderson

Posted: March 3, 2010 01:13 PM

Rethinking Beijing's Financial Options

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Controversy can lead to interesting headlines, but also contributes to public confusion. Such is the case when economists engage in debates over just how much money China has invested in Washington's mountain of debt -- and the potential consequences of same. This is exactly what happened at a 25 February 2010 gathering of the U.S.-China Economic and Security Review Commission. At a hearing titled "U.S. Debt to China: Implications and Repercussions," Americans were essentially told to ignore data provided by Tim Geithner's Treasury, and instead depend upon the musings of scholarly economists. And to think we complain about the reliability of Beijing's financial reports.

A word of warning, a few of the following paragraphs are not user-friendly for the numerically challenged. According Tim Geithner's folks, as of 31 December 2009 the Chinese were holding on to $755 billion of our Treasury notes. This figure is reported on a monthly basis via the Treasury International Capital System. Seems straightforward, until one realizes the Treasury only records foreign purchases by known country of origin. So if the Chinese acquire T-notes through an alternate channel -- say a bank in England -- Treasury credits the purchase to London...not Beijing. The result? An under reporting of China's actual T-note ownership.

Economists have known about this shortcoming for years, but have done little more than ruminate on the potential value of forecasting models that are provided less than perfect data. (Economists like to pretend they are not social scientists -- where everything is fungible. Instead of tweed jackets, many practitioners of the "grim science" would prefer to wear white lab jackets and expound on the "cold, hard facts" to be found in the world of money.) No more. In his testimony before the U.S.-China Economic and Security Review Commission Simon Johnson -- a former chief economist for the International Monetary Fund -- declared Beijing probably owns close to $1 trillion of our Treasury securities. According to Johnson, this figure amounts to almost half of the T-notes in foreign hands...and just under 1/7th of all U.S. government securities outstanding.

Now consider the figures offered by Eswar Prasad, a Senior Fellow and the New Century Chair in International Economics at the Brookings Institution. In his testimony, Prasad told the Commission we can assume approximately 70% of China's foreign exchange reserves -- $2.4 trillion and growing -- are in dollar-denominated bonds and thus could account for $1.32 trillion of the foreign-owned T-notes...or roughly 17% of outstanding U.S. public debt. Prasad goes on to highlight the fact China has also purchased $405 billion of the debt issued by U.S. government-sponsored enterprises (think Fannie Mae or Freddie Mac and an additional $7.2 in taxpayer liability). The bottom line, Beijing has a collection of U.S. IOUs that tally up to $1.725 trillion. A worrisome figure...until one realizes we are in hock to the tune of $19.5 trillion. (I arrive at the figure by adding the total Treasury debt with the promissory notes issued by government-sponsored enterprises.)

Hmmm...think about what Prasad is really saying. If his figures are correct, Beijing only owns about 9%...yup nine percent...of Washington's total indebtedness. This sort of puts China's ability to exercise a "financial nuclear option" -- threaten to sell all her T-notes and thereby collapse the value of our currency -- in a different light. Or does it? A number of economists contend such a move would have significant negative consequences for Beijing and Washington. This group likens the current Sino-U.S. financial lash up to a monetized version of mutually assured destruction. Both sides will suffer if one of the partners opts to pull the trigger.

Prasad is not so sure this analogy is appropriate. The Brookings Senior Fellow argues, "Any Chinese threat to move aggressively out of Treasuries is a reasonably credible threat as the short-term costs to the Chinese...are not likely to be large." To drive this point home Prasad succinctly dismisses three popular arguments against Beijing dumping its dollar holdings:

1. If interest rates in the U.S. spiked as a consequence of Chinese actions, there would be a capital loss to China on the value of its Treasury bond holdings. This is correct on a mark-to-market basis but it is likely that China has a hold-to maturity approach on its bond portfolio, given that it has such a large stock of reserves and has no immediate liquidity needs. Hence, the actual capital loss may not be significant enough to feature in the political calculus.

2. A plunge in the value of the dollar against other major currencies would reduce the domestic currency value of China's dollar-denominated holdings. This is indeed accurate. But only if the renminbi appreciated relative to the dollar. Otherwise, China would lose a modest amount on the value of its euro and yen holdings and this would be more than made up for by the benefits of higher trade competitiveness if the renminbi rode down with the dollar against other major currencies.

3. Currency appreciation would lead to a big loss on reserve holdings in local currency terms. If the renminbi appreciated substantially relative to the dollar, as economists believe it eventually must given the much higher productivity growth in China relative to the U.S., China would certainly take a capital loss. But this is likely to be at least partially offset by seigniorage revenue that China can get as it moves forward in tandem on exchange rate flexibility and capital account liberalization.

So what keeps Beijing from fleeing our very own version of Athens's current fiscal nightmare? Prasad contends much of the Chinese investment in T-notes and other U.S. government debt is driven by a lack of other options. But, he goes on to note, there are signs Beijing is actively exploring alternatives. More specifically, China--like a number of other nations--is seeking to diversify by employing its sovereign wealth funds. You read correctly...in addition to the publicly identified China Investment Corporation there are increasing signs the State Administration of Foreign Exchange, the designated manager of Beijing's $2.4 trillion foreign exchange reserves, is now acting like a hedge fund manager. The money available to these two entities, approximately $650 billion or a little more than a quarter of China's foreign exchange reserves.

The logic for such a move should appeal to the capitalist in all of us -- why settle for the paltry 3-4% offered by thirty year T-notes when you can diversify into options that offer 8% and higher? Yes, I know, such a strategy is risky. But if you are a long term investor and can spread the cash far enough there really is little excuse to tie all one's assets up in low return options. This is how the Harvard and Yale endowment funds invest...who says a state can't act in a similar manner? Certainly not Beijing.

And the consequences for you and I? It's not pretty. As Derek Scissors, a China scholar at the conservative Heritage Foundation, bluntly informed the Commission. If Scissors is right -- I have done a lot of work on this topic and have little reason to dispute his figures -- a Chinese decision to bail on U.S. government debt would cause our interest rates to increase by up to 3%. You don't need a degree in economics to understand how such a move would depress the sale of large-ticket items. Or what it would do to the cost of financing our current national debt. Washington's inability to ever balance a budget is set to leave us with a $14 trillion tab by December 2010. A 3% hike in interest rates means the taxpayers would have to find an additional $400 billion a year just to keep the bill collectors at bay. And that figure would continue to balloon with the climb to $15 trillion slated to occur in 2011 and $16 trillion in 2012.

Still confused? Here's the executive summary. If the economists are correct, China owns about 9% of our total national debt. Contrary to popular opinion, Beijing could sell that debt with few long-term consequences for China's economy...and likely her political reputation. Such a move would cost you and I a fortune the next time we considered shopping for a car or a house...and would further expand an already outrageous national debt. Controversy can breed confusion, but in this case it should simply generate consternation...in every American household and at 1600 Pennsylvania Avenue.