The Three Ways China May Deal With Growing U.S. Debt

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By William Patalon III
And Jason Simpkins
Money Morning Editors

Although there's a veritable laundry list of obstacles that could blunt the U.S. government's ongoing economic turnaround efforts, its single-biggest challenge may come from its single-biggest creditor – China.

When China announced a new array of stimulus measures earlier this month, this very important plan was overshadowed by China Premier Wen Jiabao's concerns about the United States' quickly growing debt load.

"We have lent a huge amount of money to the United States," Premier Wen said. "Of course we are concerned about the safety of our assets. To be honest, I am definitely a little bit worried. I request the U.S. to maintain its good

credit, to honor its promises and to guarantee the safety of China's assets."

China has cause to be concerned: As of December, the most recent figures available, China held $727.4 billion in Treasuries – about 26% more than the $578 billion in U.S. government securities the Asian giant held at the end of 2007. More than half of China's nearly $2 trillion in foreign currency reserves are tied up in U.S. Treasuries and notes issued by other affiliated agencies of the U.S. government – including beleaguered mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE).

However, the value of U.S. Treasuries has dropped steadily since the government began selling record amounts of debt to finance its economic stimulus packages. Investors have lost an average of 2.7% in 2009, according to Merrill Lynch & Co. Inc.'s U.S. Treasury Master Index.

China's leaders "are worried about forever-rising deficits, which may devalue Treasuries by pushing interest rates higher," JP Morgan & Co. (JPM) analyst Frank Gong told The Associated Press. "Inside China there has been a lot of debate about whether they should continue to buy Treasuries."

And as the U.S. debt soars as the government works to halt the worst financial crisis since the Great Depression, China's concerns about this country's growing deficits – and its creditworthiness – are escalating in kind.

Depending upon how it did so, were China to stop buying U.S. debt – or even worse, to start dumping it – the economic fallout could be widespread, and perhaps even catastrophic:

  • The U.S. dollar would drop 15%-20%.
  • U.S. stocks would get hammered.
  • Inflation would spike and interest rates on Treasuries would jump into the 8% range.
  • And the economy would end up flat on its back – where it would stay, with no rebound on the horizon.

Detailing the Deficit

During the first five months of the 2009 fiscal year, which began Oct.1, the U.S. budget deficit hit a record $764.5 billion. Last month, President Obama outlined a $3.94 trillion budget plan that would take the deficit to $1.75 trillion by the time the fiscal year ends Sept. 30. The plan then calls for a $1.17 trillion deficit for fiscal 2010.

As currently projected, the U.S. budget deficit is forecast to run at about 12% of gross domestic product (GDP) – even worse than the perennially anemic Japan, where the deficit is running at 11%. And the debt picture is certain to get worse.

The Treasury Department has the government's printing presses running overtime just to finance the $787 billion stimulus passed by Congress earlier this year. And in order to pay for all the stimulus, bailout and fix-it plans that are being put in place to arrest the U.S. economic decline, the U.S. government is assuming a murderous amount of debt: Over the next decade, the Congressional Budget Office projects that the White House budget will run $9.3 trillion in deficits.

That's $2.3 trillion more than the Obama administration had forecast. But even the CBO projection could prove way too low: It assumes that the U.S. economy – after declining 1.5% this year – will turn around an advance at a racy 4.1% clip in both 2010 and 2011, a forecast that seems far too rosy, given the depths that the U.S. economy appears to have reached.

And that brings us to China.

Enter the (Red) Dragon

During the past several years, government-operated "sovereign-wealth funds" (SWFs) from virtually every major economic powerhouse around the world had been on a global shopping spree, buying up assets and bidding up prices as they did so.

China was no exception.

So when worldwide financial-asset prices began to slide – and then to nosedive – China abandoned many of its riskier holdings, choosing to boost its stockpile of U.S. Treasury securities. That underscores one marketplace truism: Despite Premier Wen's reservations, the market for U.S. debt is the only market large enough, liquid enough, and stable enough to accommodate China's large-scale investments.

That's forced China to engage in a kind of global investor activism – although, so far, most of that activism has been aimed at one country: The United States.

About one-fifth of China's currency reserves were tied up in Fannie and Freddie debt last fall when the two mortgage firms were placed under government conservatorship, The Washington Post reported.

In fact, as Money Morning detailed back in September as part of its ongoing investigation of the bailout of the U.S. banking system, that U.S. government decision to take control of Fannie and Freddie was driven not by worries about the fading U.S. housing market, but by concerns that foreign central banks in China, Japan, Europe, the Middle East and Russia might stop buying our bonds.

China clearly made its risk concerns known at that time, adding to the sense of urgency U.S. officials felt to make a move. Today, as U.S. debt continues to mount at an obscene rate, financial and economic risks also escalate. This could lead to a spike in inflation and interest rates – a double-whammy that could cause any recovery that's under way to sputter and stall. That duo of higher inflation and interest rates could also hammer bond values, including the Treasuries held in such large quantities by China. So it's no wonder the risk concerns China articulated back at the time of the Fannie and Freddie takeovers go double or triple now.

Indeed, when Premier Wen unveiled the spending measures earlier this month, he made the point of saying that China should seek to "fend off risks" by further diversifying its reserves.

"We have already adopted a guiding management policy of diversifying our foreign exchange reserves, and at present our foreign exchange reserves are safe overall," Wen said. "Our first principle in managing foreign currency is averting risk. We have always adhered to the principles of foreign currency security, liquidity and maintaining value, and implemented a strategy of diversification."

When it comes to U.S. government debt, that strategy will take one of three forms, and will have the following potential effects:

1. Quietly threatening to stop purchasing (or even threatening to "dump") U.S. Treasuries, a form of "back-channel" communications that can generate results (just look at how China forced the U.S. government to place Fannie and Freddie in conservatorship). Because this is back channel, it stays out of the marketplace, so long as the U.S. government finds some ways to appease Chinese investors by somehow reducing risk.

2. Quietly slowing or stopping its purchases of U.S. government debt. If China does this effectively and systematically, the fact that it's cutting back on purchases doesn't surface until the plan is executed. If China is able to pull this off – and it faces long odds to do so – the fact that it's cutting back on U.S. debt doesn't roil the markets too badly, especially if it doesn't leak out until after the fact.

3. Publicly dumping U.S. debt. Self-explanatory in nature – and also the most unlikely, if it wants to maintain its "friendly" status with the United States – this is the worst-case scenario, and is the one that ends up with the dollar and the stock market getting stomped. If China chooses this route, it's also essentially cutting off its nose to spite its face. The reason: By publicly dumping U.S. debt, the Treasury market will also take a beating – meaning China's remaining U.S. debt holdings would take a haircut of 20% to 30%.

The Marketplace Realities

International demand for long-term U.S. financial assets actually fell in January, reflecting China's smallest net purchase since May, Bloomberg reported.

International investors sold a net $8.4 billion in U.S. corporate debt in January, the report showed. Net foreign purchases of Treasury notes and bonds were a net $10.7 billion in for the month, after purchases of $15 billion a month earlier.

Few analysts believe China will abandon its Treasury holdings altogether, as that would hammer the dollar, hurt the value of its debt holdings and ruin its political relationship with the United States.

Besides, it's becoming increasingly clear that Beijing wants a voice in Washington.

Yu Yongding, a former advisor to the Bank of China said last month that China should seek guarantees from the U.S. government that its holdings won't be diminished by "reckless policies."

Premier Wen echoed that request last week when he called on the United States to "honor its promises and guarantee the safety of China's assets."

"I think what they're trying to say right now is, 'Don't take any steps that would impair our ability to access your market,'" Auggie Tantillo, executive director of the American Manufacturing Trade Action Coalition, told The Post. "The Chinese are starting to flex their muscles, they are becoming more powerful commercially and economically, and they want us to know it."

The very possibility that China and other foreign countries would stop buying U.S. bonds already was enough to prompt the U.S. government to take control of foundering mortgage giants Fannie Mae and Freddie Mac

News and Related Story Links:

  • The Associated Press:
    China 'worried' about US Treasury holdings
    .
  • Tampa Bay Online:
    World Leaders Wary Of U.S. Finance Plan
    .