[R-G] [BillTottenWeblog] The Three Ways China May Deal With Growing US Debt

[Bill Totten]

by William Patalon III and Jason Simpkins, Money Morning Editors


Although there's a veritable laundry list of obstacles that could blunt
the US 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 US 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 US 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 US Treasuries and notes issued by other
affiliated agencies of the US government - including beleaguered
mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE).

However, the value of US 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 Incorporated US 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 US 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.

America's Foreign Creditors: See
http://www.moneymorning.com/images2/foreigncreditors.GIF


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

* The US dollar would drop fifteen to twenty percent.

* US stocks would get hammered.

* Inflation would spike and interest rates on Treasuries would jump into
the eight percent 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
October 1, the US 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
September 30. The plan then calls for a $1.17 trillion deficit for
fiscal 2010.

As currently projected, the US budget deficit is forecast to run at
about twelve percent of gross domestic product (GDP) - even worse than
the perennially anemic Japan, where the deficit is running at eleven
percent. 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 US economic
decline, the US 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
US 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 US 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 US Treasury securities. That underscores one
marketplace truism: Despite Premier Wen's reservations, the market for
US 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 US banking system, that US
government decision to take control of Fannie and Freddie was driven not
by worries about the fading US 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 US officials felt to make a move. Today, as US 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 US 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") US Treasuries, a form of "back-channel" communications that can
generate results (just look at how China forced the US government to
place Fannie and Freddie in conservatorship). Because this is back
channel, it stays out of the marketplace, so long as the US government
finds some ways to appease Chinese investors by somehow reducing risk.

2. Quietly slowing or stopping its purchases of US 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 US debt doesn't roil the markets too
badly, especially if it doesn't leak out until after the fact.

3. Publicly dumping US 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 US debt, the Treasury market
will also take a beating - meaning China's remaining US debt holdings
would take a haircut of twenty to thirty percent.

The Marketplace Realities

International demand for long-term US 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 US 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 US 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 US bonds already was enough to prompt the US government to take
control of foundering mortgage giants Fannie Mae and Freddie Mac.

http://www.moneymorning.com/2009/03/25/china-us-debt


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