Just before the global financial crisis, I wrote a paper on the geostrategic implications of the United States’ growing external debt—and specifically about the fact that the U.S.’s main external creditors were increasingly the reserve managers of other states, not private investors. Yes, there were large two-way gross private flows in the run up to the crisis; think U.S. money market funds lending to the offshore arms of European banks who in turn bought longer-term U.S. securities. But, on net, the inflows needed to sustain the United States’ external deficit from 2003 on mostly came from the world’s big holders of reserves and oil exporters who stashed funds away in sovereign wealth funds.
Greece’s indebtedness to private bond holders and banks proved a bigger constraint on its economic sovereignty than the debt the United States owes to the PBOC and other official investors. Germany was the creditor country that ended up with the leverage, not China.
And thinking back even further, Britain’s geostrategic vulnerability to the withdrawal of U.S. financing in the Suez crisis derived from its commitment to maintaining the pound’s external value. Letting the pound float was inconceivable at the time.
That as much as anything gave the U.S. leverage over Britain. Worth remembering.
I could argue that the global crisis reduced the United States’ need for all kinds of external financing significantly, which is true—and that the leverage that comes from the perception that China could rattle markets in times of stress has not entirely gone away.
But it is also true that before the crisis I underestimated the Fed’s ability to influence term premia and the path of long-term U.S. interest rates independently of inflows from foreign creditors.* Call it the geostrategic impact of QE.
Yet some of the more subtle aspects of my argument about the strategic consequences of the rise of new large state creditors have, I think, stood up to the test of time.
One argument was that a major creditor could have an impact on the U.S. without actually selling dollars, just by moving their dollar portfolio around. And it is quite clear from former Treasury Secretary Hank Paulson’s memoir that the risk of a Chinese/ Russian funding strike of the Agencies in the summer of 2008 was something that worried U.S. policy-makers.** Robert Preston reported back in 2014:
"I [Paulson] was talking to them [Chinese ministers and officials] regularly because I didn’t want them to dump the securities on the market and precipitate a bigger crisis ... I was meeting with someone … This person told me that the Chinese had received a message from the Russians which was, ’Hey let’s join together and sell Fannie and Freddie securities on the market.’ The Chinese weren’t going to do that but again, it just, it just drove home to me how vulnerable I felt until we had put Fannie and Freddie into conservatorship ..."**
Another argument was that rising reserves would give the world’s new group of creditors “soft” financial power.
“Today, emerging economies ... not only do not need the IMF; they increasingly are in a position to compete with it. .... Chinese development financing provides an alternative to World Bank lending. Asia is exploring the creation of a reserve pool that could serve as a precursor to a regional monetary fund. If a small emerging economy got into trouble now, it undoubtedly would seek regional financing on more generous terms than those offered by the IMF."
That doesn’t quite describe the Asian Infrastructure and Investment Bank. But it isn’t that far off either. Substitute "development finance" for regional financing and "World Bank" for the IMF.
The reality is that the world can form financial coalitions of the willing without the participation of the U.S.. Even with the fall in China’s reserves and the strain that low commodity prices have placed on many commodity exporters.
Scott Morris of the Center for Global Development has written a new CFR discussion paper on how the U.S. should respond to China’s success in setting up the Asian Infrastructure and Investment Bank.
One of his conclusions is straight-forward. If the U.S won’t support an expansion of the balance sheet of the institutions where it has the most influence and weight—institutions like the World Bank—then the world will likely proceed without the United States. And the current “core” development institutions will over time be surpassed by new institutions where the U.S. has less influence.
* I imagined a more convoluted path to stability, drawing a bit on Dooley, Garber and Folkerts-Landau. The direct path would be for the Fed to buy what others were selling. I though focused on an indirect path: European central banks, concerned about a rise in their currencies, would intervene and recycle funds back into the U.S. bond market.
** Technically, the Fed could—and in the end did—offset the loss of Chinese demand for the bonds of the Agencies. The Treasury though needed to step in to provide the Agencies with the capital needed to absorb losses on their mortgage portfolio. Dan Drezner argues China’s influence on the Agencies wasn’t decisive—which is fair. The Agencies had sold a lot of bonds to domestic investors as well. But it is also quite clear that China’s holdings weighed heavily on the minds of the relevant decision makers.