from Follow the Money

Creditors sometimes do get a vote

August 25, 2008

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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I was on CNBC on Thursday – and the planned segment on the role non-democratic governments play in financing US deficits morphed into a discussion of Chinese and Russian Agency holdings. The segment was hyped as “Do America’s creditors own the US” but the actual discussion swerved the other way: America’s creditors now depend on the US government to bail them out of their bad investment in Agency bonds. The implication seemed to be that the US still held the upper hand.

Count me unconvinced.

No doubt any large debtor does have leverage over its creditors.

Moreover, many countries finance the US not because they like US financial assets but rather because they want to hold their exchange rates down in order to support their export sectors.* They certainly haven’t done so for the returns. That gives the US a bit of room to maneuver: the US was able to attract central bank financing even as it cut US interest rates and the dollar slid.

Finally, the sheer scale of the surpluses in the oil-exporting economies and China limits their options. China and the oil-exporters will combine to run a $1 trillion dollar surplus. That implies a $ 1 trillion deficit elsewhere in the global economy. India’s $1 trillion economy cannot support a $1 trillion deficit. Realistically, that kind of surplus has to be offset by a large deficit in the US and Europe. There is a reason why the Gulf’s purchases of US assets almost certainly rose after Dubai Ports World, and CNOOC/ Unocal didn’t stop China from financing the US. Sovereign wealth funds options are a bit more limited that is sometimes claimed -- at least at a macro level.

The alternative to large-scale purchases of US financial assets is even larger scale purchases of European financial assets, or policy changes that reduce the surplus of the oil-exporting economies and China.

But the United States isn’t in a position where it can disregard its creditors either. The US now relies heavily on central bank purchases of Treasury and Agency bonds – what I have called the quiet bailout – to sustain its current account deficit. Without that flow, the US couldn’t run a counter-cyclical fiscal policy – and the Agencies couldn’t step up their purchases of mortgages to offset a collapse in the market for “private” mortgage backed securities. America’s creditors couldn’t stop financing the US without provoking a sharp fall in US demand that would damage their export sectors – but the US also cannot avoid a far large contraction that has happened to date without ongoing central bank financing.

So far, central bank demand for US debt has been remarkably resilient -- far more resilient than I ever would have expected a few years back. But a restructuring of the Agency bonds is one of the things that might bring this flow to a sharp end. Yu Yongding of the Chinese Academy is not exaggerating when he writes that “``If the U.S. government allows Fannie and Freddie to fail and international investors are not compensated adequately, the consequences will be catastrophic … If it is not the end of the world, it is the end of the current international financial system.’’ “

China holds far more than $376 billion Agencies Bloomberg reports. That data point is now over a year old, as it comes from the June 2007 survey. Adding the Agency purchases in the TIC data to that total suggests that China holds $446 billion of long-term Agencies. And that total is almost certainly too low. The TIC data tends to understate China’s purchases significantly -- and, as a result, the Chinese total holdings tend to be revised up after each US survey.

We know that China added $120 billion to its long-term Agency holdings between June 2006 and June 2007. If it added an equal number over the past year, it would now have around $500 billion of agencies. I would bet it has more than that. Between June 2006 and June 2007 China added about $400 billion to its foreign assets. Between June 2007 and June 2008 China likely added close to $800 billion to its foreign assets.

Think of it this way. China’s holdings of Agency bonds -- conservatively estimated -- exceed 10% of its current GDP, and perhaps significantly exceed 10% of its GDP. The equivalent sum for a US sized economy would be at least $1.4 trillion. And I am pretty sure that if another government’s “Agencies” didn’t repay the US government on time and in full on $1.4 trillion loan, the US public would insist that the US stop lending any new money to that country.

Restructuring the Agencies bonds truly would put the political basis of the ‘Bretton Woods 2” financial system at risk. China has to expect to take large losses when the dollar depreciates against the RMB. But it doesn’t expect to take additional losses; it generally has shied away from credit risk – not sought it out. China’s public wouldn’t understand how China could have lost huge sums from a failure of the US to repay.

Sure, the Agencies aren’t formally guaranteed. But the fact that the US wants SAFE to keep on buying Agencies gives China a bit of leverage.

China’s huge holdings have another implication – if the US were to adopt say Mr. Ackman’s restructuring plan and ask existing bondholders to swap their existing Agency bonds for new bonds and a bit of equity, it would effectively hand ownership of a central institution of the US housing market over to China and a few other governments.

The GSEs would be sponsored by more than one government.

Though in some sense they already are.

I don’t think it is realistic for the US to expect to be able to rely as heavily as it currently does on other governments for financing without giving up at least a bit of policy autonomy. The enormous holdings of Agencies by the world’s central banks (along with the Agencies held by US domestic banks) are -- in my view -- a constraint on the options available to US policy makers struggling to get ahead of a seemingly still deepening credit crisis. Dr. Yu isn’t exaggerating. The world needs the US to pay, but the US also needs the world to keep buying.

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