from Follow the Money

Read Dean, Areddy and Ng on the management of China’s reserves during the crisis

January 29, 2009

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Dean, Areddy and Ng key their story off Wen’s criticism of US economic management. But it is really much more about the political fallout inside China from China’s losses on investments that they considered safe.

The story breaks a lot of new ground. It highlights how China’s losses on Reserve Primary, Lehman, Morgan Stanley and WaMu influenced China’s decision-making It also confirms that China was very very nervous about its Agency exposure.

"The alarm for Chinese leaders started ringing loudly in July and August as problems deepened at Fannie and Freddie. Senior Chinese leaders, who hadn’t been apprised in detail of how China’s reserves were being invested, learned for the first time in published reports that the country’s exposure to debt from those two alone totaled nearly $400 billion, say people familiar with the matter. Fearing that the U.S. government might not fully back the companies, China demanded and received regular briefings throughout the peak of the crisis from high-level Treasury Department officials, including Mr. Paulson, on the market for U.S. debt securities -- especially those of the mortgage giants."

It seems like China’s top leaders knew less about China’s portfolio that American reserve watchers; it is not inconceivable (gulp) that I was the source for those published report about China’s Agency holdings. My own work with Arpana Pandey, incidentally, suggests that China’s holdings of Agencies were closer to $600 billion at their peak - though it is possible that China never held more than $400 billion of Fannie and Freddie debt, as there are other kinds of Agency bonds.

The Journal’s story also confirms that there has been a huge swing in the management of China’s reserves. The TIC data, which has shown a huge increase in China’s Treasury holdings, wasn’t off.

It turns out that one of China’s main criticism of US policy is simple: the government didn’t stand by institutions that China expected the US to support. Lehman. Wamu. And the Reserve Primary Fund. Dean, Areddy and Ng:

"Leaders in China, the world’s third-largest economy, have been surprised and upset over how much the problems of the U.S. financial sector have hurt China’s holdings. In response, Beijing is re-examining its U.S. investments, say people familiar with the government’s thinking. ...

Chinese leaders have felt burned by a series of bad experiences with U.S. investments they had believed were safe, say people familiar with their thinking, including holdings in Morgan Stanley, the collapsed Reserve Primary Fund and mortgage giants Fannie Mae and Freddie Mac."

..... The Reserve issue "is causing a lot of concern with a lot of financial institutions in China," said the Chinese official. Some officials expected that the U.S. and its financial institutions would better protect China from loss. "If the U.S. is treating us this way, eventually that will be enough cause for concern in the stability of the [U.S.] system," the official said

China’s leaders believed that China’s investments in the US financial sector would be protected, perhaps because that is how things are done in China. They weren’t. At least not consistently.

And that clearly has had a big impact on China’s leadership. And if I had to guess, I would guess that the CIC was not the only institutions in China that had a bit of direct exposure to Lehman. SAFE turned conservative at the same time as CIC. Though it may have been stung more by its losses on WaMu (Via a TPG fund).

China didn’t just stop buying Agencies. It also stopped lending out its Treasuries.

The Chinese central bank last year stopped lending its Treasury holdings for fear the borrowers will go bankrupt, according to people familiar with the discussions -- a decision that disrupted the functioning of the Treasury market. Beijing rejected pleas by Washington to resume its lending of Treasurys, the people said.

Fair enough. China owns the Treasuries after all, and has no obligation to lend them out. But, well, its actions in both the Treasury and Agency markets weren’t exactly stabilizing.

China’s leaders have a major problem. They have accumulated an enormous quantity of US assets as a result of their efforts to manage China’s exchange rate But they don’t have a mandate to lose money investing the public’s money abroad. China’s losses have generated a public outcry. However, avoiding credit losses means piling into Treasuries and -- well -- that has risks of its own.

The internal criticism of China’s central bank and the CIC is a bit incoherent. They are getting blamed both for letting the RMB rise and for accumulating US assets.

"Around October, a lengthy Chinese-language essay began circulating on the Internet excoriating Mr. Lou and other top CIC officials, along with Zhou Xiaochuan, China’s central bank governor, for being too close to the U.S. and then Treasury Secretary Henry Paulson. The diatribe quickly gained wide circulation in Chinese financial circles. One passage charged that Mr. Zhou "colluded with Henry Paulson to buy U.S. bonds, forced [Chinese yuan] appreciation, attached China’s economy to the U.S. and broke China’s economic independence.""

But the reality is that the RMB peg tied China’s economy to the US, and only by letting the RMB rise more than it has can China stop accumulating US assets.

China doesn’t really seem to want more exposure to the US. Understandably so. It already has way more exposure than makes sense. But China also doesn’t want its currency to rise, especially now. And there is no way to square that circle.

The funny thing?

China’s external portfolio actually has performed relatively well during the crisis. It only invested a tiny share of its total portfolio in risky assets. It holds a lot of long-duration bonds whose value rose as interest rates fell. And it is overweight dollars and the dollar rose ...

The true risk in China’s portfolio is one that China’s leaders clearly knew they were taking, namely that the dollar will eventually fall against the RMB. China for a long time operated its own version of the TARP. The troubled asset it bought in huge quantities in 2007 and the first part of 2008 was the dollar.

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