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Dangers of U.S. Debt in Foreign Hands

Authors: Benn Steil, Senior Fellow and Director of International Economics, and Paul Swartz
June 14, 2010
Financial News


In his recently published memoir, former Treasury Secretary Hank Paulson revealed that in August 2008 he learned that "Russian officials had {earlier} made a top-level approach to the Chinese suggesting that together they might sell big chunks of their GSE holdings to force the U.S. to use its emergency authorities to prop up these companies," referring to the debt issued by Government-Sponsored Entities Fannie Mae and Freddie Mac.  Paulson said that the Chinese declined to cooperate, but opined that the report was nonetheless "deeply troubling," as "heavy selling could create a sudden loss of confidence in the GSEs and shake the capital markets." With the U.S. needing to sell another $1.3 trillion in debt this year, how seriously should we take Paulson's concerns?

Looking at who owns U.S. debt, the risk he describes is certainly real.  Over the past decade, foreign ownership of U.S. debt has increased dramatically.  Foreign holdings of Treasurys have risen from 29% to 48% of the outstanding stock, while foreign holdings of U.S. government agency and GSE backed debt have increased from 6% to 16%.  Virtually the entire increase in both has been accounted for by foreign governments, as opposed to private investors.  And one government dominates: China.  By our estimates, China has accumulated an astounding $850 billion in Treasurys and $430 billion in agency debt over the decade - almost half the total foreign government accumulation.

To some, the fear that the Chinese might dump U.S. debt is misguided. "It would be very much against their own interest to do so," Federal Reserve chairman Ben Bernanke said back in 2006.  Heavy selling would precipitate precisely the fall in the dollar's local and global purchasing power that the Chinese fear.  So the Chinese would not cut off their noses to spite their faces.

But the same faulty argument can be made about anyone caught in a Ponzi scheme.  No one who finds himself in a Ponzi scheme wants to see it collapse, yet he will still sell because he knows he will be worse off if others sell first.

So how serious is the risk of strategic, coordinated foreign selling, of the type that could destabilize financial markets?  Here is where Paulson drops the ball.  He tells us only that China rejected the Russian scheme to coordinate the mass dumping of GSE debt.  Yet large-scale near-simultaneous selling is precisely what happened.  By our calculations, Russia sold $160 billion worth, virtually all of its holdings, over the course of 2008, while China sold nearly $70 billion worth between June 2008, when its holdings peaked, and the end of that year.

And while the fire sale went on the yield spread between GSE debt and U.S. Treasury debt soared.  From 2003 to 2007 it averaged 34 basis points.  When Russia started selling GSE debt in January 2008, it stood at 57 basis points.  When China started selling in July, it hit 86 basis points.  As GSE debt was widely used as collateral in the U.S. repo market, the rising spread forced U.S. financial institutions to pony up more and more securities to support their borrowing.  The government put the GSEs into conservatorship in September.  Yet Chinese and Russian dumping of GSE debt accelerated into the fourth quarter of 2008, as did spreads, which peaked in November at over 150 basis points.

This episode highlights the clear risks to the U.S., and indeed the wider world, of growing American dependence on foreign government lending.

Nonetheless, to Nobel economist Paul Krugman renewed foreign selling of U.S. debt would actually be a good thing.  "America has China over a barrel," he announced in a March 14 New York Times column, "not the other way around." Not only would China be hurting itself by selling, but the resulting fall in the dollar would boost American exports (without, he hopes, hammering the U.S. through higher import costs).  What about the higher interest rates the U.S. would be forced to pay on its debt?  Krugman would just have the Federal Reserve conjure up yet more dollars to buy the stuff and keep rates down.  But we suspect the Fed will find itself boxed in later this year or early next.  Bank excess reserves, at $1.1 trillion, are at exceptionally high levels, and in order to restrain their conversion into broad money growth the Fed would normally sell down its holdings of securities.  Yet its holdings of U.S. Treasuries are actually at pre-crisis levels.  The only stuff the Fed has available is $1.29 trillion of newly acquired politically toxic assets - mortgage-related securities that it cannot sell without triggering a further firestorm over home foreclosures.  The alternative tools that the Fed has suggested for its "exit strategy" - such as paying banks interest on term deposits at the Fed - all involve the Fed giving up control over short-term interest rates.  To achieve the level of term deposits the Fed believes necessary to control broad money growth, it must pay whatever rate the market demands.

In short, Hank Paulson was more right than he realized.  The dangers of America's massive and growing financial reliance on foreign governments are real and they are pressing.

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