China Holds The Key To World Economic Crisis

The Age

Monday October 13, 2008

John Garnaut

But Beijing stands to lose plenty if it abandons its US Government investments.

SO THE G7 leaders have vowed to "take all necessary steps" to stop the world's financial immolation. That's good news. But first they are doing whatever is necessary to secure what is left of their toasted assets for themselves.

Last week British Prime Minister Gordon Brown's priority was to use laws against money laundering and terrorism to seize assets in Britain of a bankrupt Icelandic bank. He says he will seize more Icelandic assets "wherever is necessary" to secure #20 billion ($A53billion) invested by Britons and British local governments.

International insolvency practitioners call it "ring fencing" - where rich countries, usually the US, can lock down their borders to seize assets and jump in front of equally entitled but less muscular international creditors.

That's why the US will get the lion's share of the leftovers of bankrupt investment banks like Lehman Brothers.

But Iceland and Lehman Brothers are sideshows in the new world of international financial co-operation and brinkmanship. The match-up that matters is between the mother of all debtors, the US, and its primary financier, the Chinese Government.

By now the Chinese Government has accumulated more than $US2trillion ($A3.11trillion) in foreign exchange reserves. The holdings are not transparent. Australian officials, for example, have no idea how much Australian currency is held by China's State Administration of Foreign Exchange.

But experts in China and the US estimate that 70% of China's foreign assets are held in the form of loans to the US Government and its agencies.

That means the official US debt to the Chinese Government is worth 10% of America's gross domestic product, 40% of China's GDP, and more than twice as much as the combined value of companies on the ASX.

To understand the power and vulnerability of China's international balance sheet, you only need to look at the demise and partial rescue of US Government agencies Freddie Mac and Fannie Mae.

Freddie and Fannie own or guarantee almost half of all US mortgages. To pay for these toxic loans that fuelled the US housing bubble, they issued $US5 trillion in "agency" bonds.

In recent years, foreign governments have foot the bill, accumulating about $US1trillion of Fannie and Freddie agency bonds, according to Brad Setser, sovereign wealth guru at the Council on Foreign Relations in Washington. He estimates China alone holds between $US500billion and $US600billion.

Foreign governments, especially China, became even more important in funding bad US mortgages after the private-sector financial system began to seize up a year ago.

But by July even they had taken fright. US Treasury data shows foreigners - read foreign central banks - bought $US34.3billion of US Treasury bonds in the month but sold $US57.7 billion of agency bonds. China was selling Freddie and Fannie agency bonds (as well as US corporate bonds and US equities) and buying only US Treasury bonds because they were explicitly guaranteed by the US Government. By August, US Treasury Secretary Henry Paulson began to realise that the biggest players in the US mortgage market were unviable. Foreign governments were turning off the tap.

The Washington Post reported that People's Bank of China officials told the US Treasury they expected it to "do whatever is necessary" to protect China's investments in Freddie and Fannie. The US Treasury promptly guaranteed China and the agency bondholders that had lent to Freddie and Fannie, while allowing shareholders to lose everything.

For 60 years the US has shaped the global financial system, and occasionally made threats to get what it wants. In August a new era began.

Now China stands between the US and national bankruptcy. Like a creditor that has invested all its savings in one stricken business, China cannot extricate itself without serious self-harm. Its challenge is to extract the advantages it can while keeping the US national enterprise alive.

The prospect of losing up to $US600billion in Freddie and Fannie was a severe shock to China. A former senior adviser to the Chinese central bank believes China faces a long fight to save its assets.

"The bonds have been taken over by the Government so they are temporarily safe," he said. "China's assets are still in danger at least of devaluation, even default, so China should join other countries on how to stabilise this situation."

Similarly, as Australia's smaller mining companies run out of capital, it can't be long before the Federal Government is forced to pull down the investment barriers against Chinese state-owned companies that it erected this year.

The risk is that governments can miscalculate, they can misread each other and they can be pushed off course by domestic politics - even in an authoritarian country like China.

The overriding comfort for the world is that it makes no sense for China to abandon its US Government investments. Even a hint that it might do so would send investors rushing for the door.

This would cause the US dollar to tumble, US long-term interest rates to shoot through the roof, and the value of China's foreign reserves to evaporate.

David James' column has been held over.

© 2008 The Age

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