Ooh, the posturing is getting interesting. As we noted in Links last night, Timothy Geithner has already climbed down from his “currency manipulator” saber rattling by pressing the G-7 to deliver a much more China-friendly statement on what they’d like to see it do with the yuan (the original version urged letting it appreciate. the watered down one merely called for “a more flexible exchange rate”.)
China seems to be pressing for advantage in advance of the upcoming G-20 meetings. From Bloomberg:
China, the U.S. government’s largest creditor, is “worried” about its holdings of Treasuries and wants assurances that the investment is safe, Premier Wen Jiabao said.“We have lent a huge amount of money to the United States,” Wen said at a press briefing in Beijing today after the annual meeting of the legislature. “Of course we are concerned about the safety of our assets. To be honest, I am a little bit worried. I request the U.S. to maintain its good credit, to honor its promises and to guarantee the safety of China’s assets.”
China should seek to “fend off risks” as it diversifies its $1.95 trillion in foreign-exchange reserves and will safeguard its own interests, Wen said…
Delegates of China’s legislative advisory body suggested that the biggest foreign holder of U.S. debt diversify away from Treasuries into more risky assets at the annual meeting that started on March 3.
Jesse Wang, executive vice president of China Investment Corp., said on March 4 that his $200 billion sovereign wealth fund may invest in “undervalued” commodity assets. Zhang Guobao, head of the National Energy Administration, said China should invest more in commodities instead of hoarding the U.S. dollar, the official Xinhua News Agency reported on March 7.
Now on one level, this verges on silly. The problem is that the Chinese carried a national strategy on blindly and are now stuck with unforeseen consequences. Remember, in the wake of the 1997 Asian crisis, the harsh IMF program imposed on Thailand and Indonesia left spectators in the region resolving never to get in the position to suffer a similar fate. The cause was hot money inflows, which led currencies to rise. When it left, the currencies plummeted and borrowers in foreign currencies suffered and often failed. The solution was therefore to build up big foreign exchange reserves so as to fight a sudden fall, which was done by pegging currencies cheap (which of course also buffered them from a further decline). The choice of Treasuries was by default, as the safest and most liquid place to park funds.
And as much as buying hard assets like commodities sounds like a good idea, those markets are small compared to the Treasury market. China cannot deploy all that much there without distorting prices, which would put it back at square zero, save buying underlying operations (mines, agricultural land) rather than commodities themselves.
But China persisted with the strategy as it got hooked on export-led growth. If it had bothered thinking about it, China HAD to know its Treasury holding would be worth less down the road. It was pegging the currency cheap, and when it eventually rose to a more normal level, dollar holdings would be worth less. Perhaps the officials believed the day of reckoning would never come.
But Wen is pointing at a completely different issue, that of the ability of Uncle Sam to honor its debts. This would seem remarkable to some until you consider the following:
Moody’s warned of the risk of a US downgrade in the next 10 years BEFORE all the emergency expenditures and financial firm emergency operations startedStandard and Poor’s said consolidation of Freddie and Fannie might impair the US’s rating (um, we aren’t going to let them go, so the distinction between consolidation and what we have now looks largely cosmetic).
Credit default swaps on US 5 year debt, last I saw, was 100 basis points. Not all that long ago, it was 2, assuming you could even get a quote, the idea of a CDS on govvies seemed ludicrous. The US now seen as far from a risk free credit
And in case you think the credit risk is exaggerated, consider. The US already partially defaulted on its debt.
Recall how Bretton Woods operated. Rather than go back to a gold standard at the end of World War II (its defect is a deflationary bias, which made the Great Depression worse), the US instead pegged its currency at $35 an ounce and other countries set rates of conversion in dollar or pound sterling terms. By 1965, the value of dollar claims by foreigners on America’s gold reserves at the $35/oz. rate were greater than the actual supply. The US defaulted on its $35 par value when Nixon cancelled Bretton Woods by suspending the convertibility of dollars into gold. As Michael Hudson noted (hat tip reader Rajiv):
The $75 billion that the U.S. Treasury [would owe] to the world’s central banks at 1968‐1972 prices and exchange‐rates would be repaid with the equivalent of perhaps less than $40 billion in purchasing power as measured by the original debt. To the extent that gold was revalued and part of this $75 billion repaid in bullion, the gold tonnage price of this dollar borrowing would be written down to less than one‐fifth of its original value as measured by the year‐end 1974 price of almost $200 an ounce
And if you don’t buy the gold valuation (remember, it had been the value peg until broken), consider that the resulting floating rate regime saw a big depreciation of the greenback against most major currencies.
In other words, the idea of a US partial default is far from a loony line of conversation; we did it less than 40 years ago.
And in light of that history, why is Wen asking for assurances? None can be made. So what concession might he be looking to extract instead? Now that China’s trade surpluses have fallen sharply, it has no particular reason to buy Treasuries at anything like its recent volumes.
As we said, this message is most likely to be posturing for domestic consumption, but China could also be putting stakes in the ground. Watch for the next move in this gambit.
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Everyone understands there will be price inflation for dollar assets in the medium term and no one wants to pay that tax. It’s natural for the Chinese to go for commodities that retain their value somewhat against inflation. I don’t see it so much as posturing as merely stating the obvious.