Toxic US Treasuries?

You know things are changing in the world when a country expresses “concern about the outlook for the U.S. and the safety of its Treasury bonds”.  This would especially be true when that country is China and they are your biggest creditor.  This is not the sort of thing one hears about industrialized nations, let alone the world’s largest single country economy. But there it is.  The US is now considered a credit risk.

Analysts who watch the interest rates that the US must pay on its debt should have felt a little shiver yesterday. The Chinese government, the largest holder of Treasuries, expressed some doubt about the turnaround of the American economy and came a bit too close to stating that US paper might be becoming less attractive as the government borrowing to stimulate the economy and save financial institutions makes American debt a more risky investment.

According to the FT, the Chinese premier said, “We have lent a huge amount of money to the United States. Of course we are concerned about the safety of our assets. To be honest, I am a little bit worried. I request the US to maintain its good credit, to honour its promises and to guarantee the safety of China’s assets.”

I posted at the end of January about the touch and go trade relationship between the US and China.  We stimulate their economy by buying Chinese stuff. They enable us to do so by buying our debt.  We don’t yell at them for restricting their capital flows, pegging their currency, or violating human rights and we get to spend a lot of money without raising taxes.  Well, that was so last month.   Today, China’s decided to publicly assert its ‘interests’.  We have yet to respond.  Is China expressing similar concerns already voiced by economists and the markets over the current handling of the US Economy by the Obama team?  Quite possibly.  This, from the previously cited WSJ article.

Mr. Wen said that China is also closely watching to see the effects of the policies taken by U.S. President Barack Obama aimed at returning the world’s largest economy to health. Chinese foreign minister Yang Jiechi was also in Washington this week to discuss how the two countries can cooperate on economic policy, among other issues.

A test of that cooperation is quickly approaching. U.S. Treasury Secretary Timothy Geithner this week called on the Group of 20 – a gathering of the world’s largest developed and developing economies – to increase funding for the International Monetary Fund by up to $500 billion to help combat the financial crisis. Achieving that sum likely will depend on getting agreement from countries that hold large foreign exchange reserves, such as China and Saudi Arabia.

Ahead of a preparatory meeting of G-20 financial officials this weekend near London, Mr. Wen said pointedly that “increased funding for the IMF is not a question for just one country” but for all member nations. He also repeated China’s desire to see reforms to the IMF that give more clout to developing nations.

They’re  ‘inkling’ that China deserves more international status and bargaining power.  They also would like the international community–especially the US– to lay off any notion of a more free and open Tibet.  I still find it intolerable that we’ve basically decided cheap Chinese manufactured goods are worth more than the religious and political freedom of native Tibetans.  That is, however, the bargain that is on the table.

Mr. Wen used harsh language against the Dalai Lama, Tibet’s spiritual leader, who accused the Chinese government this week of turning the Himalayan region into a “hell on earth.” He said talks between Beijing and the Dalai Lama, which took place last year without making any progress, could only resume if the Dalai Lama is “sincere.”

Indeed, China does have a big stake in the U.S. economy and is the nation’s biggest creditor.  It is always disconcerting when that creditor calls you at work and reminds you about the bill.  Here’s the size of the problem reported by the NYT.

China should seek to “fend off risks” as it diversifies its $1.95 trillion in foreign-exchange reserves and will safeguard its own interests, Mr. Wen said. He said that the Chinese had invested $696 billion in United States Treasury bonds as of Dec. 31, an increase of 46 percent from a year ago.

The United States Treasury Master index from Merrill Lynch shows that the securities declined 0.5 percent last month, after falling 3.1 percent in January, the worst since April 2004, as President Barack Obama sells record amounts of debt to finance his $787 billion bailout. The dollar has dropped 17 percent against the yuan since China ended a fixed exchange rate in July 2005.

This definitely presents a challenge to the Obama administration.  In order to forward the aggressive spending packages and tax cuts required for their agenda, the Chinese must continue buying US Treasuries.  It was rumored that one of the messages brought to China by newly appointed SOS Hillary Clinton was the hope that China would continue its huge investment in Treasuries.  The Chinese have now publicly stated that there will be a cost to those funds above and beyond the current interest rate.

Every time my students ask my what would happen if the Chinese suddenly dumped their supply of US Treasuries on the market, I say absolute chaos.  Chaos here in the US and chaos throughout the world markets.  I’ve also thought that an infinitesimally likely event.  I’m not so sure about that now that  we’ve had such a public announcement of our bad risk status. I’m also not sure if we’re being threatened with kneecapping, higher fees, or a mortgage on our soul.