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The politicial consequences (if any) of the United States’ dependence on Chinese financing

by Brad Setser
September 20, 2007

I am participating in the Mellon Sawyer seminar on “debt, sovereignty and power” at Cambridge University today and tomorrow.   Expect light blogging.

My own intervention will focus on a topic close to my heart – “Can the world's biggest borrower also be the world’s greatest power?”   The question can perhaps be framed a bit differently:  does the maintaining the “balance of financial terror” require that the US accept some constraints on its own policy choices, or can the US count on the world’s central banks for financing no matter what policies it adopts?

I suspect opinion here divides on the question of whether or not the United States’ current dependence on Chinese financing – and specifically Chinese government financing, since private Chinese savers currently prefer RMB to dollars —  is a good thing, or a source of concern.

One point though shouldn't really be open to all that much question: US dependence on official Chinese flows has now reached a rather impressive level.  If current trends continue – the US current account deficit is around $200b a quarter in the second half of 2007, Chinese reserve growth is around $125b a quarter and Chinese keeps around 70% of its reserves in dollars – China could end up providing close to ½ of the net financing the US needs to sustain its current account deficit in 2007.    

china_financing_of_us_small

China provides a smaller share of gross inflows than net inflows.  But unless you think Chinese inflows have induced a large share of the outflows – the net is what matters.  Without a big net inflow from China, the US economy would look very different.   The current account deficit would be smaller.   Some of key financial variables – little things like benchmark interest rates – might be different.   And the composition of US output would likely be a bit different as well.

US economic and financial stability may now depend as much on continued financing from the Chinese government as on the continued flow of Saudi oil. 

On the other hand, it isn't clear that stability should be the goal for either US or Chinese policy — not if stability means the continuation of the current trajectory, one where the share of the US deficit financed by China is rising steadily, and the intensification of the balance of financial terror.  

72 Comments

  • Posted by Asian Man

    U.S. gov’t ethnic makeup will change as well as locally thanks to open doors policy to unchecked and unlimited immigration — in the end, the declining dollar value nor the increasing foreign financing of current account deficit will ever matter because again (I repeat) the U.S. is not so much of a country but a “Big Giant Market Place” for all walks of life to make a name or statment for him/her self — just like what myself and everyone is doing daily with so much free time (blogging…blogging).

  • Posted by Guest

    DC is wrong about HP. They have thousands of hardware and software engineers in the US. HP laser printer technology is based on a partnership with Canon, but their inkjet technology and new Edgeline printing technology was developed in the US.

  • Posted by Guest

    I suspect the reason the US has still not attacked Iran is fear that this might cut off Gulf oil and precipitate a world wide panic with disastrous effects on the US. I wonder what China might do IF the US did attack Iran. I would even go so far as to wonder why the Chinese might not “loan” some nukes to Iran to be used to protect it from attack. But…..probably not.

  • Posted by TH

    Twofish: “So it’s really not clear that all these home equity loans won’t have a positive return.”

    With the degree of foreign consumption, the US consumer has been basically writing checks to the rest of the world. That’s great for the global economy but I don’t see it improving the US directly (aside from the extent to which an improving global economy affects the US). Not to disagree that the US is still in good shape, just that the US has lost huge ground that would not have been lost if consumers truly did, as a whole, put housing windfalls to productive domestic use such as education, small businesses, etc., or just did the prudent thing and left that equity in the house for a rainy day.

  • Posted by adiemuso

    UST are sold off. Look at the price actions. I think it is not by coincidence that such downward moves happened after the 50bp cuts.

    It has become a fact rather than myth. Dollar weakness compounded by imported inflation will render US assets lesser than attractive.

    By that, though the stocks are higher nominally, in real terms it is not. The rise might be just to keep them in relative worth.

    The Chinese will in no doubt, or perhaps even the Middle Eastern, take over the baton from the US if such conditions persist without remediation.

    Remember that the CNY is still not floated. Imagine what will happened. Dollar will crash.

  • Posted by Twofish

    Just to clarify something…. Freddie Mac and Fannie Mae issue two entirely different types of securities. One type is when the package together mortgages into a pool and resell them as a MBS. The second type is when the issue debt on their own to purchase mortgages directly.

    Neither is guaranteed by the US government, but the first type is far safer. In those types of securities, Freddie and Fannies role is limited to insuring the mortgages against default, and if Freddie and Fannie go bust, it doesn’t matter much because the mortgages backing the securities are still there. The second type of debt security is far riskier because Freddie and Fannie are basically issuing corporate bonds.

    Also, the politics behind these bonds are different. If you hold a mortgage backed security with massive defaults, and Freddie goes bust, you then can proceed to foreclose on the mortgages and kick the people out of their houses. If it got bad enough so that tens of millions of people in the United States were losing their houses to the Chinese central bank, I can’t imagine the US government not organizing a massive bailout, and it has the ability to do this through FHA and the Ginnie Mae program.

    Also the type of mortgage that gets put into the MBS are “conforming” meaning first mortgages with at least 20% down and no more than $250,000.

    It’s unclear from the statistics exactly what type of “agency bonds” the PBC is buying, but I suspect that most if not all of it consists of secured mortgage backed securities rather than direct Fannie/Freddie debt.

  • Posted by Visitor

    @Twofish: “people who have complained about the structural weakness of the US economy has been doing so for decades. The US has some huge structural strengths, a relatively open immigration policy, some of the worlds best schools, some of the worlds best minds in law, management, marketing, distribution and finance.”

    two friends of mine went for PhD and post-graduate medicine studies in NY and Chicago, and their definite impression 12 years ago about the USA was this: “the system is screaking, although not yet shaking”. They predicted a couple of years to start shaking, and it did in 2000-2002. It was saved with a huge military force parade to sweep away overseas’ investors distrust and also to racket some smaller countries (pushing “clientelar” regimes subordinated to USA/UK/NL-based oil/resource multinationals). As we know, force is the last resort argument in a “free market” competition, so it’s not thoughtless to suppose that we’re coming to the final stage.
    The level of state and citizen’s debt is at a maximum, also the global list of partner states which share the losses (more or less at own accord) is at the maximum: you can’t find now other members available for EU or NATO proposals, and even some key muslim allies are close to mutiny. So the solution of the last 6 years (printing USD/Euro) is reaching its natural limits. To enter the WTO global system, emerging countries’ central banks had to buy huge amounts of USD/Euro, primarily as a buffer for much greater transactions (and the dissapearance of barter) and also to avoid financial crisis and short-time insolvency (hot money). All that should have made EU economy and life-standard soar after 2001, but it didn’t too much as EU was totally sustaining USA economy and american wars over the world; also it proves how catastrophic is this union rulled (and each member individually). So now the best USA sponsor is facing bankruptcy too (just take a look at EU defficit in 2006 and 2007) – and it’s only the beginning, ECB is pumping hundreds of billions in banks to keep ’em alive after the subprime crisis emerged in USA. We got a printing press working day & night at ECB, and the EU economic growth is only 3% – less than the real inflation rate, so it’s indeed a camouflaged recession (as in USA, of course): you produce less, but the prices growth is greater, so finally you have a nominal increasing of GDP at the end of the year. And finally some consumer prices are kept low by increasing imports from China with an artificially devaluated RMB, but that’s not going to work forever.
    Also, Japan central bank lowered their benchmark at 0.5% , so nearly zero-interest money! they force their citizens and investors to buy USA treasury instead of national bonds and they give helicopter money to the commercial banks. How could they lower even more this rate? To zero? Or maybe give free money and a bonus to those who take them from central bank printing press.

    USA may have best marketing agents, but not so good to make the world buy enough american products; in fact, although $ is sinking, USA exports aren’t increasing at all! it’s not very hard to sell chinese products, cause they sell themselves at their prices, but it will be very hard in the future to find buyers for US Treasury Bills, and I hope the over-confident american economists and retailers will find a very well-paid job as treasury bonds brokers now that we can’t count on the boombastic popcorn real-estate sector for vigorous recruitments.
    Also, worlds best managers may be at GM, Ford and Chrysler – judging by their wages and incentives, but that don’t help at all those firms to survive even on their country’s market!

    P.S. when you said about worlds best minds in law you were thinking about the former president, who was an eminent lawyer? or maybe about government’s experts who designed the homeland security laws? I agree, they must have been some kind of geniuses to pass such laws through the provisions of the Constitution. And one question please (if you don’t mind) about world’s best schools in USA: what highest university did present president graduated? I ask you because I’m not sure, but it must have been a famous one… do they really have grammar and geography courses?
    God, please save us of any more experts, this planet is too small for them and they wanna blow it up fast!

  • Posted by London Banker

    What Visitor said! Excellent summation of the challenges of exporting the US out of the hole it has spent so long digging.

  • Posted by Twofish

    Visitor: Also, worlds best managers may be at GM, Ford and Chrysler – judging by their wages and incentives, but that don’t help at all those firms to survive even on their country’s market!

    Curiously, GM, Ford, and Chrysler’s big problem is the same as Chinese state-owned enterprises, health-care and pensions. The companies made commitments starting in the 1950’s for lifetime health-care and pensions, and these are coming due now.

    Visitor: I agree, they must have been some kind of geniuses to pass such laws through the provisions of the Constitution.

    Followed by the worst of those laws getting thrown out by the Supreme Court, and also the Secretaries of Defense and Attorney General getting fired over various things. My point is that the system fights back.

    Visitor: And one question please (if you don’t mind) about world’s best schools in USA: what highest university did present president graduated? I ask you because I’m not sure, but it must have been a famous one… do they really have grammar and geography courses?

    You are trying to argue that because Bush graduated from an American school, and Bush is an idiot that my point about US schools being the best in the world is incorrect. Correct?

    That doesn’t make any sense…..

    Also, GWB and Ronald Reagan are people that shouldn’t be underestimated politically ****especially**** if you don’t like their policies. What they tend to do is to act, really, really stupid so that people assume that you can politically outmaneuver them, and when you try, you find that tactically, they aren’t that stupid at all.

  • Posted by Guest

    Visitor: Bush went to Yale since Daddie went there too. Daddie was bright and got into PBK, Shrubby was dumb and got barely passing grades. Shrubby said once that he never learned anything at Yale and that is one of the few true statements he has ever made. Yale is an excellent institution, but can’t make a dolt into a brain.

  • Posted by RebelEconomist

    Twofish:

    The Ivy League may be reputable but they help America less than they could if a lot of their American students get in because of nepotism. We have a similar though less extreme problem with Oxbridge in the UK.

    I agree that the US has immense potential, but this can be dissipated by populist politicians and an ignorant electorate. The danger is that the US declines like Argentina.

  • Posted by EthanJ

    Twofish,

    Thanks for the great answer about Agency MBS vs. Agency debt. Very informative.

    More to the point, the MBS have underlying debtors beyond Fannie and Freddie; the general Agency bonds do not. The MBS only face an unexpected risk if (a) they suffer default rates substantially higher than their ratings/history have indicated, (b) if the values of the underlying homes have declined so far that the principal of the conforming loans cannot be recovered from the foreclosure sale price, and (c) that this happens to so many properties at once that the GSEs go broke guaranteeing them all.

    Recall that for “conforming” loans, the loan itself cannot exceed a certain percentage of the value of the property – usually 80% – and must be the FIRST mortgage. The buyer must secure financing for the other 20%, either cash or a second mortgage. If the buyer defaults, the first mortgagor gets paid first from foreclosure proceeds. That means such a property already has a built-in 20%-price-decline cushion for the Agency MBS buyer.

    Most of the worst loans that are scaring the markets are NOT the GSE conforming loans. It’s the loans covering 95%, 100%, or 105% of the purchase price, or the second mortgages. The loans that will default and leave lenders hurting are the ones where a foreclosure sale won’t cover the principal. Those are NOT the loans bought by China, Russia, etc… That share of the housing disaster is ticking softly in banks and SIVs.

  • Posted by Guest

    Actually Rebel, the number who get into Yale, Harvard, etc., due to “nepotism” is extremely small. The vast majority are chosen through very tough screening methods. Bushyboy was an uncommon exception and he got in way back in the 1960s before things had changed that much. Oxbrige too is very competitive. If you can cite more competitive institutions please do.

  • Posted by RebelEconomist

    Guest on 2007-09-21 08:31:12:

    Regarding Ivy League, I recall reading about a system of “legacy preference” that operates in the US.

    Regarding Oxbridge, the Financial Times published several reports this week about how to get into Oxbridge. Start by going to a fee-paying school. Alternatively, buy an expensive house that comes with a chance of access to a good state school.

  • Posted by Bionick

    Actually Rebel, the number who get into Yale, Harvard, etc., due to “nepotism” is extremely small. The vast majority are chosen through very tough screening methods. Written by Guest on 2007-09-21 08:31:12

    So why do you think, say Yale, asks the applicant on the admission application whether the applicant’s relatives (parents, grandparents) attended Yale? Out of pure curiosity, no?

    http://www.yale.edu/admit/freshmen/application/pdf/yale_supplement.pdf

  • Posted by Ponzi Q. Globalization

    A review of…

    THE PRICE OF ADMISSION

    How America’s Ruling Class Buys Its Way into Elite Colleges — and Who Gets Left Outside the Gates

    By Daniel Golden

    http://www.washingtonpost.com/wp-dyn/content/article/2006/09/07/AR2006090701299.html

  • Posted by Twofish

    One pet peeve that I have is that people use the Ivy League to mean something other than the eight universities it means. There are a lot of elite private institutions that don’t belong to the Ivies (MIT, Caltech, Chicago, Stanford, CMU, NYU to name several) and there are lots of prestigious public university (UCLA, UC Berkeley, UIUC, UT Austin). In addition the US has a relatively good system of community colleges and technical schools. So taking a discussion about the quality of US universities and restricting them to admission policies of the Ivy League seems odd.

    Also, America’s “ruling class” knows far better than to try to overly restrict admissions. The gates are open enough so that anyone who has the ability to seriously challenge the power of the ruling class, gets in and becomes part of it. An example is the “class of 1965” (kids of Asian immigrants who arrived as a result of the immigration act of 1965). These make up a huge fraction of the Ivies.

    It should be noted that the cited reference estimates that the number of people who would benefit by removing all legacies is about 15% of the incoming freshmen class (which sounds right) and that the beneficiaries would be the upper middle class (which also sounds right).

    Also the paragraph at the end sounded a bit hollow to me. I wonder “what professed ideals” the reviewer was referring to.

  • Posted by Ponzi Q. Globalization

    America’s “ruling class” knows far better than to try to overly restrict admissions

    Let’s not be naive just so we can feel better about the admissions system.

    I assume the ‘ruling class’ loves their children and wants what is best for them just like everybody else. Screwing some unconnected stranger out of a position is a small price to pay to get your kid into an elite school. To argue that they would not use whatever leverage they have to do this because of some desire to co-opt potential threats to the status quo down the road is silly. After all, it’s not a conspiracy, it’s simply the result of human beings trying to help out their kids by working a system that allows such favoritism.

  • Posted by Twofish

    The way that the admission system works is that your kid’s application to Harvard gets placed in one of several queues, based mainly on the part of the country that you apply from. If you have a relative that went to Harvard or if you donate a huge amount of money, then you get put into a special queue, in which you are compete against the other people who have rich and connected parents. Only a small fraction of people who go to Harvard go through that “legacy queue” but the people who get into that queue is even smaller, so your chances of getting in are far higher if you get into that queue. Also, this is only for undergrad admissions, none of the professional schools do this.

    And the people designed this system, *did* intentionally set things up to perpetuate their power and status. If it is one constant in history that is that people with power and status do everything that the can to keep their power and status, and this often involves making deals with people who can challenge them. The admissions systems of the elite universities can been seen as a deal between the upper class power elite, and the upper middle class “want to be’s”. The upper class needs to keep the upper middle class happy since the upper middle class has the means and resources to overthrow the upper class if they wanted to. By making most of the positions in Harvard open to the upper middle class, their threat is neutralized.

    What makes the system work also is that US has a Federal multi-party system. If you want to be among the people who run the United States, you can get there directly through Harvard (graduate Kennedy School, get a job in a think tank or in a staff position in a federal agency). However, if you don’t make it to Harvard, you can be one of the people that run the state of North Carolina by going to University of North Carolina – Chapel Hill (become a local lawyer, or state assemblyman, or state court judge), and if you are hungry, ambitious, and lucky enough, you can get to Washington through the local elites. There is also a Republican establishment and a Democratic establishment, and the two groups really don’t like each other that much.

    This makes the dynamics of power in the United States vastly different than in Japan or France which don’t have regional elites.

    Yes there is a conspiracy in which people with power seek to keep that power. That’s the way that it’s always been, that’s the way it always will be. From time to time, you need to change who is in power, but don’t expect the new people to ultimately behave much better than the people they replaced.

  • Posted by Ponzi Q. Globalization

    That’s the way that it’s always been, that’s the way it always will be. From time to time, you need to change who is in power, but don’t expect the new people to ultimately behave much better than the people they replaced.

    Do not attempt to change any of the workings of the system. It is futile. It always was and always will be. Nothing can be done to improve it.

    I assume you don’t believe this but your resigned tone makes one think you do.

    However, apart from this adopting a position of impotent resignation, I agree with much of what you write here. My point was that the actors today do not think in terms of power relations and conspiracy. Most of them just want what’s good for their kids and use the system that exists.

    Like you say, you can’t expect people to act differently. Therefore, you have to change what they are allowed to do.

  • Posted by Twofish

    Ponzi: Do not attempt to change any of the workings of the system. It is futile. It always was and always will be. Nothing can be done to improve it.

    Ponzi: I assume you don’t believe this but your resigned tone makes one think you do.

    What tone of resignation? All I’m saying is that an naive frontal assault on the system is rarely going to be successful. In order to change the system you need to have a clear-eyed notion of how the system works, so that you can spot weak points in it, and figure out what deals to make and what deals not to make.

    Any most importantly, you need to think about what you will do if you win. Power is dangerous and wielding it can be self-destructive. The real tragedy is not so much the people who failed at overthrowing the system, but the people who *succeeded* at overthrowing the system and then promptly destroy the people around them.

    Finally, people are much more likely to surrender if you can convince them that there is a good place for them in the new order.

    Ponzi: Like you say, you can’t expect people to act differently. Therefore, you have to change what they are allowed to do.

    Who watches the watchmen? If you are in a position to control what other people do. Then who controls you. Whoever controls you, who controls them?

  • Posted by Anonymous

    Has anyone considered that GWB may be dyslexic? The stupidity thing is a leftwing media thing.