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China’s dollar warning
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Chinese Premier Wen Jiabao said on Friday that he has “worried" about the safety of US assets. Whatever Wen’s political motives, his concerns about the integrity of US sovereign debt are timely and apt.
US debt held by the public has now hit $6.6 trillion—up from $5.3 trillion only a year ago. That doesn’t count the $5.2 trillion or so in outstanding Fannie Mae and Freddie Mac liabilities that we now know also have a taxpayer guarantee. And it doesn’t count the many ways that both the US Federal Reserve and US treasury have guaranteed financial assets more broadly—such as $29 billion in Bear Stearns paper, $301 billion in dodgy Citigroup assets, and hundreds of billions in Federal Housing Administration loans.
President Barack Obama’s stimulus plan and new budget will require an additional $3-4 trillion in new borrowing over the next two or three years, and that’s if the economy recovers smartly. Adding it all up, Federal Reserve chairman Ben Bernanke earlier this month estimated that US public debt-to-gross domestic product would reach 60% over the next few years, up from 40% before the financial panic hit—and the highest level since the aftermath of World War II.
That’s a lot of treasury bills (T-bills) to flog, and the world is taking note. Dow Jones’ MarketWatch reported last week that the cost to buy insurance against US sovereign debt default has surged in the past year. The spreads on credit default swaps for US government debt hit 97 basis points last week—or $97,000 to buy insurance on $10 million in debt —nearly seven times higher than a year ago and 60% higher than the end of 2008.
Wen called on the US to “maintain its credibility, honour its commitments and guarantee the safety of Chinese assets". Little wonder: China, like other trading nations, has a big stake in this fiscal free-for-all. Although it doesn’t release detailed data, roughly two-thirds of Beijing’s $1.9 trillion foreign exchange reserves are likely parked in US treasury debt.
The Obama administration revealed its sensitivity on the issue by responding quickly, with presidential spokesman Robert Gibbs saying on Friday, “there’s no safer investment in the world than in the United States". Obama added on Saturday that “not just the Chinese government, but every investor can have absolute confidence in the soundness of investments in the United States".
The White House is almost certainly right that the US won’t default; the consequences would be too dire. But there are risks well short of formal debt repudiation. As the supply of US debt increases, investors may demand a higher yield and interest rates would rise, reducing the tradeable value of current treasury bonds. The other temptation will be to inflate away the debt, which would also devalue dollar-denominated assets.
What Wen is really saying is that even the US national balance sheet has limits. The dollar is the world’s reserve currency, so the US has the rare privilege among nations of being able to borrow (and then repay its debts) in its own currency. America also remains the world’s main safe haven in a crisis, as the flight to the dollar and T-bills in recent months underscores.
But reserve currency status isn’t a birthright and it can vanish when nations are irresponsible for too long. Deficit spending has its uses when the money is spent on winning a war or to finance tax cuts and investments that promote economic growth. The tragedy of Obama’s $787 billion “stimulus" and his $410 billion 2009 spending blowout is that they spend principally on income maintenance and transfer payments that have little or no growth payback.
Wen may have been trying to placate his domestic Chinese audience, which is suffering through its own slowdown. Or perhaps he was trying to repay treasury secretary Timothy Geithner for his comments on Chinese currency “manipulation". But the Chinese Premier is right to warn that the global demand for American debt will continue only if the US runs economic policies that make US dollar assets worth the risk.
THE WALL STREET JOURNAL
Edited excerpts. Comment at otherviews@livemint.com
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