China's Big Threat

You have to wonder what China is really thinking about regarding the dollar and it holdings of US securities. The Chinese have their own set of issues at the moment. One would think that they realize it is not in their best interest to destabilize the global capital markets at this point in history.

Last Friday Chinese Premier Wen Jiabao was quoted saying:

“We have lent a huge amount of money to the US. Of course we are concerned about the safety of our assets. To be honest, I am definitely a little worried."


Again yesterday another shot over the bow from People's Bank of China Governor Zhou Xiaochuan:

Our goal is to, "create an international reserve currency that is disconnected from individual nations and is able to remain stable in the long run."


This is a high stakes game they are playing. The timing of these two announcements is not a coincidence. They are teeing this issue up in the press one week before the global summit in London. How far are they prepared to go with this?

Treasury Secretary Geithner reacted with a flip flop that caused the dollar to gyrate by 1.3% in under a half hour. He first commented:

“We’re actually quite open to that.”

Apparently some aide whispered in his ear that the dollar was getting hit so he added:

“I see no change in the U.S. currency’s role.”

There were reports that several of the big trading houses earned a months wages in those 15 minutes. Good for them. A tad sloppy on Mr. Geithner's part.


Consider the absolute worst case scenario.

Bank of China head, Xiaochuan calls Geithner and says, “We want out”.

Cool headed Geithner would respond, “Let me get the report of your holdings”... “I have it. As of today you own $1 Trillion of US paper. It is held in Treasury bills notes and bonds. You also have Agency paper and RMBS that is guaranteed by the Agencies. You want to sell it all?”

Mr. Xiaochuan would respond, “Yes, that is our intention. We will sell our bond holdings for cash and then convert the proceeds into non-dollar currencies. We will acquire sovereign credits of those countries. The diversification program will result in holdings of 10% Canadian, Australian, English and Swiss Currencies, plus 20% of Euros Yen and the Dollar.”

In the tradition of Wall Street Mr. Geithner would respond, “Hold the phone.”

This exact situation has been the subject of discussion for many years. The working assumption has always been that something along these lines would happen sooner or later. Enormous Central Bank to Central Bank swap lines are in existence today to handle this situation. The conclusion has been reached long ago that the US dollar and US Treasury are 'too big to fail'. Decision makers at the Group of 7 Central bankers are almost always available in emergencies. They could convene in short order and agree to provide the necessary swap facilities and currency repo lines to the US Treasury. Each of the Central banks will reap some benefit from providing the necessary credit.

Follow the money. China has US IOU's and wants cash so it can buy foreign currencies. Treasury does not have this cash but has the swap lines. Treasury borrows $800 billion from the 6 Central Banks. China gets the $800 billion and gives it directly back to the same 6 Central Banks in exchange for their respective currency. China uses this currency to buy Government debt securities from those same Central Banks. The books of the Central Banks are all a wash. The have new assets and liabilities, but they did not have go to the market to fund these new assets. The money came to them. While these types of transactions are not desirable they do create a situation for the foreign Central Banks where a huge slug of new capital is invested into their economies. They are required to re-lend these funds back to the US on a temporary basis. That activity should result in a net gain or savings to the participating Central Banks. All in all this would be a net plus to them.

This would be a blow to the US. But not a crisis. Treasury would be forced to absorb the risk and rewards of borrowing under the currency swap facilities. Offsetting this would be the reduced interest costs realized by funding short term at Libor rates versus the long term spreads the Chinese are currently realizing.

Mr. Geithner could get back on the phone with Mr. Xiaochuan and say, “We are prepared to put a price on the whole thing. We will use Bloomberg mid-day rates for both the bonds and the currencies. We will charge 1% on the bonds and an additional 1% on the currency conversions. If you want to come in through the markets go ahead. We will just bid for what you are selling under the market. If you do it our way it will save you money.”

Of course nothing like this will ever happen. The point is that the Chinese threat has an existing solution. That fact makes it all the more likely that China will not make good on its threats. In the end it would cost them a great deal. They would have achieved the desired currency diversification but that merely creates a different set of risks.

The Chinese threat to diversify its holdings is a real, but manageable. This observer would not be surprised to see this issue simmer down. It would be helpful if Mr. Geithner would treat his largest existing investor with a little respect. It is possible that this whole issue has been brought to a boil as a result of the Treasury Secretaries comments at his own confirmation hearing in January:

In a written submission to the Senate Finance Committee, Mr. Geithner said "China is manipulating its currency."





Financial detente should be an objective of the April 2 meetings in London.