China stimulus hurts U.S. credit markets

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China has finally answered calls from the United States to stimulate its economy through increased spending, but its decision will come with a cost.

China’s huge $586 billion spending package for building projects and social welfare programs enables it to boast of having by far the largest economic stimulus plan at a Group of 20 summit meeting of economic powers in Washington this weekend. At the same time, the massive diversion of money to needs at home means it will be investing less of its record $2 trillion of reserves in the U.S. in the future.

That means less money will be available to U.S. borrowers with big financing needs, including giant mortgage agencies like Fannie Mae and Freddie Mac, U.S. corporations and even possibly the U.S. government.

China’s announcement is the latest in a series of moves among major emerging economies from Russia to South Korea to spend more of their huge surpluses at home rather than invest them in U.S. bond markets. The trend contributed to the financial crisis and economic collapse that started in the United States this summer.

“As a country, we should be nervous,” even if the rest of the world benefits from a burst of growth brought on by China’s spending binge on raw materials to feed domestic growth, said Tom Sowanick, chief financial officer of Clearbrook Financial. “If China’s surpluses shrink, that will create a potential problem for financing the U.S. bond market.”

China was a particularly big investor in Fannie Mae and Freddie Mac securities that finance the housing market. But new investment dried up this summer and the mortgage giants as well as other private U.S. borrowers now are having great difficulty raising funds.

China will draw from the huge reserves generated by booming exports to the U.S. and other nations to fund its giant domestic spending program. Earlier this year, it used the reserves to purchase as much as $15 billion a month of Fannie and Freddie debt and a similar amount of Treasury bonds.

But China sold off more than $10 billion of its mortgage holdings in July and August, when Fannie and Freddie began to sink into a crisis that led to their takeover by the Treasury in September. China also sold U.S. corporate bonds and stocks, but boosted its purchases of Treasury securities, in effect enabling the Treasury to finance its takeover of the mortgage giants as well as a growing list of rescue programs for banks and other businesses.

China was joined in its summer selloff by a host of other nations — most notably leading oil exporters Russia and Middle Eastern OPEC nations — causing a loss of $34.4 billion in foreign investment in July and August that analysts say marked the beginning of the current credit crisis. While more recent figures are not available from the Treasury Department, analysts believe the foreign sell-off continued and worsened in September and October.

The U.S. economy, because of huge trade deficits that have made it the world’s largest debtor nation, cannot grow without the flow of more than $2 billion a day from overseas. The shutoff of the funding spigot from emerging markets helped precipitate a shutdown of entire credit markets in the U.S., a banking crisis and a deep recession.

“The sucking sound that you hear is the sound of global capital going back to the home country,” said Marc Sumerlin, managing director of the Lindsey Group on Wall Street. While the current crisis is giving the United States a taste of what it’s like to be starved of foreign capital, it will get much worse when China and Japan, another major investor in the United States whose population is rapidly aging, start repatriating funds to pay for the retirement of their vast populations, he said.

Although China’s economic problems are relatively mild, Russia and some other oil exporters have had to contend with more severe economic disruptions caused by the sudden huge drop in oil prices from more than $147 a barrel in mid-July to as low as $55 in London trading this week.

Middle Eastern and Asian oil nations, which largely depend on oil revenues to fund their economies and governments, sold $3 billion of U.S. securities in July and August. But their divestment of more than $12 billion in Fannie and Freddie securities started much earlier, in April.

Russia, beset by a severe economic crisis brought on by the collapse of the oil market and by its military action in Georgia in August, has spent more than $100 billion of its $500 billion in reserves trying to prop up its stock market, its faltering banks, and even suddenly bankrupt Russian billionaires whose failing empires threaten to drag down the Russian economy.

As oil prices plummeted, Russia severely cut back purchases of Fannie and Freddie debt that had totaled as much as $4.5 billion a month. In August, it started selling off its U.S. holdings in earnest as it raised the cash needed to remedy problems back home.

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