- The Washington Times - Thursday, November 13, 2008

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.

“There was this incredible liquidity” flooding onto Wall Street from oil exporters, China and other emerging nations during the years when revenues were booming earlier this decade, said Doug Rediker, co-director of the Global Strategic Finance Initiative at the New America Foundation.

Through lopsided trade deficits with China and oil-exporting nations, “the U.S. was exporting [dollars] to other countries, and they needed to do something with them. They had to put the money to work” by investing in U.S. markets, Mr. Rediker said.

Earlier this decade, the easy money fed the U.S. housing bubble and a credit bubble as Wall Street traders funneled much of the money into mortgage securities and complicated mortgage derivatives.

But now that process has reversed course, and the consequence is a profound shortage of credit in the United States, he said.

Compared with the abrupt withdrawal of funds from U.S. markets by oil exporters, China’s pullback of investments since the summer has been gentler, and likely will continue to be gradual as it diverts more of its surpluses to stimulating domestic growth, analysts said.

“This won’t end Chinese demand for U.S. assets,” said Brad Setser, analyst with the Council on Foreign Relations, and if the withdrawal of Chinese funds forces Americans to save more and spend less on credit, “all that is good.”

China’s current boycott of Fannie and Freddie securities does threaten to raise mortgage interest rates, Mr. Setser said. Since the Fannie and Freddie sell-off began this summer, the interest rates on Fannie and Freddie debt have risen, lifting the rates on 30-year mortgages guaranteed by the agencies, despite their explicit backing now from the U.S. government.

“I do worry that China has stopped buying [agency mortgage securities] and instead is only buying Treasuries; it would be better if China gradually reduced its purchases of both as it stimulates its own economy,” Mr. Setser said. “But I would rather see China buy more U.S. goods than see China increase its overall purchases of U.S. debt.”

Analysts note that some U.S. companies stand to benefit from China’s increased spending on building projects. The stock of Caterpillar, a top U.S. construction equipment maker, and General Electric, which manufactures nuclear power plant generators, rose strongly after China announced the program last weekend.

China’s growth program, which amounts to more than 18 percent of China’s yearly economic output, also promises to boost the economies of countries that export raw materials. China’s rapid development earlier this year lifted the prices of most major commodities, including oil, copper and soybeans, to record levels.

“China’s stimulus package should have a major impact on stabilizing global growth,” and likely was designed in part to impress the major economic powers attending this weekend’s G-20 meeting with the growing importance of China in the world economy, Mr. Sowanick said.

“It is good for China and the global economy. However, its economic impact on the U.S. won’t be noticeable, not right away, anyway,” said Sung Won Sohn, economics professor at California State University.

Although the infrastructure spending will leave China with less money to invest in the U.S. over the next decade or so, the Asian giant should not have to sell its existing war chest of U.S. securities to finance the program, he said.