- The Washington Times - Thursday, May 7, 2009

China, which recently became the American government’s biggest creditor, was bulking up on risky Fannie Mae and Freddie Mac debt and U.S. equities from mid-2007 to mid-2008 as the U.S. stock market reached record highs, a recent Treasury Department report confirms.

Then the financial crisis reached a fever pitch, sending equities plunging and forcing a government takeover of Fannie and Freddie.

After being burned on Wall Street and nearly scorched by Fannie and Freddie, China has significantly increased its appetite for low-risk Treasuries - just as the federal budget deficit approaches a record $1.8 trillion this year.

The report shows that China’s June 2008 portfolio of U.S. securities included more long-term debt purchased from U.S. government agencies like Fannie Mae and Freddie Mac than long-term Treasury securities.

At the time Fannie and Freddie imploded, there was no explicit guarantee that the full faith and credit of the U.S. government would back the debt. But after taking over the two mortgage-financing giants, and at the behest of China, then-Treasury Secretary Henry M. Paulson Jr. effectively declared the U.S. government would stand behind the agencies’ debts.

China bought more than $150 billion in agency debt during the 12-month period ended last June, bringing its total investment in those securities to $527 billion, according to the Treasury Department’s Report on Foreign Portfolio Holdings of U.S. Securities. That was $5 billion more than the value of its long-term Treasury securities.

“China consequently entered the crisis with more exposure to the agencies [Fannie and Freddie] than to the Treasury,” said Brad Setser, a fellow in geoeconomics at the Council on Foreign Relations who writes the Follow the Money blog.

China’s investment in U.S. equities increased from $28.5 billion to $99.5 billion during the same 12-month period, Mr. Setser noted.

“China, and specifically the State Administration of Foreign Exchange (SAFE), was a large, visible buyer of U.S. equities,” Mr. Setser said. “SAFE wanted to show that it could manage a portfolio of ‘risk’ assets, and thus there was no need to hand over more funds to the China Investment Corp.,” Mr. Setser said.

CIC was China’s sovereign wealth fund and had already received $200 billion from the Chinese government, with the hope that it could achieve higher returns than Treasury yields.

In 2007, however, CIC had made sizable, ill-timed investments in Blackstone Group and Morgan Stanley, which later turned sour. After that bad experience, China’s appetite for less-risky investments increased.

Since June, China has purchased an additional $200 billion in U.S. Treasury debt as it became more risk averse “and fled to safety,” Mr. Setser said.

As of February, China’s coffers held $744 billion of Treasury debt, while Japan held $662 billion in Treasuries.

“The report shows more of the same, with China continuing to buy large amounts of Treasuries and agency debt and with U.S. debt to China continuing to grow by about $300 billion per year,” said William Cline, a scholar at the Peterson Institute for International Economics.

Japan and China are America’s two leading creditors, Mr. Cline noted. Each hold about $1.1 trillion in total U.S. debt, including corporate bonds - more than double the nearly $500 billion in debt held by Britain.

“Foreign holdings of long-term marketable Treasury securities held by the public increased notably to more than 61 percent of the total amount outstanding as of June 2008, by far the highest percentage of foreign ownership in any security type,” the report said.

The fact that foreign investors now hold more than 60 percent of long-term Treasury debt “inevitably represents some potential vulnerability to a loss of confidence or even a disagreement at the political level,” Mr. Cline said.

“It is not an imminent threat,” he said, “but it is a potential long-term problem.”

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