This article is motivated by two questions. The first regards the eerie silence
from China about the subprime mortgage and US asset-backed securities meltdown.
Second, how much risk lurks in the China portfolio of US debt? How much risk is
acceptable? China has emerged as one of the principle buyers and owners of long
term US debt over the past decade and only very recently bumped the UK from its
spot as the second-largest foreign owner of US securities.
For the first time in a long time, Japan has competition as a
foreign holder of American assets. The most recent US Treasury Department data
- reproduced at the end of this article - suggests that China (excluding Hong
Kong) held US$700 billion in US long term debt as of June 2006. Of this, $107
billion was in the form of pooled mortgages. These mortgage loans are backed -
more or less - by US agencies. Hence, they are called agency bonds. China has
been a massive buyer of the bonds over the past few months. It was a net long
term agency bond purchaser of $2.5 billion in July 2007, $2.7 billion in August
and $8 billion in September. Why is China so quiet about its holdings amid the
present subprime crisis? How much have the Chinese lost and how much more are
they willing to risk?
The answers to these questions have significant revelevance to US housing and
America’s impending economic downturn. The values of the US dollar and China's
yuan are also influenced by the holdings. America’s purchasing power and the
sustainability of a very large trade deficit will depend on the limits to
Chinese digestion of dollar assets and mortgages. Deafening silence must
eventually be broken by comment, disclosure and maybe even new policy. While we
wait, we are left to ponder the size of the growing risk exposure.
The pace of China's purchases of American mortgage product seems to have
accelerated as subprime troubles roil markets and weaken demand. Is Chinese
official silence a claim to be walking through the fire unscathed? In the words
of Alphonso Jackson, Secretary of the United States Department of Housing and
Urban Development, one statistic in the financial marketplace bares this out
most of all: in 2002, the total Chinese investment in US agency mortgage-backed
securities was just over $100 million. By June 2006, this number had grown to
over $107 billion - a nearly 1,000-fold increase in less than five years. Given
the size of Chinese mortgage purchases and the heavy concentration of
acquisition across the later years of the US housing bubble, one would assume
serious loss risk.
As of June 2006, China held about $30 billion in declared long term corporate
asset backed securities, of which $9.5 billion were mortgage backed. Hong Kong
reported $13.4 billion in long term asset backed corporate debt on June 30,
2006, of which $5.159 billion was mortgage backed. China and Hong Kong have
declared exposure of $43 billion in US corporate asset backed debt with $14
billion in direct corporate mortgage exposure. To this we would add $255
billion in US agency debt, much of it mortgage backed.
Much of the comprehensive data that we have is old, dating as it does from June
2006. It is also inexact and lacks the specifics required to assess portfolio,
risks and losses. This is known to many and further begs the question, why so
little official comment? Since the midpoint of 2006, China’s reserves and
foreign asset ownership have grown very rapidly, with the country favoring US
corporate and agency debt. It is fair to assume that updated numbers will
reveal much greater mortgage and asset backed security exposure than suggested
by the dated numbers in this article.
If we assume that China has been growing her agency purchases in line with the
rates of growth of her foreign reserves or US trade surplus, the numbers would
be huge. China at present has reserves - depending on how inclusively they are
measured - in the $1.5 trillion range. This is the result of astronomic growth
across the past two years. China’s trade surplus with the US has risen rapidly.
Multiple rounds of successful initial public offerings of Chinese firms have
built up large caches of dollars. Thus, dollar holding have soared since June
2006 data was collected.
If we assume anything like parallel growth in mortgage holdings, we would be
moving toward massive Chinese mortgage exposure. In the first nine months of
2007, mainland China net purchased $61.5 billion in US agency bonds. Hong Kong
purchased $24.47 billion, for a total of $86 billion in agency bond purchases
across the first three quarters of 2007. This constitutes a backward-looking
partial answer to question two. China has been willing to take on more risk and
is continuing to accumulate agency bonds.
Where are the official comments? Chinese official reserves, state banks and
financial firms must be sitting on tens of billions in mortgage backed US debt.
Likewise, there must be real and significant loss associated with these
holdings. It is unclear how any other conclusion could be drawn. This makes
official silence strange.
Agency debt was pursued for yield and to recycle massive dollar export
earnings. Chinese purchase motivation rises with export earnings. America’s net
imports from China have stayed elevated and Beijing continues to accumulate
dollars at a rapid clip. Should it significantly decrease the portion held in
dollars, this would exert significant downward pressure on the US dollar and
the US assets they have favored.
Both of these things are already happening. China's decision to follow the
markets toward lower demand for and prices of dollars and mortgages would have
a rapid and large impact. Simultaneously, whatever currency assets China moved
into would appreciate rapidly. Maintaining the fairly rich and stable exchange
rate between the US dollar and the RMB might become politically impossible and
economically difficult.
Perhaps this goes some way toward understanding the continued strong buying in
the summer and early fall of 2007. This may also explain why we have heard so
little about looming risk and mounting loss. There seems to have been
continuing Chinese purchases of US mortgage backed debt well into the recent
emergence of market distress. We know that Europe has pressured Chinese
officials not to place further upward pressure on the euro by moving reserves
from dollars to the European currency. We know the US economy - important to
China’s growth and employment needs - is addicted to cheap plentiful credit and
is sputtering.
It is widely understood that Chinese investment in US securities is large
enough that acting to support these investments would be a prudent temptation.
Rounds of protectionist agitation and tensions around trade, currencies and
product safety have meanwhile tested US-Chinese relations of late.
All of these contextual elements must play a role. Moving away from dollars and
US mortgage assets - already weak and falling - would complicate China’s
economic goals and throw fuel on smoldering political fires. It would also
reveal and worsen losses in US assets already sustained. Even so, none of this
fully answers the real pressing question.
Why buy so much mortgage exposure so consistently and so rapidly? Perhaps the
buildup in US dollars from export earnings and an increasingly difficult drive
to keep the RMB from spiking against the US dollar have left little immediate
choice. There are so many dollars building up so fast that few markets are
large enough to be viable alternatives. Political tensions and the precarious
state of the dollar and mortgages raise the prospect of massive losses if China
moves to diversify now.
If this is correct, it could be seen as a particular and peculiar aspect of a
Chinese US dollar and asset defense program. Increasing losses are risked or
taken to prevent larger losses. Only time will tell how wise this strategy is.
In the meanwhile, Chinese export earnings will continue to be spent - in part -
to support the US dollar and housing markets.
Silence may reduce the pressure to address a situation where no immediate
option is appealing. Taking on more risk may have emerged as a way to buy time
and stall or prevent huge losses on dollar assets. This would mean that the US
trade deficit with China is artificially supporting the US dollar and the value
of home mortgages bundled into agency bonds.
Max Fraad Wolff is a doctoral candidate in economics at
the University of Massachusetts, Amherst and managing director of
GlobalMacroScope.
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