US Credit Risk: Does China Know Something We Don’t?

The blogosphere has been all a buzz this week after an article in the Financial Times suggested that America’s prized “AAA” credit rating could be in jeopardy. I first mused about this last fall even before the extent of the financial crisis was fully known and long before the government-sponsored stimulus packages added trillions to the US national debt. In the ensuing eight months since then, conditions have only worsened and, if anything, the case to downgrade the US credit rating is even greater.

Most of the pundits addressing this topic all agree that losing triple A status would be catastrophic to the US and would torpedo efforts to emerge from the recession. However, most writers seem to believe that the US economy is too big, and the US dollar too widely-held, to entertain the possibility that the US could be anything but the safest of bets. Too big? Too important? Isn’t that what they said about General Motors?

America’s annual deficit is now approaching $2 trillion a year with an accumulated debt of $11 trillion which is set to double in less than six years if the US remains on its present course. This alone must give ratings agents reason for concern but more telling perhaps is the recent actions of America’s number one lender. *

In September 2008, China surpassed Japan as the largest holder of US debt which as of March 2009, was nearly $768 billion dollars. In fact, in just over a year China has nearly doubled its US holdings – including more than $50 billion in the last four months alone. Meanwhile, many of America’s other traditional investors – countries including the United Kingdom, Brazil, Switzerland, and Germany – actually reduced their US dollar exposures.

But if China is increasing its investment in the US, isn’t this a vote of confidence in the long-term prospects for America? Actually, no – lending the US more money in this manner has more to do with China protecting its own investments as any drop in the US dollar also hits China’s bottom line.

Further to this point and as noted in yesterday’s New York Times, China may be buying US debt, but it is being much more selective, eschewing long-term Treasuries and government-sponsored enterprises (such as Fannie Mae and Freddie Mac) in favor of short-term notes. In other words, China is increasingly less willing to accept the greater risk of long-dated bonds and is actually exchanging long-term bonds for short-term notes, which even though they have lower yields, provide greater flexibility should China wish to divest itself of some of its US holdings.

The implications of this should not be ignored as it represents a major shift in China’s policy from even as little as a year ago. Not only is China reducing its exposure to long-term US securities, China is also – as we learned recently – increasing its supply of gold in a bid to alter the composition of its $2 trillion foreign currency portfolio. This is a strategy clearly aimed at minimizing the risk of future inflation eroding the value of long-term US-denominated holdings, while at the same time reducing exposure to what it feels are riskier investments.

* Source: US Treasury Department Website

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