20/02/2009: Breaching the Fed’s Maginot line

In 2004, calling it “a kind of balance of financial terror,” Lawrence Summers, President Obama’s Director of the National Economic Council, noted that “The incentive for Japan or China to dump Treasury bills is not very strong given the consequences it could have for their own economies.” Back then, China’s reserves were roughly 600 billion US dollars; by the end of 2008, they had crossed the 2-trillion threshold.

Most of China’s reserves are in US government bonds. If these bonds were sold on a large scale, their prices would tumble, triggering a sharp increase in US interest rates, surely the wrong medicine for frozen credit markets right now. Thus China’s vast currency hoard looms large as a threat to the US economy. But Summers spoke of a “balance of financial terror,” and there was indeed a counter-threat.

By selling its reserves, China would have lost money twice: the sale would have weakened the US dollar, thus undercutting the proceeds of the sale; and with higher US interest rates, China’s bond portfolio itself would have lost value.

Today, with the Fed saying it might buy US Treasuries to keep interest rates low, we argue that the balance of financial “terror” has started to tilt in favor of China. In buying Treasuries, the Fed presents China an opportunity that is too good to refuse: since the Fed aims to keep interest rates low, China’s portfolio would not be hurt by lower bond prices; the dollars from the sale would have no effect on China’s currency; and, not least, China could rebalance its rather poorly diversified reserve portfolio. Win-win-win, we would say, for China.

Of course, this dollar windfall would need to be reinvested somewhere. And this recalls another image of twentieth-century warfare, the Maginot Line, France’s supposed impenetrable defensive cordon built up along its border with Germany prior to World War II. It was, of course, anything but failsafe. The German army simply circumvented it, invading neighboring Belgium on its way to Paris.

So who, or what, might be the Belgium of America’s financial Maginot Line? The euro is one obvious candidate. The European Central Bank is far more reluctant to enter a currency devaluation contest than the Fed. By buying euro-denominated assets with its US dollars, China would drive up the euro and keep Eurozone interest rates low. Commodities are another route for China to avoid self-inflicted damage from a weakened dollar. Commodity prices are relatively low now, and building up inventories might appeal to China’s economic planners and voracious industrial base.

Clearly, the Fed is the loser in this scenario. “Don’t fight the Fed,” runs the old Wall Street truism. But two trillion dollars in currency reserves is a mighty big gun if China chooses to test it. This financial power play could lead to higher US interest rates despite Fed interventions, to lower European interest rates despite a more hawkish European Central Bank, and to a far weaker dollar versus the euro and other currencies and against commodities, with a corrosive effect on the dollar’s status as the world’s reserve currency of choice.