Ali.009
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The world order is changing, because China is propping up the US.
SO THE Group of Seven leaders have vowed to "take all necessary steps" to stop the world's financial immolation. That's good news. But first they are doing whatever is necessary to secure for themselves what is left of their toasted assets.
Last week Gordon Brown's priority was to use money laundering and terrorism laws to seize the British vaults of a bankrupt Icelandic bank. He says he will seize more Icelandic assets "wherever is necessary" to secure £20 billion ($52 billion) invested by Britons and British local governments.
International insolvency practitioners call it ring fencing - where rich countries, usually the United States, can lock down their borders to seize assets and jump in front of equally entitled but less muscular international creditors. That is why the US will get the lion's share of the leftovers of bankrupt investment banks like Lehmans.
But Iceland and Lehmans are sideshows in the new world of international financial cooperation and brinkmanship. The match-up that matters is between the mother of all debtors, the United States Government, and its primary financier, the Chinese Government.
By now China has accumulated more than $US2 trillion ($3 trillion) in foreign exchange reserves. The holdings are not transparent. Australian officials, for example, have no idea how much Australian currency is held by China's State Administration of Foreign Exchange.
But experts in both China and the US estimate that 70 per cent of China's foreign assets are held in the form of loans to the US Government and its agencies. That means America's official debt to the Chinese Government is worth 10 per cent of America's GDP, 40 per cent of China's GDP and more than twice as much as the combined value of all of the companies on the Australian Stock Exchange.
To understand both the raw power and vulnerability of China's international balance sheet you only need to look carefully at the demise and partial rescue of the US government agencies Freddie Mac and Fannie Mae.
Freddie and Fannie own or guarantee almost half of all American mortgages. To pay for these toxic loans that fuelled the US housing bubble they issued $US5 trillion in "agency" bonds.
In recent years it has been foreign governments that have footed the bill, accumulating about $US1 trillion of Fannie and Freddie agency bonds, according to Brad Setser, the sovereign wealth guru at the Council on Foreign Relations in New York. He estimates China alone holds between $US500 billion and $US600 billion.
Foreign governments, especially China, became even more important in funding bad US mortgages after the private sector financial system began to seize up a year ago.
But by July even they had taken fright. US Treasury data shows foreigners - read foreign central banks - bought $US34.3 billion of US Treasury bonds in the month but sold $US57.7 billion of agency bonds. China was selling Freddie and Fannie bonds (as well as US corporate bonds and US equities) and only buying US Treasury bonds because they were explicitly guaranteed by the US Government.
By August the US Treasury Secretary, Henry Paulson, began to realise that the biggest players in the American mortgage market were unviable. The foreign governments that had been funding them were turning off the tap.
The Washington Post reported that officials of the People's Bank of China told the US Treasury they expected it to "do whatever is necessary" to protect China's investments in Freddie and Fannie.
The US Treasury promptly gave guarantees to China and the agency bond holders that had lent to Freddie and Fannie, while allowing shareholders to lose everything.
Last month China again tested its new-found financial leverage. The Chinese Vice-Premier Wang Qishan reportedly sought an assurance from Paulson that Chinese investors would no longer face political opposition when investing in US companies. Paulson would have gladly given that assurance if he had the political credibility to do so.
For 60 years the US has shaped the global financial system and occasionally made threats to get what it wants. In August a new era began.
Now China stands between the US and national bankruptcy. Like a creditor that has invested all its savings in a single stricken business, China cannot extricate itself without seriously harming itself.
Its challenge is to extract the advantages it can while keeping the US national enterprise alive.
The prospect of losing $US400 billion, perhaps even as much as $US600 billion in Freddie and Fannie was a severe shock to the Chinese political and financial system.
A former senior adviser to the Chinese central bank puts it this way: "If these two companies went bankrupt, then all mortgage bonds will go down. So we will lose $US400 billion in one go."
The former adviser believes China has a long fight ahead of it to save its assets.
"The bonds have been taken over by the Government so they are temporarily safe. Temporarily. China's assets are still in danger at least of devaluation, even default, so China should join other countries on how to stabilise this situation."
The risk is that governments can miscalculate, they can misread each other and they can be pushed off course by domestic politics, even in an authoritarian country like China.
The overriding comfort for the world is that it makes no sense for China to abandon its US government investments. Even a hint that it might do so would send investors rushing for the door, causing the US dollar to tumble, US long-term rates to shoot through the roof and the value of China's foreign reserves to evaporate.
