Special report: China flexed its muscles using U.S. Treasuries By Emily Flitter
| Thu Feb 17, 10:21 am ET
NEW YORK (Reuters) – Confidential
diplomatic cables from the U.S. embassies in Beijing and
Hong Kong lay bare China's growing influence as America's
largest creditor.
As the U.S. Federal Reserve grappled with
the aftershocks of financial crisis, the Chinese, like many
others, suffered huge losses from their investments in American
financial firms -- from Lehman Brothers to the Primary Reserve
Fund, the money market fund that broke the buck.
The cables, obtained by WikiLeaks, show
that escalating Chinese pressure prompted a procession of
soothing visits from the U.S.Treasury Department. In one
striking instance, a top Chinese money manager directly
asked U.S. Treasury Secretary Timothy Geithner for a favor.
In June, 2009, the head of China's powerful
sovereign wealth fund met with Geithner and requested that
he lean on regulators at the U.S. Federal Reserve to speed
up the approval of its $1.2 billion investment in Morgan
Stanley, according to the cables, which were provided to
Reuters by a third party.
Although the cables do not mention if Geithner
took any action, China's deal to buy Morgan Stanley shares
was announced the very next day.
The two Treasury officials to whom the cables
were addressed, Deputy Assistant Secretary for Asia Robert
Dohner and Deputy Assistant Secretary for International
Monetary and Financial Policy Mark Sobel, declined through
a spokesperson to comment for this story. The State Department
also declined to comment.
China is America's biggest foreign lender,
playing a crucial role in the U.S.Treasury auctions that
allow Washington to borrow what it needs to keep its government
running. At the same time, the United States is China's
top export destination: America's trade deficit with the
nation reached a record $273.1 billion in 2010. Most economists
describe the two economies as co-dependent.
The concern in certain influential Washington
and Wall Street circles is that Beijing would leverage its
position as the main enabler of U.S. overspending. And the
cables provide a glimpse into how much politics inform relations
between the world's two largest economies.
One cable cites Chinese money managers expressing
concern that U.S. arms sales to Taiwan -- a major, longstanding
irritant in the relationship -- could sour the Chinese public
on Treasury purchases.
The subject of Taiwan came up during an
October 9, 2008 meeting the U.S. financial attache's office
had with Liu Jiahua, Deputy Director General of China's
foreign currency reserve manager, the secretive behemoth
known as the State Administration for Foreign Exchange,
or SAFE.
"Liu observed that the recent U.S.
announcement of another arms sale to Taiwan made it more
difficult for the Chinese government to explain its policies
supportive of the U.S. to the Chinese public," reads
an account of his comments in one of the cables.
The cables also indicate a high level of
confidence among the Americans that China can't entirely
stop buying U.S. debt, a sentiment shared by most economists
who describe the dynamic as a form of mutually assured financial
destruction.
But the cables do show that China can and
will pull back, with financial repercussions. In the spring
of 2009, with U.S.-China financial tensions running especially
high, China's Treasury holdings fell to around $764 billion,
down from nearly $900 billion. In July, after tensions between
the two nations mostly subsided, its holdings rose to a
record $940 billion.
During the financial turmoil, the cables
show that Beijing also shifted its portfolio away from longer-term
Treasury notes, which helped drive up America's long-term
borrowing costs.
NOT TOO BIG TO FAIL
The collapse of Lehman had a swift and powerful
impact on SAFE. "Several interlocutors have told us
that Lehman was a counterparty to SAFE in financial transactions
and as a result SAFE suffered large losses when Lehman collapsed,"
Deputy Chief of Mission at the U.S. Embassy in Beijing Dan
Piccuta wrote in a cable to Washington on March 20, 2009.
The hit to its balance sheet is likely what
prompted a Chinese official to tell a U.S. diplomat months
earlier that SAFE was afraid to re-enter the U.S. repo market
-- that is, it was reluctant to resume lending its short-term
Treasuries to counterparties wanting to use them as collateral
in cash loans.
On October 9, 2008, officials from the U.S.
embassy's office of the financial attache in Beijing met
with SAFE Deputy Director General Liu Jiahua. "SAFE
is very concerned over the danger involved in lending U.S.
Treasuries to U.S. financial institutions in the repurchase
agreement market," Liu said.
Liu said SAFE's confidence in U.S. banks
had been shaken. SAFE had exited the repo market, which
is a way for corporations and financial institutions to
borrow overnight.
The cable continues, "Liu remained
noncommittal on the possible resumption of lending, but
agreed that SAFE had sufficient confidence in those institutions
and would consider a system whereby the Federal Reserve
or other U.S. government agency would act as a guarantor."
Public opinion clearly rattled China's financial
leaders. One cable shows Liu citing an internet discussion
forum, saying "the Chinese leadership must pay close
attention to public opinion in forming policies."
The U.S. government does not appear to have
offered the Chinese a special setup guaranteeing U.S. banks.
Instead, the cables show, American diplomats reassured the
Chinese by pointing out that Washington had infused banks'
balance sheets with $700 billion in fresh capital, effectively
propping up the banking system.
FANNIE AND FREDDIE, GUARANTEED OR
NOT
China holds hundreds of billions of dollars
in debt issued by Fannie Mae and Freddie Mac, the housing
agencies known as Government Sponsored Entities, or GSEs.
Like many other investors, it purchased
agency debt before the crisis with the expectation that
Fannie and Freddie were implicitly backed by the U.S. government.
In September 2008, when the Treasury Department
took control of the two GSEs, SAFE officials grew alarmed,
the cables show. Suggestions that senior GSE debt holders
would have to take a haircut sparked a public outcry in
China. The media warned that the government's currency manager
faced monstrous losses similar to those suffered earlier
by the nation's sovereign wealth fund, China Investment
Corp., after its investments in U.S. financial institutions
blew up.
Media outlets had already heavily criticized
the government for CIC's losses -- a Financial Times story
circulated by outlets such as China Daily speculated that
CIC had lost $80 billion of the government's foreign reserves.
In late 2008 Chinese newspapers routinely ran headlines
with the words "Fannie Mae" and "Freddie
Mac" spelled out in English.
To defuse the situation, the Treasury Department
sent Undersecretary for International Affairs David McCormick
to Beijing for two days in October 2008. The gesture went
over well.
"All of Undersecretary McCormick's
counterparts appeared to appreciate his willingness to come
to Beijing in the midst of a financial crisis," Piccuta
wrote in a cable dated October 29, 2008. "Interlocutors
stressed that unless leaders' concerns about the viability
of banks and U.S. government-sponsored enterprises (GSEs)
are assuaged, lower-level officials will be constrained
from taking on greater counter-party risks."
The cables show McCormick trying to reassure
the Chinese. "In each meeting, Undersecretary McCormick
emphasized that even though the U.S. government did not
explicitly guarantee GSE debt, it effectively did so by
committing to inject up to $100 billion of equity in each
institution to avoid insolvency and that this contractual
commitment would remain for the life of these institutions,"
Piccuta wrote.
PACIFIC RIFT
The U.S. Federal Reserve announced a program
to buy agency mortgage-backed securities and Treasuries
in early 2009 to help flood the financial system with liquidity
and stop Treasury yields from rising. But at first the purchases
had very little impact on yields, which climbed steadily
while the Treasury Department's auctions of new debt wobbled.
In China, top officials began publicly criticizing
the inflationary side-effects of the Fed's program. They
said the expansion of the Fed's balance sheet would devalue
their Treasury holdings -- and indeed, the Chinese public
watched as Treasury yields rose and the older debt the Chinese
had sank in value.
On March 13, 2009, Chinese Premier Wen Jiabao
said at a press conference he was "concerned"
about the security of China's investments in U.S. Treasuries.
The March 20 cable, titled "Premier Wen's comments
on U.S. Treasuries: Protect China's investments," documents
a score of Chinese officials discussing their worries about
U.S. Treasuries and the potential consequences of their
uncertainty.
One economist at Caijing Magazine, which
diplomats described as a "respected" Chinese outlet,
told U.S. officials in late February "there has been
a 'huge debate' within the government about China's holdings
of U.S. Treasuries."
According to the cable, the Chinese economist
told U.S. embassy officials that "SAFE has been shifting
its portfolio toward shorter-term assets to reduce the risk
of capital losses from higher inflation."
That information dovetailed with data, released
many months later, showing the Chinese had indeed sold longer-dated
Treasuries and bought more T-bills, which surged to $210
billion by May 2009. The move likely contributed to the
rise in long-term yields.
GEITHNER IN BEIJING
Tensions remained high during Geithner's
visit to China -- his first as Treasury Secretary -- on
June 1 and 2, 2009.
Geithner, who has lived in China and other
parts of Asia and holds a master's in East Asian studies,
met with top Chinese officials, including the head of CIC,
China's $200 billion sovereign wealth fund, and the ministers
of finance and commerce.
The trip had been scheduled for months with
a predictable agenda, but the meetings were full of spontaneous
discussion and frank complaints from the Chinese, the cables
reveal.
Xie Xuren, China's minister of finance,
met with Geithner on June 1 and "expressed concern
about the potential for inflation and the long-term sustainability
of U.S. budget deficits," according to a cable detailing
Geithner's visit, dated June 17, 2009.
The next day, June 2, CIC Chairman Lou Jiwei
confided in Geithner that his fund had halted all new investments
in 2008 after the financial crisis broke out, but had since
scoped out a new stake in Morgan Stanley, the U.S. investment
bank.
At the time of Geithner's visit, Morgan
Stanley was planning a new share issue to raise funds to
repay the government for the money it received during the
financial crisis.
"Lou asked if it would be possible
for the Fed to expedite approval of CIC's request that this
investment be exempted from restrictions on investment by
bank holding companies, as the customary two-week process
for considering such exemption requests is too long to allow
CIC to take advantage of this opportunity," according
to the cable.
There's no record in the cable of how Geithner
responded, but it was only a day later, on June 3, that
CIC announced plans to purchase $1.2 billion in Morgan Stanley
shares.
A spokesperson for the Fed said in the instance
of the June 3 CIC investment, no application for an exemption
was made to the Federal Reserve Board.
(Additional reporting by Kristina Cooke
and Mark Hosenball; Editing by Jim Impoco and Claudia Parsons).