The New Money Power

How Peking forced its biggest debtor, the USA, to negotiate the financial crisis

For weeks, the activity of Chinese central bankers in the financial crisis was barely perceptible. They didn’t emerge from cover until last Friday, when it became known that the government-owned China Investment Corporation (CIC) was negotiating with Morgan Stanley for a further takeover of their shares.

China as a bankruptcy vulture? That would be underestimating the awakening giant. The Chinese Central Bank was an important player in the U.S. financial crisis right from the beginning. They were subtle, to be sure, but as hard as nails. Top executives in the Chinese financial system won’t speak openly about it, but secretly they give hints where the evidence can be found. And when one has found it, the evidence reveals more pieces of the puzzle.

The story begins with two expensive mistakes. The Chinese didn’t only jump in with U.S. financial investor Blackstone, which since has lost much of its previous value, but also with Morgan Stanley. The second-largest U.S. investment bank urgently needed capital after suffering their first losses in the billions, thus the Chinese were welcomed last December when they invested 5.5 billion dollars in return for a 10 percent interest in the bank. A bad investment, as it turned out. “We underestimated the weakness in the U.S. economy, otherwise we wouldn’t have invested in firms such as Morgan Stanley,” a Chinese central banker said today. He described it as “annoying” but “not dramatic.”

The second mistake was underestimating the speed at which the U.S. crisis developed. In their state-controlled mentality, the Chinese assumed that the U.S. government would be successful in putting off any collapse until after next year’s presidential elections. And, in fact, both Fannie Mae and Freddie Mac tried to reach an agreement with the administration allowing them to shift their losses onto the 2009 books, according to the New York Times. But the pressure became too great. Representatives of the rising world power, China, had overestimated the maneuvering room of the reigning world superpower.

Until the middle of this year, the Chinese had put 376 billion dollars, that’s one-fifth of their gigantic 1.8 billion dollar reserve of American currency, into the bankruptcy-bound Freddie and Fannie duo. In July, however, it became abruptly apparent to Chinese creditors that both were on the rocks. In the shadow of the approaching Olympic games, the Chinese increased the pressure. From mid-July until the beginning of September they sharply decreased their support. Had they increased their credit support in the first six months of 2007 by an average 23 billion dollars a month, during the Olympic games they could have decreased their credits quietly to 23 billion dollars. The Japanese, second largest foreign creditor of Fannie and Freddie, followed suit.

How closely did the Chinese and Japanese cooperate? Both sides are politely silent on that point. That the two largest creditors in the crisis acted in concert, however, is obvious. The cup is full. The delicate subject was dealt with at the opening of the Olympic games when President George W. Bush met with leaders of the Chinese government. According to their own sources, the Chinese didn’t beat around the bush for very long. The liabilities were to be taken over by the state, they demanded. One can well believe that it wasn’t just the heat during the ceremonies that was causing George W. Bush to perspire. The Chinese made an offer Bush couldn’t refuse: If you don’t pay it back, we’ll have to convert our dollar holdings to Euros, thus putting further pressure on the U.S. currency. And who will be willing to loan you any money in the future if we won’t?

The United States needs nearly 20 billion dollars in loans every month

It’s mainly the Chinese who have been financing a significant portion of the United States’ deficit for a long time. The money they get from the sale of Chinese goods purchased by Americans is loaned back to the Americans so they’re able to continue buying Chinese goods. And that’s how Americans fell into the debt trap. As of now, the American government needs at least $20 billion loans in loans every month in order to finance current expenses. The money comes predominantly from Asia.

Naturally, the Chinese would suffer massive losses if they dumped their dollars on the market. The exchange rate would collapse and Americans wouldn’t be able to import much in the way of Chinese goods. But this is less a question of all or nothing than it is a demonstration of financial power.

When the Americans didn’t begin negotiating immediately, the Chinese clarified their position. On August 22nd, the Director of Institute of World Economics and Politics (IWEP), Yu Yongding, wrote to the Bloomberg Financial News with the blatant threat: “If the United States government allows Fannie Mae and Freddie Mac to collapse without adequate compensation to foreign investors, it will have catastrophic consequences. It won’t mean the end of the world, but it will mean the end of the current world financial system as we know it.” Yu is an advisor to the Chinese government and this was not the first time he had functioned as a sort of informal government spokesman. “The ramifications of such a collapse could be beyond human imagination,” he wrote.

Plain language. When there was still no action from the U.S. government, the Chinese accelerated Wall Street’s demise just a bit. On the 29th of August, i.e., shortly after the close of the Olympic games, the Bank of China announced in its quarterly conference that it was cutting its support for Fannie and Freddie by 25 percent. The next day, the Financial Times headline read, “The Bank of China deserts Fannie-Freddie.” Fannie and Freddie stocks each lost around 14 percent again, the greatest one-day loss for either, and both were finished. The Chinese had made it clear that they weren’t to be toyed with. Even if the threat to stop lending to the United States was just a bluff, the precarious situation kept America from risking worsening relations with its chief creditor.

On September 8th the government put Fannie and Freddie under “temporary control”. The plan was to pump 100 billion dollars into each investment house. The Chinese tactic worked. As they saw it, they had achieved or at least hastened the most serious intervention into the American economy since the Great Depression. “Different people may give different answers,” said Central Bank Director Zhou Xiaochuan of the action. “From my perspective, I see it as positive.”

In the short term, those in the United States may also see it that way, but over the long term it amounts to a defeat for the West of historic proportions. Here we have the leading industrial nation, which in 2007 alone produced a trade deficit with the rest of the world of 750 billion dollars; there we have the largest developing country that has raised its surplus to 370 billion dollars. And David has forced Goliath to own up to the fact that he was responsible for cleaning up his own mortgage mess while driving the debt level even higher. Chinese losses here are, in comparison, manageable. Asian central bankers, above all the Chinese, “come out of this crisis as winners,” admitted the influential magazine Business Week. Many western experts had earlier ridiculed the notion of “useless Chinese foreign currency reserves.” Useless my foot!

A week after Fannie and Freddie were nationalized, the chief of China’s central bank gave a new domestic policy signal. For the first time since 2002, Zhou allowed interest rates to decrease and simultaneously, for the first time since 1999, allowed a reduction in banks’ reserve ratios. With these actions, China plugged up the international crisis hole thereby ensuring any further crisis would be negligible for China. With a smirk, the Chinese take note that the USA wants to form a receiving company for bad debts. When the Chinese did exactly this several years ago in an attempt to relieve their insolvent banks, the United States criticized them saying they were only switching the debts from one pocket to another. Now George Bush justifies America’s action by saying, “This is a big package, because it was a big problem”.

Meanwhile, three of the world’s five largest banks are now in China.

With a mixture of skill and backwardness, the Chinese have so far been successful in isolating their economic system from the effects of the crisis. Just as rulers during the Han Dynasty used their Great Wall as protection against the Mongol hordes 2000 years ago, Chinese leaders in the 1990s built a protective wall against global financial currents. The Chinese currency doesn’t float but is pegged to a market basket the contents of which China brazenly refuses to make public. Even their stock markets, banking industry and real estate markets are, despite China’s membership in world trade organizations, protected to the point where foreigners are incapable of causing major disruptions if they suddenly join or quit.

In addition, neither the Chinese state nor private entities are allowed to accumulate large foreign debt. Chinese leaders forced these barriers through after China was nearly pulled into the financial abyss during the 1997 Asian crisis. In the booming southern province of Canton, which at the time already had command over Thailand’s economic power, financial institutions had borrowed billions behind the backs of the central banks in Peking and now found themselves unable to pay back the loans. Some of the loans were also from German banks. Then Prime Minister Zhu Rongji intervened just in time and was able to withstand the international pressure. Most western banks got just 10 percent of their investments back. China was not forced to devalue its currency and emerged for the first time from a great international crisis as the guarantor of Asian stability.

It must be added that the Chinese banking system is still very primitive although, when measured by stock exchange value, three of the five largest banks in the world are in China. The world’s most valuable bank, meanwhile, is the Industrial Bank of China (ICBC). Ninety percent of its business is done with terrible interest rates, but without relying on speculative financial products. At large western banks, the percentage of such business is 50 percent at most. In the first quarter of this year, ICBC became the world’s most profitable bank, increasing its profits by 77 percent. That individual large Chinese banks might go under because of carelessness is therefore highly improbable. At Bank of China, which is the bank most involved in the U.S. crisis, shaky investments account for a mere 1.5 percent of their business. At ICBC, their involvement with the crisis stands at 1.23 billion dollars. The other side of their balance sheet shows a quarterly profit of more than 7 billion dollars.

Danger from a different direction, however, is very real. Because of the crisis, Americans are consuming less. Because of the uncertain future, they hesitate to spend on anything but necessities. That reduces Chinese exports. But the Chinese are hoping that increased competition for customers will lower prices, resulting in even more companies wishing to relocate their production facilities to China. And, in fact, the trade deficit with China actually shrank by 6 billion dollars to 152 billion, although that trend seems to be reversing.

Economic experts currently debate openly in the Chinese media about China’s future direction. Government supporters warn against any further opening of the banking market. The nation, they feel, is already too dependent on foreign investment and world trade. Only the Great Wall in the financial sector is protecting China from anything worse, as we have just seen.

Those who support a market-oriented approach, like Fan Gang, Director of the National Economic Research Institute, argue otherwise. Banks have to be opened further, he argues, if for no other reason than to gain knowledge of the newest financing methods. That has nothing whatsoever to do with speculative investments. “An overly restrictive regulatory system,” he says, “means we passively run the risk of regulation from outside.”

And therein lies the greatest danger after America’s latest victory – that China may draw the wrong conclusions from it. China can no longer act as if it is alone in the world, Fan says. From his point of view, it makes sense for China to begin buying more from the West. In Peking, the fight over the right strategy continues. As regards Morgan Stanley, a spokeswoman for Chinese investment bank CIC said on Friday, “CIC will remain cautious on the subject of international investments”.

One disclaimer sounds different.