The debt nexus that binds the world
MASOCHISTS seeking further evidence of the West’s decline will have had a field day this weekend. Most strikingly, China’s premier Wen Jiabao, currently visiting the UK, said his country was ready to buy billions of European debt to prop up the single currency. The Chinese haven’t lost leave of their senses – they can afford to throw a few billion away buying toxic debt as a PR gesture, knowing that their geopolitical power will increase if they are owed money by half-bust Europeans. Diversifying into euros is also another way the Chinese can thumb their nose at Washington and undermine the dollar’s role as the world’s reserve currency.
The fact that this latest act of Chinese chutzpah comes as America finds itself plunged into a fresh debt crisis won’t have been lost on Washington. The US government has already hit its $14.3 trillion national debt limit. If that ceiling is not increased by Congress by 2 August, the Treasury will be out of cash and will either have to slash spending on wages or default on its debt by missing interest payments. The Republicans want multi-year spending cuts worth a cumulative $2 trillion and no tax hike as a prerequisite for raising the ceiling — the Democrats disagree. The Chinese, who own a large chunk of this debt, are looking on wrily – for them, just as with their Eurozone investment, the cost of losing money pales in comparison with the pleasure they will derive from seeing mighty America humiliated.
But this crisis is about far more than pride and geopolitics. A US technical default, even if it doesn’t last long, could have dire consequences. US bonds are meant to be ultra-safe; the moment markets begin to assume that they are actually risky, bond yields will shoot up and bond prices will plummet. Investors will be badly hit – even the Chinese, whom by this point will be nursing big losses (by which time their jubilation may actually turn to anger). The US sovereign crisis could soon turn into an almighty market rout if credit default swaps are activated. Even if they are not, America’s all-important money market funds may hit the rocks, just as they did after Lehman’s demise.
They own $338bn of US sovereign debt; even a temporary, technical default could lead some to “break the buck” (which would imply small losses to investors on what is meant to be an ultra-safe investment) which in turn would probably cause a run on these funds, with retail investors withdrawing tens of billions of dollars. The problem is that these institutions are a key provider of financing for global banks – short-term debt issued by the 15 largest banks in the world account for some four-tenths of the $2.7 trillion of money market funds’ assets. But no fewer than ten out of these 15 are European institutions – so when the US money market funds’ liquidity runs out, European banks will be forced to turn to the already massively over-stretched European Central Bank for funding. The nightmare will have come full circle.
So far the Chinese are laughing, cushioned as they are by vast forex reserves. Beijing forgets two things, however: its own system is deeply defective and is fuelling massive bubbles, domestically and internationally – and there is no way that a US and European debt crisis wouldn’t badly affect the Chinese economy. The West may be in decline – but it will drag the East down with it.
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