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Turn to last resort increases economic jitters

By Cai Hong (China Daily)
Updated: 2009-03-24 07:46

A patient, whose life hangs by a thread, might be treated with heavy doses of medication.

The US Federal Reserve has resorted to this treatment to address the country's recession.

The Fed decided on Wednesday to buy back US$300 million of long-term Treasury bonds - debt issued by the US government.

The Fed will buy a further US$750 billion worth of mortgage-backed securities, taking the total purchase of these debt instruments this year to US$1.25 trillion.

Most of the mortgage debt purchases will be from the two big government-controlled mortgage providers Fannie Mae and Freddie Mac, which without massive government assistance in recent months would have gone belly up and sparked another round of global panic.

In a last resort, the Fed will print new money to the tune of US$1 trillion.

The aim of buying back government bonds is to lower mortgage rates in the US and ease strained balance sheets, thus restoring credit flows.

The most important word I heard in Washington used in the past couple of days by US President Barack Obama and his White House officials was "confidence".

Amid the recession, these people are responsible for taking care of the psychic threshold of Americans and the rest of the world. They were trying hard to bolster confidence at home and abroad.

Obama and his White House aids were eager to give their word on the "soundness" of investments in the US. They were quelling Premier Wen Jiaobao's concerns about the safety of China's investments in US Treasury bills.

However, the Fed's approach to stimulate the US economy by printing more money is not a sign of confidence.

In a rare interview with CBS's 60 Minutes on March 15, Fed Chairman Ben Bernanke insisted that the US recession should calm by the end of 2009 and suggested signs of recovery might start popping up like spring buds beneath the melting snow of a long cold winter time in 2010.

The US has been trying to convince the rest of the world that it is a safe haven for foreign investment. During her China visit, US Secretary of State Hillary Rodham Clinton urged China to keep buying US bonds.

Now the Fed cannot wait for foreign buyers.

It resorted to printing more money because basically the US has run out of other options.

It has cut interest rates to virtually zero, and is already expecting to run a deficit of some 12 per cent of GDP this year. So further spending is difficult.

The aggressive strategy of "quantitative easing" to jumpstart the economy and avert a deflationary spiral is a sobering acknowledgment that Bernanke believes the Fed needs to make the strongest possible moves to prevent an accelerating economic disaster.

The Fed should be well aware of what its move means to other countries.

It leaves them, China in particular, little room for initiative.

There is a clear cost to massive quantitative easing. If another trillion dollars is pumped into the money supply, the value of the dollar will fall.

The US dollar rebounded on Friday but remained in line for a huge weekly loss against major rivals following the Fed's announcement.

A lower US dollar will make China's exports, which have already been shrinking, less competitive.

Brookings expert Darrell West said the US cannot rebuild its economy unless countries around the world feel confident about its long-term health. The US needs to keep China's investments in Treasury securities safe because this is vital to its economic future.

The US Treasury Department's latest monthly report showed that China's holdings of US Treasuries rose by US$12.2 billion in January to US$739.6 billion, maintaining China's status as the biggest foreign holder of US Treasuries.

International demand for long-term US financial assets fell in January, reflecting sales of corporate and government agency debt and China's smallest net purchase since May.

Before the Fed announced the quantitative easing, the US scholars I talked to were divided on whether their country is a "safe haven" for China's investments.

Albert Keidel, senior associate at the Carnegie Endowment for International Peace, said that China's concerns about the risk of holding so many reserves in US-dollar denominated instruments are "misplaced" if they are US government-backed bonds, especially Treasury bills.

The US dollar is strong, and the US economy - especially its manufacturing and advanced service sectors - are the largest and most sophisticated in the world.

Thanks to the combination of a strong taxation system and the role of the Federal Reserve system as the US-dollar lender of last resort, the US government will always honor its debt commitments.

He mentioned the US's long and successful track record of taking appropriate steps to use fiscal and monetary policy to reduce the risk and the impact of inflation, even in extreme circumstances like during the oil shocks of the 1970s.

In Keidel's words, currently planned large US budget deficits are intended to reverse the sharp decline in US economic activity and economic activity globally. Historically, the best way to be able to service and retire one's national debt is during times of economic prosperity; hence this deficit-spending stimulus strategy is said to be the best way to ensure that the US will eventually be able to minimize its long-term debt.

Critically, the most important force in terms of the value of US Treasury obligations is the US Federal Reserve system's policies, which can tighten US dollar liquidity at some point in the future if an inflation risk emerges.

Keidel predicted that there will be normal diversification away from dollar holdings if and when the current crisis is over and the global economy is healthy.

He maintained that for the near- and medium-term, the US dollar's strength will reflect its unchallenged position as the world's strongest currency.

However, he warned that non-US-government bonds and other investments carry a risk that all prudent investors, including Chinese lenders, need to consider carefully.

Nicholas Lardy, a senior fellow at the Peterson Institute for International Economics, is not as optimistic about the US Treasuries as Keidel.

Though the US government responded strongly, the professor did not rule out the possibility that China could suffer a loss on its holdings of US dollar-denominated assets.

Large looming fiscal deficits in the US validate the Chinese government's concerns that US interest rates will rise and that, as a result, the market value of Chinese holdings of US securities will fall.

Although this would only be a paper loss since the Chinese generally hold these obligations until they mature, the additional worry exists that the US fiscal deficit would lead to much higher inflation in the US and thus reduce the purchasing power of China's reserves, Lardy warned.

According to analysts, the Fed should know that by doing so, it increases the chances of inflation rearing as recovery eventuates.

But it is probably a risk the Fed is willing to take right now amid the possibility of deflation, or falling prices, a much more pervasive short-term concern.

(China Daily 03/24/2009 page9)