Monday, July 14, 2008

Agency Issues

Brad Sester has a (slightly) less polemic and more data driven follow-up on Roubini's idea. It turns out that foreign official holdings of agency debt (Freddie, Fannie, Ginnie) are roughly 20% of the total $5 trillion agency debt outstanding. Looked at from the other side, he also estimates that between teh agency debt and the (explicit) treasuries they hold, China is sitting on a US government obligation position that equates to 25% of their GDP. Canned disclaimer on comparing stock numbers and flow numbers here. No matter how you look at it though, this is an extraodinarily large position for either side.

The basic take-away from this is that China is simply going to have to suck up the inflation that results from pegging to the US economy in this way, and the US is simply going to have to wallow through several years of stagflation. The other options -- letting the renminbi appreciate, or diversifying away from dollars, seem less and less viable every time I think about this. Sester has some interesting reflections on the irony of all this:

In some sense, it is remarkable that the system for channeling the emerging world’s savings into the US housing market - a system that relied on governments every step of the way, whether the state banks in China, that took in RMB deposits from Chinese savers and lent those funds to China’s central bank which then bought dollars and dollar-denominated Agency bonds, or the Agencies ability to use their implicit guarantee to turn US mortgages into a fairly liquid reserve assets — hasn’t broken down after the “subprime” crisis. The expectation that the US government would stand behind the Agencies is a big reason why.

That allowed the US government to turn to the Agencies to backstop the mortgage market once the “private” market for securitized mortgages dried up, as emerging market governments continued to buy huge quantities of Agencies.

And it now seems that this game will break down on the US end before it breaks on the emerging market end. The Agencies will run out of equity before central banks lose their willingness to buy Agency paper.

History, it is said, rhymes rather than repeats. Bretton Woods 1 broke down because some key governments weren’t willing to import inflation from the US. Bretton woods 2 has survived — even intensified — the subprime crisis because many emerging market governments have preferred importing inflation to currency appreciation. China seems more worried about textile job losses than inflation, negative real returns on household deposits or the risk of financial losses on its (large) holdings of Agencies.

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