The Bonds of State

Don't look too close

Hilary Clinton, US Secretary of State, visited China and “pleaded with her Chinese hosts to continue purchasing US bonds, of which China now holds close to $700 billion,” as the Asia Times put it.

Promises have been made and now governments have to figure out how to finance them.

An estimated $3 trillion of stimulus spending has been promised by governments around the world. That is an extremely large amount of money, and taxpayers will finance it over the long-term.

However, where does the money come from in the short-term?

When you spend money on your credit card, you borrow it from the bank immediately, and pay it yourself from your future income and over a period of time. But this crisis is caused by banks being unable to lend, so where are governments to get the money?

Well, big companies and sovereign states have an alternative mechanism to raise cash. It’s called a bond.

If individuals could issue bonds, you would put out a prospectus telling people how much money you need, how much you will pay back, and how you will do so. Then, if people believe you, they’ll buy your bonds. For individuals, such bonds can be very risky and the types of people who would be willing to buy your bonds probably break knee-caps if you fail to deliver.

Bonds in the millions of dollars can be traded on ordinary capital markets. The US needs to finance almost a trillion dollars, and this brings us to Clinton’s visit to China.

There are few funds with hundreds of billions of dollars to spend. Exporting countries, like China, Japan, Saudi Arabia and Russia, for instance, have been running major fiscal surpluses (albeit for different reasons) and so have a large amount of US dollars in cash that needs a place to be invested.

The US has been doing everything possible to shore up its ailing economy. Their over $1 trillion stimulus package includes numerous “Buy America” provisions and has triggered global concern about a new race to protectionism.

“History tells us that trade protection measures hurt not only other countries, but eventually the country that erected them in the first place. Trade protectionism differs from legally acceptable measures to protect trade. It is an abuse of remedies provided by multilateral trade rules.”

The words are stern enough, but their source may strike you as unusual. They are by Chen Deming, China’s Minister of Commerce.

China has a $250 billion trade surplus with the US. In other words, Americans buy $250 billion more stuff from China than the Chinese buy from America. China needs the US to keep buying things if the Chinese economy is to maintain its stability and growth. Their fear of US trade protectionism is very real.

And this ushers in the first ray of sunlight in the entire anti-trade protectionist rhetoric that has been flowing around the world.

It turns out that the countries most in need of bond finance are also the countries most keen on trade protectionism. The countries with sufficient cash to finance these bond issues are also the world’s biggest trade exporters.

When a private company lends money to you, they demand sureties and dictate terms around the way in which such money is spent. Sovereign lenders are in a position to demand political, as well as economic, terms.

China is now, as a potential investor, in the enviable position of being able to dictate lending terms to the world’s super-power.

In some respects, this is a setback, with the US offering to ignore human rights abuses in China as a first offer in order to keep the cash flowing. The Chinese will ask for far more than that, including open access to the US economy.

The hope in all this trade tussling is that heavily interlinked economies will continue to trade freely, despite the protectionist sentiments at home.