In the early evening of 05 August 2011, news from the other side of the globe forever changed the benchmark risk assessment standard the world had used for decades.  For the first time in history, US Treasury securities were not rated AAA.  Active investors know financial analysts the world over have used US securities as the risk free investment standard against which all other investments are measured.

But no more.  According to S&P, US securities are no longer risk free.  With an entire weekend to ponder the implications of this historic change, there was no shortage of dire predictions.

The two that seemed to pass the test of common sense were a sell-off in US treasuries, since they were no longer risk free, followed by a rise in the interest rate at which the US can borrow.  It seemed obvious that existing investors would seek greener pastures and new investors would demand higher interest to compensate for increased risk.

As the largest holder of US debt instruments, the reaction of the Chinese government was crucial.  Over the weekend the Chinese press carried stories condemning the US “addiction to debt” and even the Russians chimed in, with Vladimir Putin branding the US economy as parasitic.

Here in Australia we are clinging to the belief that Chinese demand for what we have will see us through another global cataclysm, so anything the Chinese do should be of more than just a passing interest to us.  Concerned Australians woke up to the news on Saturday morning with one question in their minds – what does this all mean for China?

As world stock markets opened for business at the beginning of the week, market participants weighed in on the downgrade by selling off shares on fears of renewed global slowdowns and flocking to less risky investments.  Many fled to the safety of the supposedly more risky US Treasuries.  In fact, global demand was so high interest rates on Treasuries went down, subsequently driving US mortgage rates to historic lows.

This outcome was predicted by some experts, well aware that in a world filled with money in search of less risky investments, there are a limited number of places to go.  Only US Treasuries offer a large enough supply to meet world wide demand.  

The Chinese did not begin shedding US Treasuries largely because they had no place else to park their excess cash.  Of the remaining AAA rated countries in the world, only Australia and Canada have reasonably solid economies and neither could come anywhere close to meeting world wide demand.

However, there may be another reason the Chinese did not back up their bluster with their bite; and that reason should concern us here in Australia.  

Some observers view the relationship between the United States and China as something akin to a Kabuki dance, where the conflict performed masks the mutual interests of the dancers.  The truth is the Chinese have built a massive export driven economy fueled by a cheap currency in order to subsidise their exports.  The Chinese Yuan is pegged to the US dollar and Washington has long claimed the Chinese deliberately understates the value of its currency.  Manipulated or not, the result has been a flood of cash, which the Chinese sinks into US debt, which props up the US dollar and its own currency.

Even if the Chinese could rid itself of some of its trillion dollar holdings in US debt, they would in effect be shooting themselves in the foot by eroding the value of the dollar and simultaneously their own reserves.

In the short term, there is just no way China can take the risk of dumping or substantially reducing their foreign reserves in US Treasuries.  Here is what Professor of Economics at Beijing University, Huan Yiping, had to say about the current situation:

•    "There really isn't a better choice than U.S. Treasury bonds. The basic requirements for foreign reserves are safety, stability in value and liquidity. Although U.S. Treasury bonds might not meet the first two criteria right now, the problem is still that we do not have a better choice.",

But the Chinese citizenry is becoming increasingly angry for what they see as their government’s willingness to play the role of banker to the United States; loaning money in the expectation it will be recycled towards the purchase of Chinese exports, propped up by a weak currency.  There are voices in China calling for a decoupling of the Yuan, allowing market forces to determine the value of their currency.  That would drive up the cost of exports and is not seen by many experts as a serious choice.  However, that choice may be forced on the Chinese government.  

To the eyes of many in the west, the Chinese are in the process of creating a viable middle class within their country.  In reality, huge segments of the population have not shared in the economic prosperity the country has experienced.  As proof, consider the majority of Chinese cannot afford the homes and apartment units the government has created.  Those who warn of a housing bubble in China cite the fact that many of these housing units are bought as investments by upper class Chinese who have nowhere else to invest their money; while literally thousands of other units remain unoccupied.

The policy of the Chinese government to support exports at all costs in effect lowers the purchasing power of their own citizens for their own domestic products, thus keeping their standard of living low.  Some voices in China are asking why the government supports the American consumer by buying US debt to the detriment of the Chinese consumer.

More than anything else, the Chinese government is concerned about social stability.  Right now they may be caught between the proverbial rock and the hard place.  On the one hand they are equally addicted to US debt and a weak currency to drive their economic expansion.  On the other hand, you have the potential of an aroused citizenry asking for their share of the economic pie.  China will soon assume the role of the world’s leading economy.  Can they do it without a world-class currency and more growth in their middle class?

Their government has done an admirable job of adjusting policy to meet economic realities.  They have promised to restructure their economy towards more domestic consumption but are well aware of the risks of doing so too quickly.  With a change in leadership to take place in 2012, major changes in the near term are unlikely.  

Right now it appears Australians have nothing to worry about in regards China’s reaction to the downgrade of the US credit rating, with one glaring exception.  Increasing social unrest could force the government’s hand.

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