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The Fed Surpasses China as Owner of U.S. Sovereign Debt
By Mel Miller

By Mel Miller, Chief Economist, First Affirmative Financial Network

Now that the inauguration is over, the political focus shifts to the budget deficit talks. Will taxes need to be increased? What are the acceptable spending cuts? Can the debt ceiling debate be bifurcated from the deficit talks? Will the rating agencies downgrade U.S. sovereign debt, and if so, what will be the impact on treasury interest rates?

All of these are important questions and need to be answered to provide clarity for the financial markets. Debt alarmists are also fond of asking: “How high will interest rates need to rise if the Chinese quit purchasing U.S. debt?”

I want to add another and perhaps bigger question to the mix. “How much will interest rates increase if the Federal Reserve quits purchasing U.S. debt?”

The Federal Reserve now owns more U.S. sovereign debt than China! The financial press seems to have either missed this point or, perhaps, they do not see the significance.

QE 1-3 (three Quantitative Easing programs developed by the Federal Reserve) have been effective in reducing long-term interest rates even as the Chinese have slowed their purchases of U.S. debt.

Why have the Chinese not increased their holding of U.S. debt? In my opinion the Chinese government is worried about its own internal debt.

China has a debt problem. According to a recent study by GK Dragonomics, China’s corporate debt has risen from 108% of GDP in 2009 to 122% in 2012. In fact, total public and private debt in China increased from approximately 168% to 210% of GDP during this three-year time period. Since many of the heavily indebted companies are state owned, and the lenders also state controlled, the possible problem is obvious.

One of the lessons learned in the last recession is that private debt often becomes public debt in a crisis (i.e. TARP). While China avoided a recession because its state owned banks flooded the corporate sector with cheap loans, the financial risk has increased. China cannot afford a slow-down and will need to reduce total debt in the future. The bottom line is that China will be more likely to invest internally rather than investing as heavily in U.S. debt going forward.

Thus, the importance of the Fed, as purchaser and owner of U.S. sovereign debt.

If you can’t explain it to a six year old, you don’t understand it yourself.  Albert Einstein

Posted: February 4, 2013