The infosphere is abuzz with news about the imminent bailout of Frannie, in time for Monday morning here. And with good reason – the Chinese hold a fair bit ($376 billion) in US agency debt, most with Freddie and Fannie. This August 22nd article from Bloomberg describes the potential fallout if the situation worsens:

A failure of U.S. mortgage finance companies Fannie Mae and Freddie Mac could be a catastrophe for the global financial system, said Yu Yongding, a former adviser to China’s central bank.

 

“If the U.S. government allows Fannie and Freddie to fail and international investors are not compensated adequately, the consequences will be catastrophic,” Yu said in e-mailed answers to questions yesterday. “If it is not the end of the world, it is the end of the current international financial system.”

The end of the world? Mortgages are so much less climactic than nukes or killer plagues. Regardless, it does seem to be an increasingly popular meme that China (and other foreigners) might maliciously dump the bulk of their USD denominated investments.

This hasn’t been reported, so it’s either anecdotal, or not widespread enough to register: a fair number of people here are saying “sure the banks could try to sell – but who would buy all of it?” I mean, it’s obviously possible – they just seem more skeptical that it would be as logistically easy to tank all of their USD denominated investments. Or at least are more realistic about the zero-sumMachiavellian implications involved. 

Contrarily, it seems that the current regime will likely continue, precisely because they’re in so deep. This NYT article elucidates:

Those investments have been declining sharply in value when converted from dollars into the strong yuan, casting a spotlight on the central bank’s tiny capital base. The bank’s capital, just $3.2 billion, has not grown during the buying spree…

 

The central bank’s predicament has several repercussions. For one, it makes it less likely that China will allow the yuan to continue rising against the dollar… The central bank has been the main advocate within China for a stronger yuan. But it now finds itself increasingly beholden to the finance ministry, which has tended to oppose a stronger yuan. 

How do you get a weaker yuan? Buy more foreign securities. Coupled with a general concern here about the impact a cooling world economy will have on China’s exports make it all the more likely that there will be pressure for the yuan to depreciate against the dollar (or at least, fail to appreciate as much as some in the U.S. have called for). 

Given the current political climate, it seems likely that a widening China trade deficit will increase cro-magnonesque calls for protectionism. It’ll be a return to the good ol’ days – with the slight wrinkle that the US government will be on the hook for god know’s how much in mortgage losses. Not worries though – state ownership seems to have worked out just fine here.