Chinese Ratings Agency Warns of de Facto Default on U.S. Debt

Fed’s failure to defend dollar causes PIMCO’s Gross to look elsewhere; Canada a safer bet?

The Moody’s of China, Dagong Global Credit Rating Co., has warned bond investors that the United States is on the path of insolvency. “In our opinion, the United States has already been defaulting,” Guan Jianzhong, Dagong’s president, was quoted telling China’s English-language Global Times. Dagong is China’s only credit rating agency that rates sovereign debt.

Since the start of the financial crisis, market observers have noted the possibility that the U.S. might repudiate its debt through inflation or a weakened currency. Since the Chinese are the largest foreign owners of U.S. debt — holding $1.1 trillion in U.S. Treasury securities — China is naturally concerned about the sinking value of its investment portfolio. Since January 2009, the dollar has lost 9% against a basket of major currencies; it has lost a quarter of its value in the last decade.

While the Chinese are the largest foreign owners of U.S. debt, the largest single owner is the U.S. Federal Reserve, which has acquired $1.56 trillion in Treasury debt made in two rounds of massive securities purchases in a policy known as quantitative easing.

And that’s what troubles a lot of owners of U.S. debt: the Federal Reserve, as the U.S.’ biggest creditor, would have the most say in any insolvency issues; notice that the Fed has not been critical of U.S. monetary policy as the Chinese have been — of course, because the Fed is the one that makes U.S. monetary policy. Also, the Fed can at will pay back all the debt it owes by turning on the printing press.

bill gross of pimco This phenomenon is known as “dollar hegemony,” and some prominent participants in the U.S. debt market such as PIMCO’s Bill Gross (left) are starting to describe the U.S. as a “repressive” hegemon at that.

In a keynote address at the Morningstar Investment Conference earlier this week, the famed bond portfolio manager noted that the real return on 5-year TIPS has fallen to minus 0.05%. While negative rates benefit the U.S. government, they are “picking the pockets” of investors and savors.  Gross counseled investors to avoid “repressive countries” like the U.S. in favor of friendlier regimes such as Canada, whose economic stewardship has notably bested that of the U.S. since the economic crisis began.

Dagong’s trash-talking of the dollar is not unimportant. It could be a prelude to a further downgrade of U.S. debt, which last occurred at the start of QE2, when the ratings agency lowered the U.S. credit rating to A+ with a “negative” outlook from AA. And as a matter of fact, the Chinese have recently become net sellers of U.S. debt, cutting holdings of Treasury securities for the fifth consecutive month. Financial advisors would be well advised to look to safer plays like Canadian debt for their clients’ money.

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