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Friday, August 13, 2010

Who cares what the Chinese think?

Earlier this year Dagong Global Credit Rating agency, a little known entity located in Bejing, downgraded US Government debt and gave it a negative outlook.  Should we be listening to the message that Dagong Global Credit is putting forward? Here in the US the SEC has standards for assessing NRSRO’s (Nationally Recognized Statistical Rating Organizations) which are detailed on their website, and Dagong Global Credit is not one of those recognized agencies. In the mean time the “Big Boys” S & P, Moodys and Fitch still rule the roost, regardless of the fact that their ratings were of little value prior to, during or post this entire turbulent market period beginning in 1999 to the  present. Even so the “Big Boys” retain the ability to rank investment vehicles for creditworthiness and are still taken seriously after all that has transpired. One of the jokes in my family is that the best job in the world has to be weather forecaster as they are constantly wrong, yet manage to be taken seriously and keep their jobs; well now we can add working for SEC recognized credit rating agencies to that short list.

So should we be taking Dagong seriously? As of this moment Dagong is the National Enquirer of rating agencies. We do not really know what methods they use to derive their rankings, but is that truly critical given the track record of the “Big Boys”? The arguments that Dagong Global Credit puts forward do seem logical regarding the US and other countries debt out look, however, many will argue that the agency is just an extension of China’s government and meant to forward and bolster their vision and agenda. To this I would counter that the “Big Boys” have moved from their original mission of actual ratings to being cheerleaders for the Wall Street and Washington agendas. So while it is normal for either agency to “talk their book” one has to look at the facts. It appears that the “Big Boys” are in a concerted effort to gloss over problems in the system and promote a positive outcome, which is what we all want, at least those of us in the US. On the other hand, Dagong Global is coming at this from an outsider’s perspective of one who holds a significant amount of US debt so you would think that they would not want to risk that position with a downgrade.

I believe that this downgrade is very telling as the Chinese people have a long tradition of forward thinking and planning. It is my contention that they see the handwriting on the wall and are positioning themselves to reduce the amount of US debt they hold. The downgrade gives the Chinese government cover to drastically reduce purchases of US debt, and buys time for them to figure out how to diversify their existing portfolio of US Debt. If you polled most economists they would say it is not in China’s interest to stop buying debt or allow the debt to go down. I would argue that this is a highly ethnocentric point of view and that the mindset of the Chinese allows them to look forward and weigh what acquiring the debt has accomplished for them versus the short term pain associated with the paper losing value. Additionally, as China develops its own local trading partners and its internal markets grow the US becomes less of a factor in the Chinese economic equation.  If you don’t belive that this is happening let me ask you something. Would you have thought 10 years ago that the Chinese auto industry would out sell Detroit in number of vehicles? Well they did just this past year.

So the message of Dagong Global credit is pretty clear. China is looking to buy less US debt and this rating provides air cover. The implications of this are also clear. As of this writing the US needs to seek out $3.8 Billion Dollars each and every day from the world to fund its deficits of which China has been a major buyer. If China is not buying for their own reasons then others may follow suit making it even more difficult to fund the gap. The inability of the US to sell the debt out to foreigners is setting the stage for the FED to implement what has been dubbed “QE2” or quantitative easing number 2. For those not familiar with QE  it is when the FED prints money out of thin air to buy treasuries to inject money in to the system. The problem appears that the US Government debt demands continue to increase rapidly and a dearth of buyers will force QE on a grand scale. QE is highly inflationary because you are printing money to buy debt, which simultaneously devalues the currency and the debt worthiness, leading to less outside demand for debt and more QE. This is an inflation treadmill that once we get on we can’t get off until it runs its course.  It is  appropriate at this time to quote the Chinese proverb “May you live in interesting times”, to which I say I will take boring any day of the week.

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