Besides, to the extent the U.S. has to resort to using real money to shore up confidence in Freddie and Fannie, the result may not be all good for China. A key risk is that Paulson's bailout plan may expand the U.S. budget deficit, which may be inflationary and push Treasuries lower.
At last count, China owned $502 billion in Treasuries. Including agency debt, its holdings are more than $1 trillion, about a quarter of China's gross domestic product, Setser says.
Will China panic and dump U.S. assets? Perhaps not.
Like most of China's economic policies, the nation's approach toward reserve diversification will also be gradualist. With China's reserves reaching $1.8 trillion in June -- a $280 billion increase this year -- Freddie and Fannie, even after losing their yield premium, are assured of the Asian country's reluctant patronage.
I must admit that I couldn't resist taking yet another potshot at the investment record of the PRC. Loaded with the dollar, Treasuries, Blackstone stock, and tons of Fannie Mae and Freddie Mac guaranteed mortgage-backed securities, I've always thought of the Chinese government as a sucker for whatever detritus the Americans are trying to dupe the rest of the world with. As caveat emptor is the operative principle when it comes to investing, I am hardly surprised that China is once again taking it on the chin as spreads on agency debt are likely to widen in light of the current spotlight placed on the woes of these government-sponsored enterprises. Of course, you could make the argument that the losses in the Chinese official sector from putting the people's hard-earned money into these el crappo investments is more than offset by the gains China has made in the private sector which have been enabled by mind-boggling official accumulation of dollar-denominated assets. On the other hand, I like to use Chinese official investment as shorthand for what to avoid. If the PRC is piling into a particular asset class, perhaps it's best to avoid it like Michael Jackson at a children's party. Brad Setser has more, as does Bloomberg Asia columnist Andy Mukherjee; here's a snippet from the latter on China's lose-lose situation: