By staff reporter Li Zengxin

Foreign governments, including China, could get stuck with a bill if the U.S. Congress passes a US$ 700 billion bailout plan for Wall Street, said Shen Minggao, Caijing’s chief economist. But China can take steps to protect its financial interests.

Writing in Caijing Macroeconomic Weekly Review, Shen said September 28 that a bailout could lead to new purchases of U.S. Treasury bonds by China if the U.S. government buys bad assets from American financial institutions. Rescued financial firms would then use those funds from the government to invest in China. In effect, China would exchange its high-quality assets for American T-bonds.

China is currently the United States’ second largest creditor after Japan. At the end of June, China held US$ 503.8 billion in T-bonds, accounting for 5.3 percent of the outstanding balance and nearly 20 percent of those held by foreign investors. By the end of July, China’s holdings stood at US$ 518.7 billion. Therefore, China is more likely than other countries to incur losses from a government bailout in four ways.

First, the U.S. dollar may further depreciate. If a bailout plan is completed in two years, the U.S. government deficit could reach US$ 1 trillion, leading to the dollar’s depreciation. Consequently, China’s T-bonds would lose value.

Second, rising inflation would weaken U.S. purchasing power. If the U.S. dollar depreciates, import prices would rise and inflation could soar in the United States, which is a major importer of consumables. If China holds too many long-term bonds, its real returns could be negative.

Third, China’s liquidity risk would grow. If foreign capital flees China, China may need to sell off T-bonds at prices that could have fallen significantly.

Finally, China may shoulder a huge risk without proper compensation if it buys T-bonds from the U.S. government. The bonds would be sold to China to raise funds for buying bad assets from U.S. financial institutions, which would then invest in China. This process would represent a de facto China-U.S. financial agreement for swapping China’s growth assets and U.S. fixed-return assets.

To avoid these risks, China and other countries must require that they receive a share of the benefits from rescued U.S. financial institutions through the following means:

First, they should require a margin to cover potential losses tied to U.S. inflation, or peg interest rates to inflation to keep real returns on their T-bonds positive.

Second, they should require a form of investment option. If the U.S. government’s investment in bad assets gets value added, foreign institutional and government investors should reap benefits along with the U.S. government. This should work like a convertible stock option in which creditors may choose to convert debt into shareholding.

Third, they should require a correlated return scheme by pegging T-bonds to the salvaged financial institutions and receive additional returns if they perform well.

Shen’s comments in the review’s seventh edition appear with Caijing Columnist Talk – Why Wall Street Falls, which features an exclusive interview with Shen Liantao, chief consultant to the China Banking Regulatory Commission, focusing on the causes and influence of the U.S. financial crisis – and the lessons for China.