What happens when a foreign government becomes the most important customer for U.S. government-issued debt?

Why, that government gets its own special, and up until now, secret bank account at the U.S. Treasury Department! Reuters blows the lid off the special privileges that China now has for buying U.S. debt direct from the source:

(Reuters) – China can now bypass Wall Street when buying U.S. government debt and go straight to the U.S. Treasury, in what is the Treasury’s first-ever direct relationship with a foreign government, according to documents viewed by Reuters.

The relationship means the People’s Bank of China buys U.S. debt using a different method than any other central bank in the world.

The other central banks, including the Bank of Japan, which has a large appetite for Treasuries, place orders for U.S. debt with major Wall Street banks designated by the government as primary dealers. Those dealers then bid on their behalf at Treasury auctions.

The documents viewed by Reuters show the U.S. Treasury Department has given the People’s Bank of China a direct computer link to its auction system, which the Chinese first used to buy two-year notes in late June 2011.

China can now participate in auctions without placing bids through primary dealers. If it wants to sell, however, it still has to go through the market.

The change was not announced publicly or in any message to primary dealers.

As part of the U.S. Treasury’s deal with China, the Chinese government gets to buy U.S. Treasuries effectively without any public attention. In return for that secrecy, the U.S. Treasury gets to borrow money at very low interest rates.

So, what can possibly go wrong? Back to the Reuters’ exclusive:

The granting to China of direct bidder status may be controversial because some government officials are concerned that China has gained too much leverage over the United States through its large Treasury holdings.

For example, economist Brad Setser, who is a member of the National Economic Council and has also served on the National Security Council, has argued China’s large Treasury holdings pose a national security threat.

Writing for the Council on Foreign Relations in 2009, Setser posited that China’s massive U.S. debt holdings gave it power over U.S. policy via the threat of a swift, large sale of U.S. debt that could send the market into turmoil and drive up interest rates.

You can hear what Brad Setser had to say about China’s U.S. debt holdings in this 2009 interview with NPR.

References

Flitter, Emily. Exclusive: U.S. lets China bypass Wall Street for Treasury orders. Reuters. 21 May 2012.

National Public Radio. Our First Podcast: Brad Setser Explains the China Thing. 8 September 2009.

Featured Image: Source: Representative Diane Black