Russia's Central Bank does not hold Fannie Mae and Freddie Mac debt - but what about the rest of its U.S.-mortgage backed debt holdings?
Over a year ago I wrote about Deputy Secretary of the Treasury Robert Kimmitt's trip to Moscow ("Is the U.S. Seeking Capital from Russia's Stabilization Fund?"). In June 2008 RosBusinessConsulting reported that Mr. Kimmitt was in Moscow to ask the Kremlin and Russia's Central Bank to invest more petrodollars in the U.S. Mr. Kimmitt gave RBC an interview, but provided few details about his discussion with Russian Central Bank officials, so the report was largely ignored by the Western media.
At that time, American media outlets were more focused on the prospect of Arab and Chinese sovereign wealth funds acquiring equity stakes in U.S. companies, and the potential political backlash to such moves. Russian companies such as Evraz and Severstal have proven to be saavy about their American acquisitions, (so far) flying under the radar screen of an increasingly unpopular and protectionist U.S. Congress, which clearly has much bigger fish to fry now than worrying about what the Russians are buying.
As we now know, most of the Russian money that was invested in America went into "safe" U.S. government-backed agency debt securities. After the collapse of IndyMac Bank in California on July 12, 2008, Russia's Central Bank denied that it held any Fannie Mae or Freddie Mac equity, and declared its billions in U.S. debt holdings to be safe. Today the New York Times is reporting ("Trouble at Fannie Mae and Freddie Mac Stirs Concern Abroad") that Russian buyers currently hold $75 billion worth of U.S. agency securities backed by pools of mortgages, farm credits, and other loans.
President Bush with Secretary of Treasury and former Goldman Sachs CEO Henry "Hank" Paulson. Many foreigners have started to ask: does the left hand know what the right hand is doing? Does America's present foreign policy recognize the urgent need of the U.S. economy for additional foreign capital and resources?
Although not federally guaranteed, Fannie and Freddie were sold to American and foreign buyers as offering nearly as much safety as U.S. Treasuries, while earning investors a higher yield. If Fannie Mae and Freddie Mac ever did get into trouble, both investors and underwriters assumed that the U.S. government would step in to support their debt, which is exactly what appears to be happening this month. American financial analysts have estimated that the current proposed federal government bailout of Fannie Mae and Freddie Mac could cost U.S. taxpayers $5 trillion, but others say the final tally could be even higher. Placing both government-sponsored enterprises, which currently have socialized risks and privatized their profits, in FDIC receivership is another possibility.
On June 30, 2008, U.S. Treasury Secretary Henry Paulson met with Russian President Dimitry Medvedev in Moscow, probably to assure him that Russian investments in America are safe, and perhaps, to ask for even more investment from the combined $130 billion in the Reserve Fund of the Russian Federation. Whether or not the former Goldman Sachs chief's request for additional capital was heeded we do not know, but the Russian Central Bank and other major financial institutions have been reducing their exposure to U.S. agency debt since April 2008. This tectonic shift in international currency markets may be part of the reason for the ruble continuing to reach all-time highs against the dollar.
The appreciation of the ruble against the dollar (and more importantly, the euro), makes Russian exports more expensive abroad while making imports more attractive at home, hampering Russian Central Bank efforts to reduce Russia's double digit inflation rate. In spite of the Central Bank raising interest rates to fight inflation, the U.S. Federal Reserve Bank's inflationary monetary policy continues to exert upward pressure on the euro, and hence, the ruble.
Many analysts now contend that a decade-long flood of cheap dollars from the Fed has created U.S. asset bubbles, first in stocks, then in housing, and now a bubble in commodity prices worldwide. However, this alleged "bubble" is different. No one expects a repeat of the mid-Nineties collapse in oil prices, not with so much new energy demand from India, China, and other developing countries. The possibility of renewed social tensions in Russia, however, could increase as a continued trebling of oil prices raises living standards for younger, upper and middle class Russians while higher prices for (mostly imported) food push aging pensioners deeper into poverty. Alternatively, Russia's long neglected agricultural sector, rendered more competitive by higher prices for imported food, might start to catch up with the rest of the Russian economy and alleviate some food inflation in the country.
After gaining a hard-won measure of stability for Russians in the past eight years, the last thing Msrs. Putin and Medvedev want is to expose Russia to any unnecessary economic shocks. Mr. Medvedev's recent speeches at global forums have emphasized these points, and suggested that stabilizing monetary policy and financial markets is likely to move even higher on his agenda for future meetings with other world leaders.
Drawing from these facts, I would just like to make three modest points:
1) In 1998, the collapse of the ruble and of Russia's banking system briefly spooked the U.S. and other developed markets, while compounding the misery of the 1990s for millions in Russia. Just ten years later, a crisis of confidence in U.S. debt, financial markets, and the stability of the dollar as a global reserve currency is slowing Moscow's stock market, but not the overall Russian economy. This represents a revolution in world affairs and a fundamental shift in economic (and eventually, political) power away from the U.S. and Western Europe towards Eurasia. Future historians may one day marvel not at the speed of this transition, but at how long it was delayed for so many centuries.
2) The fact that Russia and China hold such huge amounts of U.S. debt strongly mitigates against any confrontational American policy towards Moscow and Beijing. America, with its sprawling infrastructure vulnerable to oil price spikes, costly military commitments in Iraq and Afghanistan, and pending multi-trillion dollar government bailouts of its troubled financial institutions at home, is in no position to pursue a new Cold War with anyone. For the next U.S. President, trying to refight the last war by installing missile defense bases on Russia's borders or promoting the further expansion of NATO into Ukraine and Georgia would be the height of strategic blundering. Needlessly antagonizing Russia is likely to prove a non-starter with America's European allies, and has already proven to be unpopular with the Czech, Polish and Ukrainian electorates. The Kremlin is now running out the clock, waiting for the next American Administration to save face by dropping these ill-advised policies. Both Senators Barack Obama and John McCain are likely to have their hands full with developments in the Middle East and at home, so this Russian position seems firmly grounded in a realistic assessment.
3) Of course, the real story is not all U.S. debtors and Eurasian creditors. With high oil prices fueling inflation at home, in the absence of some grave American provocation, neither Russia nor China have any incentive to dump dollars en-masse, as this would only make their currencies painfully appreciate and further devalue their holdings in the U.S.A. In effect, the U.S. and Russia have replaced the mutually assured destruction (MAD) of the Cold War with mutually assured financial dependence. For better or for worse, in spite of the fashionable talk of "decoupling" between developed and emerging markets, we are now tied together. Russia's Central Bank will continue its policy of shedding dollars, albiet slowly, while adding euros to its basket and promoting the ruble as a global reserve currency in its own right.
In conclusion, to paraphrase the American President Calvin Coolidge, the real business of U.S.-Russia relations is business. The sooner America's political leadership recognizes this fact, the sooner we will see substantial improvement in U.S.-Russia relations, spreading the benefits of greater financial and political stability to the whole world.
Vladimir F. Kuznetsov is currently providing corporate development and fund raising services for a number of Asian mineral development companies. Previously, he served as director of equity finance at the FINAM Investment Company in Moscow and published his own blog on Russian capital markets, Equity Finance in Russia. Mr. Kuznetsov is a fellow of Discovery Institute's Real Russia Project.