The following is a paper published earlier this week by former Sempra Metals economist John Kemp looking in detail at the Fed’s emergency money market operations and its ultimate reliance on Chinese support. It’s a long read - 5,000 words - so we’ve split it into five parts. If you would like an accompanying selection of charts that are simply too large to publish here email alphaville@ft.com. (UPDATE — bear with us! Too many requests!)
In an underground car park in Washington DC, FBI Deputy Director Mark Felt told the young Washington Post investigative reporter Bob Woodward to “follow the money” in the hunt for the source of the Watergate break-in. The advice remains good today. Tracking the flow of funds through the financial system and across the balance sheets of the Federal Reserve and other banks provides the best way to understand what his happening below the surface.
Even before Congress passed the Emergency Economic Stabilisation Act and approved spending up to $700 billion to purchase mortgage-backed securities from the market in the Troubled Assets Relief Programme (TARP), the Federal Reserve and the United States Treasury were intervening in the market to prop up the banking system in a way that has no precedent in modern history.
By the close of business on Fri Oct 3, the Federal Reserve had already extended various emergency loans to domestic borrowers and foreign central banks totalling more than $600 billion, and the United States Treasury had gone out into the money market to borrow $400 billion and deposit it with the Fed to replenish the central bank’s exhausted balance sheet.
Details of the rescue operation are available in near real-time in two documents published on the internet: The Daily Treasury Statement of Cash and Debt Operations of the United States Treasury published by the US Financial Management Service (FMS), and the tabulation of Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks published weekly by the Federal Reserve System.
These two sources reveal a massive support operation in which the assets and liabilities of the US banking system have been largely merged onto the balance sheet of the Federal Reserve, and the US Treasury has pledged the full faith and credit of the United States to support the central bank. By the end of Oct, the US authorities will have provided more than $1 trillion in support – on top of the $700 billion which Congress has authorised the Treasury to spend buying up impaired mortgage-backed securities.
But even $1 trillion is unlikely to be enough to stabilise the system and end the crisis. The scale of the rescue operation will strain the Fed’s and the Treasury’s resources to the limit, and beyond. Nationalising the debt problem will not make it go away. The United States needs access to a fresh source of funding in order to restore confidence. The only country with sufficient free resources to recapitalise the US banking system is China, with its mountain of foreign exchange reserves.
China’s support is crucial. It could take many forms, and it remains to be seen whether support will be pledged openly (in the form of a loan to the US government, or an operation swapping some of China’s mountain of US Treasury paper for impaired securities) or tacitly (in the form of exchange-rate support, or continued buying of US government bills as the Treasury struggles to roll over its growing debt). But one way or another only China has the resources to stabilise the financial system.
