Exclusive: U.S. lets China bypass Wall Street for Treasury orders

By Emily Flitter

NEW YORK | Mon May 21, 2012 3:35pm EDT

(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.
China, which holds $1.17 trillion in U.S. Treasuries, still buys some Treasuries through primary dealers, but since June 2011, that route hasn't been necessary.
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.
"Direct bidding is open to a wide range of investors, but as a matter of general policy we do not comment on individual bidders," said Matt Anderson, a Treasury Department spokesman.
While there is been no prohibition on foreign government entities bidding directly, the Treasury's accommodation of China is unique.
The Treasury's sales of U.S. debt to China have become part of a politically charged public debate about China's role as the largest exporter to the United States and also the country's largest creditor.
The privilege may help China obtain U.S. debt for a better price by keeping Wall Street's knowledge of its orders to a minimum.
Primary dealers are not allowed to charge customers money to bid on their behalf at Treasury auctions, so China isn't saving money by cutting out commission fees.
Instead, China is preserving the value of specific information about its bidding habits. By bidding directly, China prevents Wall Street banks from trying to exploit its huge presence in a given auction by driving up the price.
It is one of several courtesies provided to a buyer in a class by itself in terms of purchasing power. Although the Japanese, for example, own about $1.1 trillion of Treasuries, their purchasing has been less centralized. Buying by Japan is scattered among institutions, including pension funds, large Japanese banks and the Bank of Japan, without a single entity dominating.
Granting China a direct bidding link is not the first time Treasury has gone to great lengths to keep its largest client happy.
In 2009, when Treasury officials found China was using special deals with primary dealers to conceal its U.S. debt purchases, the Treasury changed a rule to outlaw those deals, Reuters reported last June. But at the same time it relaxed a reporting requirement to make the Chinese more comfortable with the amended rule.
Another feature of the U.S.-China business relationship is discretion: The Treasury tried to keep its motivation for the 2009 rule change under wraps, Reuters reported.
Documents dealing with China's new status as a direct bidder again demonstrate the Treasury's desire for secrecy -- in terms of Wall Street and its new direct bidding customer.
To safeguard against hackers, Treasury officials upgraded the system that allows China to access the bidding process.
Then they discussed ways to deflect questions from Wall Street traders that would arise once the auction results began revealing the undeniable presence of a foreign direct bidder.
"Most hold the view that foreign accounts only submit 'indirect bids' through primary dealers. This will likely cause significant chatter on the street and many questions will likely come our way," wrote one government official in an email viewed by Reuters.
In the email, the official suggested providing basic, general answers to questions about who can bid in Treasury actions.
"For questions more extensive or probing in nature, I think it prudent to direct them to the or Treasury public relations area," the official wrote.
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.
But Treasury officials have long maintained that U.S. debt sales to China are kept separate from politics in a business relationship that benefits both countries. The Chinese use Treasuries to house the dollars they receive from selling goods to the United States, while the U.S. government is happy to see such strong demand for its debt because it keeps interest rates low.
A spokesman for the Chinese embassy in Washington did not respond to calls and emails seeking comment.
The United States has, however, displayed increasing anxiety about China as a cybersecurity threat. The change Treasury officials made to their direct bidding system before allowing access to China was to limit access to the system to a specially designed private network connection controlled by the Treasury.
China is among the most sensitive topics for bankers and government officials who court the country as a financial client because of its size and importance, and none would agree to comment on the record for this story.
A former debt management official at the Treasury who did not want to be identified said that as China's experience in the U.S. Treasury market has deepened over time, Chinese officials may have felt more comfortable taking the reins in the management of their holdings.
Their request to bid directly, in his view, came from a confidence that their money managers could buy U.S. debt more efficiently on their own than through Wall Street banks, which can often drive up the price of Treasuries at an auction if they know how much large clients are willing to pay. Such a practice that is not specifically illegal, though most traders would deem it unethical.
Evidence of China's growing sophistication as a money manager in the U.S. markets is clear in its expansion of operations in New York. Its money management arm, the State Administration for Foreign Exchange (commonly called SAFE), has an office in Midtown Manhattan and a seasoned chief investment officer -- former Pacific Investment Management Co derivatives head Changhong Zhu -- in Beijing.
A woman who answered the phone at SAFE's New York office said no one in the office was authorized to talk to the media.
(Editing by Martin Howell and Steve Orlofsky)