There is a rumor flying around that the Chinese government will unilaterally cancel all OTC derivative related debts of state corporations. The contracts would be considered void as well as any debts owed on losses of the contracts. Whereas congress and the treasury have given away Trillions of dollars to these banks in order to cover losses, secure their jobs and ensure future campaign donations, the Chinese are actually doing the right thing. Unfortunately, it could spell dire consequences for the US economy.
There are three possible outcomes here. The first is that the banks who issued these derivatives will all suffer massive losses and probably fail. This is what should have happened when this whole mess started. Businesses that act irresponsibly should fail. Otherwise, there is no incentive, or less incentive, for them to act responsibly. Had the government allowed this to happen to begin with, we would already be out of this mess. The government, however has a different idea of incentives in business.
This brings us to the second possibility. The current government has already tried to save these corporations once through massive bailouts. Some of them did this so they could play hero and win votes and campaign contributions. A few are just ignorant of economics. Some even voted for stimulus to get money for their pet projects. Whatever the reason, the public is now committed to saving these corporations through stock holdings, loans and public opinion. The fate of the country, or at lease those running it, depends on the success of the banks. The government will probably bail them out again - at our expense. This could take several forms, from another direct cash injection, to purchase of troubled assets, to some sort of payout to China. Regardless of the for the bailout takes it will come from money borrowed or printed into existence and will go to fueling inflation.
The final possibility is a "diplomatic" solution. This is one hell of a bargaining chip for China. They may use it to accomplish goals from access to resources to full currency convertibility to military equipment and support. The possibilities are endless. I think it is more likely, however that the US will try to put pressure on China in some way. This could result in anything from economic sanctions all the way to all out war. The possibilities are endless. Most of them are also unlikely.
If this rumor turns out to be true, its significance can not be overstated. It will have a huge negative effect on our economy regardless of the response, probably as bad or worse than the Lehman Brothers failure. Strangely, the media has been almost completely silent on this issue. It is still basically rumor, however it is so significant that it should be headline news across the country. Ultimately, this OTC derivative debacle will most likely result more bailouts, more government debt, more money printing and more inflation. Whatever happens, though, one thing is certain: China, as well as pants throughout Wall Street and Washington are pissed.
Further Reading:
http://in.reuters.com/article/oilRpt/idINPEK33016020090829
Update:
A slightly different view from the economist - maybe China won't actually be able to go through with this.
http://www.economist.com/businessfinance/displaystory.cfm?story_id=14365...