China’s discreet option on trade

Forget Beijing “weaponizing” its currency through devaluation or the “nuclear option” of it dumping US Treasuries. It could quietly shrink the US trade deficit – at Europe’s expense.

US President Donald Trump has recently deepened the trade dispute with China by singling out microeconomic players like telecoms equipment maker Huawei. As he has done so, speculation has mounted China might retaliate at macroeconomic level by pushing its currency lower to make exports cheaper, or by liquidating its hoard of US Treasury bonds to hurt the US economy. Both fears are unrealistic – it is more likely that China will gradually re-allocate its holdings from US sovereign bonds to those of other countries to support the yuan. This option would even enable it to quietly give Trump what he wants - a reduction of the US trade deficit with its biggest trading partners.

Is China “weaponizing” its currency?

The yuan has fallen sharply against the US dollar since the trade negotiations between the US and China fell apart. At the time of writing, one US-Dollar buys CNY 6.9, very close to the CNY 7 mark that most analysts believe to be a critical downward threshold. Some analysts now believe China is “weaponizing” its currency, allowing it to fall so that the additional tariffs US consumers now have to pay on some Chinese goods are offset by lower US dollar prices as a consequence of a weaker yuan.

This line of thinking is compelling since China has manipulated its currency to artificially low, export-invigorating levels in the past. But it seems unlikely that the yuan’s current fall is the work of Beijing: Firstly, every time the trade conflict has escalated the yuan has suffered. Secondly, Beijing has already been gradually reducing its holdings of US Treasuries, a sign that it wants to support, not weaken its currency.  Thirdly, current market volatility makes it dangerous to play with depreciation: It could cause a mass sell off and capital flight. Finally, devaluing the yuan would further inflame Trump.

Aside from “weaponizing” the yuan, analysts have also been speculating about People’s Bank of China’s (POBC) use of its “nuclear option,” selling its enormous trove of US sovereign bonds that the country amassed as a consequence of years of manufacturing-driven trade surpluses. The US Treasury reckons China holds more than USD 1 trillion – USD 1,000 billion – of its bonds. Selling them could see their prices tank, yields soar, and a US stock-market sell off as money flowed into bonds.

A destabilized US economy would also hurt China

The “nuclear option” would be very destabilizing for the US – but, crucially, also costly for the world economy, China included. If China dumped its US Treasury, the value of its portfolio would plummet as it was forced to accept lower and lower prices to find buyers. Destabilizing the US would also be doubly costly: The Chinese economy still depends to a large degree on Americans buying its goods; a destabilized US economy would hurt Chinese industry considerably. Liquidating US Treasuries is a double-edged sword that any sensible Chinese leader would consider drawing only as a last resort.

Speculation about the nuclear option was fuelled by the PBOC selling USD 20 billion in US sovereign bonds in March, its biggest monthly sale for two-and-a-half years. But such fears ignored the fact the China’s central bank has been gradually selling US Treasuries since September, mainly to keep the yuan above that mark of USD 7 as the trade dispute made investors move some funds elsewhere. Continuing on this least spectacular of the paths may be the most attractive option for China.  

If China’s central bank continued its gradual sale of US Treasuries, the US Federal Reserve could print money with which to purchase them, keeping markets steady. The dollar would come under pressure as China exchanged its holding for other countries bonds. As a result, China would reduce its reliance on the US financial markets, lower the price of the dollar, and weaken American purchasing power.

Even an unspectacular option might have far-reaching effects

Most likely China would shift to euro-denominated sovereign bonds, the Eurozone being the only economy comparable in size to the US. With some USD 27 trillion in debt securities outstanding, the Eurozone bond market is almost as big as that of the US, which counts USD 40 trillion. European bond yields, already low, would be pushed down even further by the added liquidity, meaning China would earn even less interest than on its US Treasury holdings.  But the euro would likely rise against both US dollar and yuan, which would lead to Europeans buying more goods from the US and China.

The interconnected global economy means that even China’s least spectacular option would still have far-reaching effects: A continuation of US Treasury sales would weaken the US dollar against the yuan and the euro; the Europeans and Chinese would find that US goods become cheaper and more alluring, while the Americans would find Chinese and European goods more expensive and not buy so many.  China could quietly lower the US’s trade imbalances with China and Europe. Trump might hail the lower US trade deficit. But export-dependent European businesses would be more critical and perhaps demand EU politicians “take control” of international trade by, for instance, imposing tariffs, much like Trump tries to do.

This article was first published on the Financial Times' Beyond Brics blog on June 6, 2019.