How big is the chance that China will use its own currency – the yuan – as a countermeasure in the trade war with the US? In my view, the chance that China will do so is negligible. Another possibility to hit back and harm the US is by stopping to buy and/or selling US Treasuries. This could potentially wreak havoc on US interest rates, driving them much higher. What are the odds that Beijing will use this weapon of financial destruction?
To cut right to the chase: the odds that Beijing will resort to this countermeasure in its fight over trade with the US are quite low. This because of the following reasons.
At its core, China does not explicitly choose to buy US government debt. The country does not really have a choice. China has, after all, a considerable trade surplus, which implies that the country is selling more stuff to the rest of the world than it buys back. Last year, China´s total trade surplus amounted to approximately $425 billion dollar. A large portion of the total surplus consists of China´s surplus with the US, namely $375 billion dollar.
Whenever a country has a trade surplus, it simply means that it earns more from foreign trade than that it spends. Within a company, we would call this profit.
China earns, therefore, an annual “profit” on its trade with foreign countries and receives as a consequence, on average, at bit more than a billion dollar a day. If Beijing would stuff these billions of dollars under its metaphorical matrass, then one thing would be a certainty: namely, that the returns on these billions of dollars would be exactly zero. Worse, the real return on the trade surplus would be negative since the US dollar inflation rate ranges from two to two-and-a-half percent annually.
To earn returns, the country is forced to invest those dollars. Investing in stocks would be rather risky for a government, such that Beijing is putting its trade surplus in government bonds: the country receives interest payments and the odds of the counterparty defaulting is slim to none. With regard to its investments in government bonds, the Chinese are especially limited to buying US Treasuries. The reason why has everything to do with the Chinese monetary regime.
The yuan was pegged to the US dollar until the summer of 2005. Ever since, the currency has been pegged to a basket of currencies in which the dollar is still dominantly present.
To keep the exchange rate of the yuan stable against the US dollar, the Chinese central bank must essentially be prepared to buy and sell dollars in unlimited quantities against a fixed rate. Since, on the whole, Chinese companies have a dollar surplus (that is, the earlier mentioned trade surplus), the central bank buys dollars against a fixed exchange rate. And that brings us back to the necessity to invest those dollars in such a way that the risks are minimal. Hence, to invest in US Treasuries. As long as the Chinese yuan is largely pegged to the dollar, China cannot do anything else but continue buying US Treasuries.
If China would, keeping in mind their current monetary regime, begin purchasing primarily government bonds of for instance euro countries or Japan with its trade surplus, then the country would, besides price risk (bonds can fluctuate in price), also run exchange rate risk.
If China would stop buying US Treasuries or sell all their Treasury holdings, then that would severely weaken the dollar. After all, this would create a surplus of dollars on foreign exchange markets. Such a move would, per definition, lead to an appreciation of their own currency, the yuan, against the US dollar. This would result in painful economic consequences, for example by raising the prices of Chinese exports to the rest of the world. Put differently, if China would utilize selling or ceasing to buy US Treasuries as a geopolitical weapon, then the country must be prepared to see its own currency appreciate significantly or allow the yuan to float freely against other currencies. While in the long run this might be Beijing’s ambition, for the moment it seems way too early for such a move. The decision to allow the yuan to float freely would only be made after the growth of the Chinese economy becomes more dependent upon domestic demand and less dependent upon foreign exports. The country has gradually embraced this shift, but there is still a long way to go before the shift toward a freely floating currency will be completed.
Moreover, and besides all the above considerations: if China would stop buying US Treasuries or even sell part of its holdings, then this would probably lead to interest rate increases in the US. Not only would this have a negative impact on the growth of the US economy, it could also risk an escalation of the trade conflict between China and the US. Economically, both countries would suffer deeply from such an escalation: China is economically just as dependent upon the US as the other way around.
In addition, it is not very clear how hard the US will be hit: the Federal Reserve could, for instance, react by starting another round of quantitative easing (QE). China itself would, moreover, suffer an enormous decline in its exchange rate. Lastly: because China holds a large part of the US Treasuries in circulation at US banks (according to some estimates up till $1 trillion dollar), the US could potentially freeze those assets, turning them unsaleable.
Adding everything up, the facts strongly suggest that these two instruments, which many have feared that China would use in a fight over trade with the US, will probably not be utilized.
This, however, does not mean that such a conflict will bring no consequences at all. For instance, central bank policy could be affected by a conflict between China and the US.
From the point of view of the ECB and the Fed, the trade conflict between China and the US produces additional uncertainty and a whole range of new risks. A trade war tends to cause upward pressure on prices and inflation, but a downward pressure on economic growth. Central banks could prevent the former by raising interest rates and the latter by lowering interest rates. Doing both things at the same time, however, is something they are not able to do. They would be forced to choose between either preventing a too high inflation or supporting their economy.
For markets, this would mean that central bank policy becomes less predictable. Especially since in such a scenario a cacophony of different opinions can be expected from the side of the central bankers, depending on the specific preferences of the individual board members of the ECB and the Fed. As long as this uncertainty and risk would continue to play an important role, it would not surprise me if especially the ECB would adopt a more “dovish” tone. Not in the sense that an unwinding of quantitative easing will be postponed, which in my view is a certainty, but in the sense that the central bank could emphasize that its prepared to intervene and possibly start another round of quantitative easing if deemed necessary. It would also not surprise me if the first interest rate hike since 2011 would come rather later than what the market is currently anticipating and pricing in (summer of 2019). The prospect of a long-term very loose monetary policy in a context of high economic growth is, as history teaches, one of the most effective methods to push up inflation. Throw into the mix increasing geopolitical tensions and all ingredients seem to be present for an impressive rally in precious metals prices in 2019.