By Gwynn Guilford
Tensions between the US and China just keep rising. Last week, for example, US vice president Mike Pence made a speech laying out the Trump administration’s case for an all-out economic confrontation with China, beyond its current tariffs on Chinese goods. But does the White House have the upper hand? A recent New York Times column by Andrew Ross Sorkin points out that China does have a “nuclear option” in its arsenal: US Treasuries. This scenario would involve ”the Chinese, the biggest holder of United States foreign debt with more than $1 trillion, publicly taking a step back from buying United States Treasuries—or worse, dumping what they own in the open market.”
This scenario is very scary indeed. It should also be very low on the list of things to worry about. For one thing, as Sorkin himself acknowledges, Beijing is unlikely to go down this road. For another, even if China did decide to go nuclear, the maneuver would be unlikely to cause economic catastrophe for the US. And so to give too much weight to the possibility of a Treasury dump perpetuates a flawed understanding of the US-China relationship.
China is not America’s banker
The notion of a Chinese “nuclear option” goes hand in hand with the idea China has lent the US money—or as Sorkin puts it, the idea that, in the US-China relationship, “China is very clearly the bank.”
China is indeed the biggest foreign holder of US government debt, with nearly $1.2 trillion in US Treasuries.
But China did not buy US Treasuries because it wanted to invest in the US, nor because it decided out of the blue one day to bankroll US borrowing. Rather, Beijing snapping up Treasuries has been a crucial instrument of its economic development strategy.
In the mid-2000s and the aftermath of the financial crisis, China’s trade surpluses and the inrushes of investment from abroad were titanic—so big they would have driven up the value of the yuan. If its currency had been freely traded, that is.
But China’s currency market is not remotely free. The government tightly manages the value of the yuan, pegging it to a set exchange rate against the US dollar. (In 2015, it loosened its grip slightly and pegged the yuan’s value to a basket of other currencies in addition to the dollar.)
To keep the yuan from rising against the dollar during its boom years—which would have hurt its export sector—the People’s Bank of China had to trade yuan for greenbacks by buying dollar assets. US Treasuries are the only market big and liquid enough to absorb the sheer volume of dollar-denominated purchases China needed to make to keep the yuan cheap.
And so, even though US government debt is low-yielding, China had to keep buying Treasuries to bolster its export sector, which employs a vast swath of its working population.
An artificially weaker yuan meant an artificially stronger dollar. So the flip-side of the capital it pumped into the US Treasuries market is the trade surplus that it ran with the US. This, as explained in more detail here, is the “currency manipulation” that Trump once railed so ferociously against.
In short, the American government debt that China bought was the cost of maintaining a trade surplus with the US. China is, therefore, not the US’s banker. The US didn’t really have much choice in the matter. And neither did it much benefit from China’s “lending,” since its own export-focused sectors—particularly manufacturing—suffered.
What’s more powerful than the “nuclear option”? The Fed
Regardless of how or why China got ahold of so much US debt, the fact is that it does have a big bunch of Treasury certificates sitting around. What happens if Beijing dumps them?
The fear, as outlined by Sorkin, is that the volume of offloaded Treasuries would overwhelm the normal supply and demand for safe US government assets, causing a jump in interest rates and other “unpredictable” market swings. But as Sorkin also notes, quoting economist Brad Setser, the US Federal Reserve could well be in a position to counter such a move.
Setser, one of the world’s foremost experts on global financial flows, explains that the US Federal Reserve “is the one actor in the world that can buy more than China can ever sell.” His analysis deserves a more thorough treatment than it receives in Sorkin’s article.
As Setser explains, one advantage that the Fed would have in the event of a Treasury dump is that it’s currently in the middle of a rate-hike cycle. That means investors expect the Fed to raise short-term policy rates a few more times in the next year or so. Rates on US Treasuries are typically influenced by how much investors expect the Fed to raise those bench market rates. So it could counter a Chinese selloff by signaling that it plans to hike less.
The Fed has still another tool in its belt: it could take a break from its “balance sheet roll-off”—that is, selling down the debt it bought during quantitative easing.
“Stopping that, and perhaps signaling that over time the Fed would raise the size of its balance sheet in the long-run would provide a powerful counter to Chinese sales,” says Setser in his post.
It’s also worth noting that these waters aren’t exactly uncharted. China did halt its Treasury purchases around 2011, picking them up again in early 2013. And throughout the first half of 2016, it actually sold off a good chunk of its holdings. In both instances, markets more or less yawned.
An all-around bad idea
Conventional wisdom holds that China also has little reason to sell off its Treasuries, since doing so would leave it in some dire straits indeed. In this case, conventional wisdom is correct.
China is currently trying to both dampen the impact of US tariffs and offset slowing growth with looser monetary policy. Selling Treasuries would thwart each of those efforts.
For one thing, dumping Treasuries would drive up the value of the yuan against the dollar—amplifying the already harmful effects of Trump’s trade war on China’s competitiveness. China’s export sector would crater.
The monetary impact might be even more devastating. By reducing the amount of yuan in circulation, a selloff would be hugely deflationary, effectively enlarging outstanding debts. Mind you, this is a country with corporate sector borrowings that total 164% of GDP, the highest of any major economy on the planet, according to the Bank for International Settlements.
Unless the Chinese government could pump enormous sums of money into its system, the resulting liquidity squeeze could be catastrophic to its financial system (more on these dynamics here).
It’s also worth considering what, exactly, the point of China’s pushing the red button would be. By unloading its Treasuries, China would fell two of Trump’s bigger bugbears: it would cheapen the US dollar against the yuan, which, all else equal, would shrink the US-China trade deficit, and give the Fed a reason to back away from rate hikes. China would basically hand Trump a bona fide trade-war win—all for the bargain basement price ravaging its own economy. China’s leaders can be petty. Dumb, though, they’re generally not.
This isn’t to say that the US is poised to “win” the trade war, or that fears about escalating tensions between the US and China are overblown. There are plenty of economic concerns the world should be pondering right now. The “nuclear option” doesn’t happen to be one of them.
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