The threat of a US-China currency war
From trade war to currency war is a perilously simple step. As the US-China tariff skirmish escalates and the renminbi sinks against the dollar, there is a growing risk that President Donald Trump may take it. The more specific concern in the markets is that the US administration could intervene directly to weaken the dollar. While the yen, the euro and sterling are all potential targets, the greatest scope for global financial instability relates to the US and China.
In a strikingly vivid phrase Paul Volcker, former chairman of the Federal Reserve, once referred to the close financial ties between the US and China as a potentially “fatal embrace”. Those ties include the fact that China holds more than $1tn of US Treasury securities. Against the background of rumbling trade friction between the two countries, the obvious nightmare scenario would be the weaponisation of Chinese official foreign exchange reserves against the US.
There are straws in the wind. In the three months to the end of May, China’s holdings of US government IOUs were reduced by $20.7bn to $1.1tn. This is still the biggest foreign stake in the US Treasury market, although it has shrunk by $81bn since June last year. But over the longer run Chinese ownership of outstanding US Treasuries has fallen from a peak of 14 per cent in 2011 to 7 per cent at the latest count. Clearly, Beijing’s readiness to finance America’s burgeoning fiscal deficit is waning. The question is how sinister an interpretation to put on this evacuation from the world’s biggest sovereign debt market and whether everyone is too complacent about the threat of weaponisation.
The fear that China would use financial leverage to influence US policy is not entirely without foundation. Back in 2011 Ding Gang, a senior editor at the People’s Daily, argued in an editorial that Beijing should use its financial clout to teach the US a lesson in response to its arms sales to Taiwan. Yet this threat left the US Department of Defense unbothered. In a 2012 report it argued that the threat was not credible because the use of Treasury securities as a coercive tool would have limited effect and would do more harm to China than the US.
The Pentagon had a point, in that China could not dump Treasuries without pushing up yields (and thus reducing capital values), leading to big losses on its holdings. If the proceeds were repatriated, the losses would be compounded by a surging renminbi and a falling dollar.
Now, Treasury yields have actually been falling while Beijing has been selling. That suggests that the pool of domestic and foreign savings supporting what is perceived to be the world’s safest collection of assets is so great that the Chinese divestment is no more than a blip.
Equally important, alternative havens for Chinese official reserves are less than compelling. There is a limit to how much the gold market can absorb, while the eurozone sovereign debt market is fragmented and relatively illiquid. Moreover, a growing share of eurozone government debt shows a negative yield, unlike the US.
There is, nonetheless, an important caveat in any analysis of Chinese capital flows. The US Treasury’s international capital data releases do not capture all the changes in China’s official reserves portfolio. Holdings can be moved to custodial accounts in Luxembourg or Belgium. It is possible, too, that Beijing is trying to enhance the return on its reserves by switching to other, higher yielding dollar assets.
The real question that remains is, how does the Communist party leadership in Beijing perceive its interests, particularly at this fraught stage in trade negotiations with Mr Trump? The one certainty is that any abrupt decision to sell off China’s Treasury holdings would precipitate extreme volatility across global markets. So it is important to note that Chinese leaders fear instability above all else.
In the end, the real force of Mr Volcker’s reference to a fatal embrace lay in an unintended consequence of interdependence. Before the global financial crisis China’s excess savings, which were reflected in the build up of its official reserves, were an important contributory factor in the US credit bubble, whose collapse in 2007-8 came close to precipitating a 1930s-style depression. But to be fair to the Chinese, their huge fiscal and monetary pump priming in 2009-10, albeit carried out purely in their own interest, helped put the global economic show back on the road. What emerges from this story, at the risk of stating the obvious, is that everything about economic interdependence is double-edged.