Hit by a hike in US tariffs China could: respond with equal tariffs (impossible); dump US Treasury bonds (ineffective and impractical); let the yuan weaken (expensive)
Or it could give in to Trump and lose face (for Xi, unthinkable)
21 May, 2019
From the volume of bellicose rhetoric in China’s state media, you might think Beijing is digging in for a bloody fight to the finish in its trade conflict with the United States.
The policy responses it is considering are all either impossible, impractical, ineffective or expensive. This leaves Beijing in an unenviable position.
The usual trade-war response to the imposition of tariffs is to impose countervailing tariffs of your own, inflicting enough pain on your antagonist to bring him back to the negotiating table.
But that’s impossible in the US-China dispute. Yes, last week the Chinese government slapped 25 per cent tariffs on US$60 billion of imports from the US. But that just highlights Beijing’s problem.
Last year, the US imported US$540 billion of stuff from China, whereas China bought just US$155 billion from the US (or maybe as much as US$180 billion, if you include all the US goods shipped to Hong Kong).
So, if the US imposes 25 per cent tariffs on everything it buys from China, and China retaliates by doing the same, its retaliation will be ineffective in comparison.
Worse, many of those imports from the US, advanced semiconductors for example, are important for China’s economic growth, so imposing tariffs on the US would hurt back home. And if Beijing tried to relieve the pain by paying subsidies to injured importers, it would defeat the object of imposing tariffs in the first place.
Aware that countervailing tariffs are not an option, many Chinese commentators (and some in the US) have suggested Beijing could punish Washington by “dumping” its holdings of US Treasury bonds.
Considering that at the end of February, China’s declared holdings of US Treasuries amounted to US$1.1 trillion, this might sound like a viable threat.
If Beijing were to sell them, say the move’s backers, it would trigger a collapse in bond prices, and therefore a sharp spike in US interest rates, which would punish the US economy and trash confidence in the US dollar.
Except, as this column has explained before, things wouldn’t work like that at all.
China’s US$1.1 trillion pile of Treasuries might sound a lot, but it’s less than 5 per cent of the total outstanding. If Beijing were to sell them slowly, private investors would have little difficulty absorbing the paper, especially given the safe haven flows into the Treasury market at a time of heightened tension.
And if China were to try and sell them all at once, the US Federal Reserve would step in and buy them to preserve an orderly market and hold down interest rates; it bought more than that in the few weeks following the 2008 implosion of Lehman Brothers.
And if Beijing did manage to sell its Treasuries, what would it do with the proceeds? Put them on deposit at Citibank in New York? Well, guess what? Citi would put the money straight back into the Treasury market. Net result: zero.
And if China were to sell the US dollar proceeds of its Treasury bond sales in the foreign exchange market, what would it sell them for? Euros? No chance. There is already such a shortage of low-risk European government paper that the yield on 10-year German government bonds is negative.
In any case, selling US dollars would just push down the US currency’s exchange rate, which would benefit US exporters and further hurt Chinese companies already penalised by US tariffs – hardly the ideal outcome in a trade war.
Nor would funding hard assets work. China has tried that with its Belt and Road Initiative. Even according to the most generous estimates, current investments and future commitments come to less than US$200 billion. That’s already causing massive capacity problems. There’s no way China could attempt to invest US$1.1 trillion in short order and ever get its money back.
So, if selling its US Treasuries isn’t practical, what else could Beijing do to exert pressure on Washington?
Firstly, a weaker yuan would help to offset the impact of tariffs on China’s exporters. Secondly, if the experiences of 2015 and 2018 are anything to go by, a sharp fall in the yuan would spook global investors and trigger a steep sell-off in the US stock market.
And if there’s one thing we know Donald Trump sets store by, it’s the level of the US stock market.
So allowing the yuan to weaken would have the twin benefits of supporting China’s exporters and hurting the US administration, possibly enough to achieve a trade deal acceptable to Beijing.
But there would be costs involved. First, faster credit expansion would support Chinese growth, but at the cost of increasing leverage in the economy – which Beijing has spent the last two years urgently trying to contain.
Second, allowing the yuan to weaken would risk triggering destabilising capital outflows, which would exacerbate the danger posed by excessive leverage in the domestic financial system.
And third, allowing the Chinese currency to weaken would badly set back the progress of yuan internationalisation – a key long-term policy goal of Xi Jinping’s government.
Of course, considering all the difficulty and expense of responding to the US tariffs, the other option would be for Beijing to return to the 150-page outline trade deal with the US which it rejected so effectively two weeks ago.
But that too would have costs: a loss of face, and the acceptance of constraints on Beijing’s long-term industrial strategy – another of Xi’s highly prized policies. Not an enviable position at all.
Tom Holland is a former SCMP staffer who has been writing about Asian affairs for more than 25 years