In the trade war with the US, China should fight smart – and weakening the yuan or selling its US Treasury notes wouldn’t help

Should Beijing weaponise the yuan or offload its US Treasury holdings to retaliate against Washington? Probably not. Such measures either make no economic sense or might backfire on China

Hao Zhou

Published: 2:00pm, 28 May 2019

Why you can trust SCMP

Will China weaponise or weaken its currency as a retaliatory measure amid rising trade tensions with the United States? And will Beijing offload a trillion dollars in US Treasury holdings? These are some of the most frequently asked questions of late, given that trade talks seem to be deadlocked. Both the US and China have seemingly taken a tougher stance and are now preparing for a prolonged dispute.

Certainly, both options are available and probably feasible for the Chinese government, since the US has taken a hard line against Chinese companies and Beijing needs to flex its economic muscles, as well. However, rationally speaking, it doesn’t make much sense for China to devalue its currency or sell its holdings of US Treasury bonds before things really get out of control. One thing is clear: both the options are double-edged swords that could hurt both the US and China.

Let’s look at the idea of yuan devaluation. At first glance, it seems to make sense to allow the currency to weaken when Chinese exports will be hit by higher tariffs. In theory, a country could increase its exports by devaluing its currency.

However, in a trade war scenario, the US could levy more tariffs on Chinese goods if China deliberately weakens the yuan to gain a competitive advantage. In the meantime, a yuan devaluation could also reduce China’s imports from the US, as import prices will rise.

And this is likely to result in complications: China’s trade surplus with the US could widen further and US President Donald Trump might ratchet up the pressure, making more accusations that China is stealing from the US.

As it is, the Chinese yuan is very close to its weakest level in a decade, and further weakness will ultimately spark concerns about financial stability, and spur further capital outflows. At the National People’s Congress in March, Yi Gang, the governor of the People’s Bank of China, said the Chinese currency had been under depreciation pressure since 2015 and in response, China had reduced its foreign exchange reserves by US$1 trillion.

In other words, the Chinese central bank sold those forex reserves to defend the Chinese currency. As the currency is already under pressure, letting it slide at this juncture could bring about an uncontrollable free fall, as has happened in many emerging economies. Also, instead of giving China a bigger say in the trade talks, yuan devaluation could cause chaos in financial markets and eventually intensify concerns about the Chinese economy.

Where did the money go? Trade war triggers capital flight

Moreover, the PBOC has built up strong credibility by defending the Chinese yuan and keeping it at some distance from the 7-per-US dollar mark. As long the central bank sticks to this line, it is hard to imagine any market participants challenging the PBOC.

Basically, the Chinese central bank already has a powerful tool to ensure a roughly stable currency when the external environment become unfavourable. Therefore, it would be unwise for the PBOC to lay down a credible instrument and let the currency depreciate rapidly.

The other question is whether China will sell its US Treasury holdings to retaliate. To be blunt, this is another naive idea. From a foreign-reserve-management perspective, it makes perfect sense to allocate money into US Treasury bills, as these are the most liquid assets on the planet.

In addition, while most other government bonds in developed economies offer negative returns, US Treasury bills have much more attractive yields. For China to sell its US Treasury holdings would make political sense but certainly not economic sense.

Let’s imagine China makes a purely political decision, and does sell its US Treasury notes. After liquidating its dollar-denominated assets, what would Beijing do with all these US dollars? The PBOC could convert the greenbacks into other currencies and buy other currency-denominated assets.

When the scared money has nowhere to go, market volatility is here to stay

However, this would probably lead to dollar depreciation and consequently yuan appreciation – which might be exactly what Trump was hoping for. As such, this political decision would not achieve its intended aim.

Put simply, these seemingly feasible measures won’t help China gain any ground on the US in the trade negotiations. For sure, nobody wants to be seen as weak during times of war, but not all battles are won with swords and spears. From a logical perspective, China should neither weaken its currency nor offload its US Treasury holdings to increase its bargaining power.

Hao Zhou is senior emerging markets economist at Commerzbank

This article appeared in the South China Morning Post print edition as: China must fight smart

Post