Should China play hardball in the trade war with Trump and start targeting US Treasuries?

David Brown says the US should be wary of what China chooses to do with its US$1.2 trillion dollars in Treasury securities. Based on the impact of Russia dumping its much smaller holdings earlier this year, a similar move by Beijing could play havoc with the American economy

PUBLISHED : Tuesday, 07 August, 2018, 2:01am
UPDATED : Tuesday, 07 August, 2018, 2:31pm

They say that all is fair in love and war. There is certainly no love lost between US President Donald Trump and Beijing, with his griping about China’s so-called trade advantage over the United States and his threats to drag the world into a deeper trade war. Maybe Beijing should take the gloves off and play hardball with Washington. After all, it is the sort of political brinkmanship that Trump revels in. It’s time for China to raise the stakes and do some street brawling of its own.

Trump’s trade tactics are already starting to backfire back home with China’s tariff hikes on US exports affecting key voters in America’s farm and rust belts. Now that Trump is committing to compensating farmers and companies who may lose out financially, Beijing has a chance to hit back. Tariff subsidies will intensify strains on the US budget deficit at a time when it is already ballooning, thanks to Trump’s fiscal stimulus programme.

The US budget is so bloated with new tax cut and spending commitments that the deficit is bursting at the seams. So it is not a good time for the US Federal Reserve to be raising interest rates and winding down its massive US$4.3 trillion asset pile created by the Fed’s quantitative easing programme. The upwards pressure on US bond yields exposes a soft underbelly of weakness that Beijing can easily use to its advantage.

If Beijing wants to tighten the screws on America, this would be the prime opportunity. A buying strike or aggressive dumping of US Treasuries back into the market would pose double trouble for Washington, forcing US bond yields even higher and ramping up US dollar demand in the process. It should give more leverage to Beijing’s tacit devaluation tactics and cause wider scattergun carnage to the US economy at the same time.

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Higher Treasury yields will increase long-term borrowing costs, load US consumers with higher mortgage costs, slow the housing market and dent retail confidence and spending all at the same time. US companies will be hit with higher financing costs for new investment, adding a further drag on the US economy. The stronger dollar is already dulling the outlook for US exporters.

Rather than crowing about his contribution to the US’ dynamic 4.1 per cent growth rate, Trump could soon be looking for excuses and targets to blame for US growth falling through the floor. The US has much to lose and Trump could be putting jobs, livelihoods and national well-being at risk.

Beijing clearly holds the whip hand as one of the dominant investors in the US Treasury market. According to official figures for May, China held up to US$1.2 trillion dollars in Treasury securities, accounting for close to 20 per cent of all foreign holdings of US Treasury debt. Off-loading just a small part of its US government investments or embargoing future auctions could have a significant effect on market confidence, pushing US bond yields sharply higher in the process.

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In fact, Beijing has already been pipped on this by Russia, which used the tactic earlier in the year when Moscow retaliated against Washington for trade sanctions slapped on Russian aluminium exports. Between March and May this year, Russia dumped 84 per cent of its US debt holdings, a move that spiked 10-year Treasury yields above 3 per cent for the first time since 2014. It could easily happen again, but in a bigger way.

If China took the cudgel to the US Treasury market, the effects would be devastating. Even a small Treasury market intervention by Beijing could have a catastrophic effect on confidence, pushing an already fragile market further onto the back foot. Ten-year US Treasury yields could gain a foothold above 3 per cent and target decade-old highs in the 3.5 to 4 per cent range quite soon.

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Beijing has a stark choice. It can respond in kind and trade tit-for-tat tariff blows with Washington or go for the knockout punch. Trump says that he is winning the battle with China, but this is a war that China can still win on its own terms, resisting US coercion at the same time.

Playing the Treasury market wild card would be a dangerous game but could yield quick results.

David Brown is chief executive of New View Economics