The US is whispering about financial war against China. Investors must brace themselves

The possibility of Washington restricting US investment in China shouldn’t be taken lightly. US-China financial interconnections have increased in the past decade, and a financial decoupling would be even more damaging than the trade war

Aidan Yao

Published: 1:00am, 10 Oct, 2019

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The recent news that the United States might consider restricting investment in China underscored the deep divide between the two countries and cast a dark shadow over the upcoming trade talks.

Although the news of the deliberations was subsequently dismissed by White House officials, enough damage had already been done to the markets and investors pared back expectations of a breakthrough in the coming trade negotiations. We remain sceptical of any tangible progress in this week’s gathering and expect the proposed tariffs – scheduled for mid-October and December – to be applied in due course.

While a substantial financial decoupling seems unlikely in the near term, there is a clear tendency for the US-China conflict to spread beyond trade. The trade dispute remains a mere symptom of the contest for global influence between the world’s two pre-eminent powers. Beyond the trade tussle, technology is a more important battleground, with the US already flexing its muscles by curtailing the rise of Chinese tech firms and the spread of Chinese 5G technology.

Whoever wins this technology race could command the power to reset the global order in the coming decades. Looking ahead, we expect more intense competition in this field.

Besides technology, another area of contention could be finance. As in tech, the US has strong incumbent advantages. The US dollar is the world’s No 1 trading, investment and reserve currency. US equity and bond markets are the world’s largest, deepest and most diverse, financing not only companies and the government in the US, but also those from abroad, including China.

Finally, US investors collectively represent the largest force in cross-border capital flows, and the most widely followed investment benchmarks, such as the MSCI, are created and managed by US-based financial institutions. Hence, if the US wanted to wage financial war against China, it would have quite a deep war chest.

Worryingly, the rumoured financial restrictions on China would cover all of the above. According to a Bloomberg report, the White House was contemplating delisting Chinese companies from US stock exchanges; reducing US pension funds’ exposure to Chinese markets; and limiting the inclusion of yuan assets in investment benchmarks managed by US firms.

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Had such action been taken a decade ago, the impact on China would be minimal. Back then, China had very few companies listed in the US, yuan assets were not in global indices due to China’s sealed capital account, and there were few portfolio flows between the two countries.

Indeed, China’s domestic savings were so abundant back then that the surplus savings – after the financing of domestic investment – had to be recycled in overseas markets. As the lion’s share of this money was invested in US Treasury assets, limiting China’s investment in those years would, in fact, have backfired on the US.

But things have clearly changed since then. Financial linkages between the two countries have strengthened markedly. Today US-listed Chinese stocks are valued at US$1.1 trillion. The liberalisation of China’s onshore markets has increased foreign capital inflows, including many from the US.

Renminbi assets have started to enter global indices, with MSCI predicting that Chinese equities, both onshore and offshore, may make up over 40 per cent of its Emerging Markets Index when domestic Chinese equities are included at full weight.

Finally, China still holds more than US$1.1 trillion in US Treasury bonds in its official reserves, with a total exposure – including non-Treasury assets – that we estimate is potentially worth more than US$2 trillion.

The financial interconnections between the US and China have therefore increased substantially. Hence, a forced decoupling of the two could create more damage to the global financial system than the trade dispute.

Why China-US decoupling makes no sense

For now, the risk of a catastrophe seems low. But the long-term trajectory of the US-China relationship is worrying, and the risks of further confrontations, however small, cannot be downplayed.

With the world’s most powerful country considering putting up walls around technology and capital – the things you would usually expect to transcend boundaries – investors must be prepared for a world segmented by protectionism.

Aidan Yao is senior emerging Asia economist at AXA Investment Managers

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