China may use foreign exchange reserves to fight US financial war risk, analysts say
- The People’s Bank of China has maintained the world’s biggest pile of foreign exchange reserves at a stable level of around US$3.1 trillion in recent years
- But it now may consider a more defensive stance, such as supporting the yuan’s exchange rate, as the tensions with the United States spread to finance
As the United States widens the conflict with China into the realm of finance, raising the possibility that Washington will use the US dollar payment system as a weapon, analysts are wondering whether China will shift how it uses its US$3.1 trillion in foreign exchange reserves in anticipation of extreme financial volatility.
China, analysts said, may consider preparing itself against a possible US financial attack by shifting towards a more defensive stance, such as using its foreign exchange reserves to support the yuanâs exchange rate while diversifying its investments out of US dollar assets to limit exchange rate and financial market risks.
âCurrently, foreign exchange has already become a target of the US to launch trade attacks or financial warfare,â said Chen Yuan, former chairman of the China Development Bank, the countryâs biggest policy lender. Therefore, we should consider shifting strategic thinking on foreign exchange reserves, from being our national wealth to becoming the focus of a financial battleground.â
According to Chen, the US wants to see the decoupling of the financial markets and exchange rates of the two countries, which could lead to unexpected risks to Chinaâs US dollar reserves and yuanâs exchange rate, which in turn, could result in even larger economic damage to China.
While the US announced on Tuesday a three-month delay in the implementation of a new 10 per cent tariff on more than half of the US$300 billion of Chinese imports that was originally expected to take effect September 1, concerns are still lingering that the American President Donald Trump will eventually raise tariffs on all Chinese imports to 25 per cent.
One of the primary goals of US policy is to maintain the advantages that comes from the US dollar being the main reserve currency of the world, with all other countries having to trade in US dollars for essential commodities such as oil and food products, helping fund the twin US current account and budget deficits, analysts agreed.
âChinaâs economic rise and power is a threat to the current US situation. But there can be only one âtop dogâ in this world,â said David Chin, the founder of Basis Point Consulting in Sydney. â[So to Trump], a no deal or 25 per cent tariff situation is fine as long as China crashes far more than the US.â
Chinaâs ability to access a sufficient supply of US dollars to pay for its massive imports and growing foreign borrowings, as well as to fund its signature Belt and Road Initiative, is now especially vulnerable after a series of financial attacks made by the US in the past month.
The yuan was changing hands at 7.04 against the US dollar on Wednesday, with the PBOC expected to let it gradually slide to 7.30 per dollar this year.
Early this month, the Trump administration seized Venezuelaâs US dollar assets held in America, and threatened penalties on China and Russia for aiding the government in Caracas, in an attempt to pressure Venezuelan President Nicolas Maduro to turn over power to opposition leader Juan Guaido. The move was also a reminder that Washington has the ability to freeze a nationâs assets in held in the US, including Chinaâs US$1.1 trillion in US Treasury securities.
That follows a US judgeâs decision in late June to hold three commercial banks in mainland China China Merchants Bank, Bank of Communications and Shanghai Pudong Development Bank â in contempt of court for failing to comply with subpoenas in an investigation into their possible breach of American sanctions against North Korea, pointing to the susceptibility of Chinese banks to being cut off from the US dollar international financial system.
âThe US already has a long history of using access to the [US dollar] as a tool to achieve other objectives,â said Richard Yetsanga, ANZ Bankâs chief economist. âOnly for the reserve currency is it meaningful to threaten prohibiting another country from accessing that currency as payment.â
Despite the security and liquidity of US government securities, market talk continues to swirl on whether China would offload its US Treasury holdings or cut back further on the portion of US dollar-denominated assets in its reserves portfolio.
âChina will trigger a US decoupling when it has no choice, dumping US Treasuries and dumping dollars,â Basis Point Consulting founder Chin added. âSuch a worst-case scenario has been building with progressive plausibility as each trade war punch and counterpunch ratchets up tensions.â
Kevin Lai, chief economist for Asia excluding Japan at Japanese investment bank and securities brokerage Daiwa Capital Markets, said that a sliding yuan may prompt Chinese companies to sell their yuan-denominated assets to the PBOC in exchange for US dollars to repay their overseas debt, ultimately causing Chinaâs US$3.1 trillion in foreign exchange reserves to fall.
Chinese government data showed the nationâs external debt rose 12 per cent year-on-year to US$1.97 trillion in 2018, due largely to increasing US dollar borrowing by Chinese companies.
âIf the PBOC refuses the dollar demand of Chinese debtors, the companies could scramble to get US dollars from the market, causing domestic liquidity to tighten and the yuan to fall even faster,â added Lai. âThat would be a nightmare scenario that the PBOC would want to avoid.â
Natixis Bank said that Chinaâs net capital outflows increased sharply from US$21 billion in the first quarter of 2019 to US$85 billion in the second, due mainly to a surge in US dollar outflows, even though they are still small compared to the peak seen in 2015.