Will China use its $ 1.2 billion US debt as a firepower to fight the trade war?

This story is published by POLITICO as part of a content partnership with the South China Morning Post. It originally appeared on scmp.com on May 10, 2019.

China's promise to react after US President Donald Trump on Friday increased tariffs on Chinese goods worth $ 200 billion heightened uncertainty about resolving trade tensions between the two countries and has sparked fears among investors and analysts to hinder global growth.

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According to analysts, if China refused to play ball on Trump's terms, the United States could not only retaliate by imposing countervailing duties, but it also has a panoply of financial arsenal powers to deal with. punish the United States.

For starters, China could retaliate by getting rid of its vast holdings of US public debt. Flooding the treasure market may lower US bond prices and drive up yields. This would make borrowing more expensive for US businesses and consumers, which would dampen US economic growth.

Cliff Tan, head of global market research at MUFG Bank for East Asia, said it was unlikely that China would choose to sharply reduce its holdings of Treasury bonds would undermine its own interests and fuel "extreme" market volatility.

"Dumping treasure would be an inefficient weapon for China, as it would increase yields and hurt the position of their own holdings in treasuries," Tan said.

"If China were to completely dispose of its assets in US dollars, it would be very risky for them because of the extreme volatility of the markets."

The trade war seemed on the verge of ending until Sunday when Trump threatened to raise existing tariffs in a tweet, lowering Chinese stocks and its currency this week. Shanghai's benchmark composite index reached its lowest level in 10 weeks, as the yuan moves towards its biggest weekly decline since mid-2018.

A few minutes after the US raised tariffs by 10 to 25 percent on Friday, the trade ministry reaffirmed its tough stance in the trade war, saying in a statement that "we will not have to pay any more. alternative than taking the necessary countermeasures ".

Nevertheless, the statement said that Beijing remained confident in the hope of solving the problem "through cooperation and negotiations". Deputy Prime Minister Liu He has been in Washington since Thursday for two-day trade talks. Discussions will resume Friday morning in Washington.

Until 2016, the People's Bank of China bought US dollars from exporters by selling them yuan to avoid excessive appreciation of the Chinese currency. Most of China's $ 3.1 billion foreign exchange reserves, the largest in the world, are parked with US Treasury securities, which enjoy safe haven status. China needs US dollar assets as a security reserve if it needs to bail out the domestic banking system or support the yuan through foreign exchange intervention.

Although it has reduced its holdings of US Treasury securities in recent years, it still ranks first among foreign creditors with $ 1,122 billion, followed by Japan with $ 1,042 billion.

This amount, however, represents only about 5% of the United States. $ 22 trillion in total debt owed by federal, provincial and local governments starting in February. Of this total, more than US $ 5 trillion in debt is held by the federal government in trust funds dedicated to social security. Much of the rest of the debt belongs to individual investors, corporations and other public entities, including the Chinese government.

Although $ 1.123 billion is a modest amount, it represents only about 5% of the US national debt and it remains to be seen whether China's reduction of its assets will produce effective results. .

"The dumping of cash is unlikely to be an effective means for trade war negotiations. It is unlikely that China will find other investment options as it holds so many treasures, "said Betty Rui Wang, chief economist for China at ANZ Bank.

Nevertheless, if China decides to sell US treasuries and buy oil, oil producers who receive US dollars could redistribute them in US treasuries, which would not increase China's leverage to protect his interests.

Tan, of MUFG, said that a better option for China would be to allow the yuan to depreciate against the US dollar to offset the negative impact of tariffs.

But the drop in the yuan's exchange rate this week has wiped out any hope that Beijing will meet US demand to keep its currency stable at all costs.

"If there is no negotiated monetary stability pact, it is certainly one of the ways in which China can prepare for what we think is a serious escalation of tariffs," he said. said Tan.

The latest round of tariff increases by the Trump administration, which is up to 25%, now matches the rate applied to a previous $ 50 billion category of Chinese machinery and technology products. Trump also threatened to charge 25% of tariffs on Chinese products worth an additional $ 300 billion.