There has been speculation that the trade dispute between the US and China could prompt Beijing to sell down its holdings of US Treasury debt. While Chinese leaders clearly feel compelled to retaliate against Washington’s recently imposed tariffs, it is unlikely that foreign exchange reserves would be used for this purpose. Progress on some of the West’s legitimate complaints about China’s trade practices seems remote, but so does any Chinese response that might trigger a fully-fledged financial crisis.
Chinese officials will weigh some difficult issues as they shape their strategy. Textbooks would suggest that selling dollar-denominated assets would put downward pressure on the dollar. It is doubtful that this is an outcome China would want against the backdrop of a trade dispute that, in a wider sense, would threaten its own export performance. However, the situation might be more nuanced than it first appears. Currency movements do not always conform to theory. If retaliation were intended to trigger a US financial crisis, the experience of the 2008 crisis might be worth heeding.
A decade ago, as the US housing crisis morphed into a global crisis, the dollar benefited from a ‘flight to quality’. This perverse outcome was a consequence of dollar hegemony in the financing of international trade.
Beijing began the process of establishing its own currency in the global trading network partly to ensure that China would be in a stronger position in a future crisis. Any Chinese reaction that risks triggering a flight to quality onto the dollar, and which boosts dollar hegemony, would be inconsistent with the decade-long policy of internationalising the renminbi.
Moreover, there is nothing to stop the Fed from simply mopping up any Chinese sales of US debt. China, even if it were inclined to embark on a financial market skirmish, might be wise to avoid one that US authorities could neuter with minimal effort. Moreover, in 2015-16, China liquidated around $1tn in foreign exchange reserves, of which around two-thirds were probably denominated in dollars. During that period, US bond yields actually declined.
For China, the benefits of maintaining a large and stable position in US debt instruments might be more useful than weathering the consequences of liquidating that position. In fact, doing nothing might be a winning strategy. China has been adept at filling the vacated moral high ground in international relations since the election of President Trump.
China has been keen to position itself as a defender of free trade at a time when the US is moving towards protectionism. This would also enhance China’s international standing but would be consistent with the objectives of the Belt and Road initiative, which may help establish a China-centric trade network and further boost international usage of the renminbi.
The Chinese response to US tariffs will probably focus on trade and investment, including tariffs against US imports and further restrictions on US investment in China. A measured response may encourage other nations to tone down their concerns about Chinese trade subsidies or poor protection of intellectual property.
In terms of foreign exchange reserves, the views of Fan Gang, a member of the People’s Bank of China and adviser to the State Administration of Foreign Exchange, a subsidiary of the central bank, are relevant. He has said that China should not buy more US debt but should instead buy real assets. From the Chinese perspective, this could be a good time to exhibit patience and skill in playing the long chess game.
Gary Smith is Member of the OMFIF Advisory Council and Member of the Strategic Relationship Management Team at Barings.