China on the ropes

At the beginning of summer a series of US protectionist tariffs has been implemented, including both allies and rival markets. The legitimacy of such an economic solution is secondary now, as the decision has already been made. The reasoning is mostly based on false assumptions and observations regarding world trade, and even real problems – such as the Chinese market barriers or intellectual property rights handling – could have been handled more effectively by undertaking reciprocal measures on the US market (e.g. entry only through a domestic partner).

China retaliated with its own package of tariffs on US goods. The targeted products were mainly picked by political considerations, and aimed at producers and sectors who are predominantly Trump supporters. Nonetheless, people started to make guesses on how can China more effectively retaliate against a new rounds of US tariffs on Chinese goods. Capital market measures are among the cards, at least according to several websites and magazines. China is among the biggest US government debt holders with a stock of 3 trillion USD and a market share of 15 percent. The discussion talk about a range of possible solution, from analytically reasoned lower purchasing volumes to click-bait published sell-it-all solutions.

As China is keeping to its mercantilist economic policy in order to export capital and expend its strategic influence or build strategic funds to compensate later for its rapidly aging population, the Chinese economy needs a feasible asset for keeping its savings safe. Thus selling their stock would hurt their own long-term interest too. Firstly, in order to fire-sell  such an immense amount (both in absolute and relative terms) you must accept lower prices, making a loss for yourself if there is no buyer. Secondly, even if such sale would be possible, the leadership should find and equal alternative to park its savings.

The only viable buyer one can consider is the Fed itself. Since collapsing bond prices would drag on interbank activity to household and company balance sheets to the public sector due to the bills and bonds’ central role in modern monetary politics, the Fed should step up to safeguard the economy from the turbulence. As the mandate of the Fed (on financial stability) makes this solution possible, money pumps could run wild once more.

As a last resort for the Chinese retaliation, the devaluation of the yuan is also among the cards. On one hand, a weaker yuan could counterbalance the negative price effect of tariffs in yuan terms. On the other hand, the Chinese private sector is heavily loaded with both local and foreign currency debt. A devalued yuan might spark a dollar buying frenzy to hedge against increasing liabilities, creating a slippery slope for the Asian currency. To manage the float the PBoC should sell dollars once more and buy its own currency, resulting in a de facto monetary tightening and higher domestic debt-servicing costs. Between a rock and a hard place.

After we considered all these technical details, I find a capital market retaliation an unlikely, tail-risk scenario.

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