May 2019 Newsletter
Trade is back in the headlines again. Many had expected a deal to be inked this past week between the US and China, but instead talks broke down and new retaliatory measures were put in place on both sides. This month, we look at the potential for escalations in this trade battle.
According to reports in the NY Times, the two countries were on a verge of a deal last week, even discussing logistics for a potential signing ceremony. However, according to US officials, China attempted to back away from some of the commitments in the deal at the 11th hour, including provisions on increased access to Chinese markets. This triggered President Trump to increase tariffs on $250 billion in Chinese goods from 10% to 25% and instruct his administration to prepare for tariffs on the rest of Chinese imports, an additional $300+ billion. The Chinese responded by saying they may cease purchases of US farm products and reduce Boeing orders. Both sides did say that talks haven’t broken down completely and that they will continue to work toward a resolution.
Additionally, in a tweet from Hu Xijin, editor in chief of the state-run Global Times, noted that “Chinese scholars are discussing the possibility of dumping US Treasuries and how to do it specifically.”
So what can the two sides realistically do to ratchet up the economic pressure on the other?
First, we can look at the total amount of tariff “ammunition” left between the two countries. On that front, it isn’t even close. The Chinese already have tariffs on almost all US imports in to China, while to date the US has only imposed tariffs on about half of Chinese imports (see figure 1). Prior to last week, the 10% tariffs imposed were largely unseen by importers and consumers, but the 25% will not be so easily absorbed in to the market. Supply chains will move, prices will go up, and demand will likely slow. This will have an impact on the Chinese economy and there is much more that we can do.
The biggest hit in the US will be to the agriculture sector, but the President has already indicated that his administration is prepared to purchase US farm products directly, providing aid to those hit by reduced Chinese demand. Critics will say that this is an unsustainable measure and cutting off relationships with the Chinese market will have long-lasting impacts. That may be true, but in the short-term it is likely that the government can step in and prevent US farms from bearing the full weight of this trade dispute.
Figure 1: Tariffs on US and Chinese Goods
China already imposes tariffs on almost all of US goods entering their market. The US has another $300+ billion of untaxed imports in can impose tariffs on.
Next, we can turn to the prospect of China selling their US debt on the open market as suggested in the tweet by Hu Xijin. China is by far the largest sovereign holder and buyer of US obligations, and currently hold approximately $1.2 trillion of US bonds.
Figure 2: Top Foreign Holders of US National Debt
At almost $1.2 trillion, China is the largest holder of US obligations and could cause a significant disruption in global debt markets should they choose to start an earnest reduction of those holdings.
Figure 3: Chinese Holding of US Debt
China has already been reducing their holdings of US debt over the last year, and Russia has exited the market entirely.
This is considered by many observers to be the “nuclear option” in the trade war. The US relies on sovereign entities to buy a portion of its debt, and China is typically the biggest buyer. If they decide to walk away from that market, it would in theory create a substantial dislocation. However, it may be self-destructive as well, and could have second and third order effects that would end up helping the United States.
For one, a Chinese reduction in Treasurys would weaken the US dollar. This would make US businesses more competitive in international markets and could provide unintended support to US companies. Additionally, as the supply of US paper on the market increased prices would fall, and yields would rise. This would reduce the value of China’s portfolio and end up inflicting losses on their own financial position.
Finally, if you look around the world at where governments can invest their money, the US has by far the best yields for the risk that they must take (Figure 4). Would China really start moving investments to somewhere like Germany, which is tied to the risk of the Eurozone and yielding basically nothing?
However, with the US facing down an expected $1 trillion annual budget deficit in the years to come, there is a legitimate fear that buyers could dry up and cause problems domestically. But with the options so limited around the world, it seems highly unlikely.
Figure 4: Yield on Ten-Year Government Bonds of Selected Countries
At approximately 2.5%, the US still provides by far the best value for risk in the world, and it isn’t even close.
Overall, the US has the economic leverage to ratchet up the pressure on the Chinese, and they have relatively little they can do to respond. But China has the political leverage. They are not worried about an election, they control the media their population sees, and Xi Jinping will be the President in China for decades to come. The risk is that they view the US government as transitory and may just wait it out and see what happens come November 2020.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine what is appropriate for you, consult a qualified professional.
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