Blog Post

US tariffs and China’s holding of Treasuries

China has the biggest bilateral trade surplus vis-à-vis the US but is also a top holder of US government bonds. While China has started to counteract US trade tariffs, economists have been discussing the case of China acting on its holdings of US Treasuries. We review recent contributions.

By: Date: July 2, 2018 Topic: Global Economics & Governance

The recently published Reuters’ article on the current situation between the US and China  holds some interesting quotes. Answering a reporter, Zhu Guangyao – Chinese Vice Finance Minister – reportedly reiterated China’s policy regarding its foreign exchange reserves, saying it is a responsible investor and that it will safeguard their value. Jeffrey Gundlach, chief executive of DoubleLine Capital LP, believes that China can use its Treasury holdings as leverage, but only if they keep holding them. Jeff Klingelhofer, portfolio manager at Thornburg Investment Management Inc., anticipated that if China committed to dumping Treasuries, it would have an immediate and temporary impact on money markets in the United States; however, it would be a bigger hit to the sustainability of what they are trying to accomplish. Brad Setser, senior fellow at the Council on Foreign Relations, said China can sell Treasuries and buy lower-yielding European or Japanese debt.  

Source: Reuters

Brad Setser at the Council on Foreign Relationship has been watching developments in China’s external portfolio for a long time. He also of estimates what would happen if China started selling off its Treasury portfolio. Selling the entire Treasury portfolio would generate about 6% of US GDP in sales, which could raise long-term interest rates by about 30 basis points. The impact would be larger in the short-run but then higher US rates – in relative terms to the to still low European rates –  would pull private funds into the US fixed income market. If China’s sales are pushing up long-term rates and slowing the US economy, the Federal Reserve should logically slow the pace of rate hikes or scale back its “quantitative tightening”/ balance sheet roll off.

 


On the surface, it looks like the US is vulnerable: the stock of Treasuries that the market has to absorb to fund the rising US fiscal deficit is large, and if China started to sell, the amount of US paper that non-Chinese investors would need to absorb would be massive. However, Setser thinks China’s sales are in some ways easier to counter now, as the Federal Reserve can signal a slowdown of rate hikes and it can respond to Chinese sales by changing its pace of balance sheet roll off. On its side, the Treasury could start issuing more bills and fewer notes, offsetting the impact of China selling longer dated bonds and likely increasing its cash holdings. Furthermore, the Fed could raise the maturity of its holdings. Overall, Setser thinks that the US government should spend some time thinking about the impact of Chinese sales of assets other than Treasuries, because Treasuries sales, in a sense, are easy to counter.

Martin Sandbu thinks that Setser’s analysis is correct but not the end of the story. If China were to shift its holdings from low-paying bonds to higher-yielding assets or pursue a policy of not financing the US economy at all, then the American economy would need to pay more to finance its current account deficit or run down its international investment position. Such a dent in the American “exorbitant privilege” of guaranteed cheap external borrowing rates could easily be self-reinforcing in that others will demand a higher yield for holding US assets. If this leads to a fall in the dollar and a smaller deficit, then this could be sustained and might even be in line with what Trump sees as desirable. That being said, this government is not about to tighten its belt, so it would have to be the private sector doing so through less investment by companies or lower consumption for households.

Michael Pettis wrote a long post in which he argues that if China is threatening to retaliate against any US trade action by reducing its purchases of US government bonds, not only would this be a pretty hollow threat but, in fact, it would be exactly what Washington wants. Pettis looks at five ways in which Beijing can reduce official purchases of US government bonds. He argues that some of them would not change anything for either China or the US; others would change nothing for China but would cause the US trade deficit to decline either in ways that would reduce US unemployment or that would reduce US debt; and another still would cause the US trade deficit to decline in ways that would likely either reduce US unemployment or reduce US debt but also cause the Chinese trade surplus to decline in ways that would likely either increase Chinese unemployment or increase Chinese debt. Pettis’ conclusion is that by purchasing fewer US government bonds, Beijing would leave the US either unchanged or better off; however, doing so would leave China either unchanged or worse off.

Jeffrey Frankel has a broader post on why he thinks China will not yield in Trump’s trade war. In this piece, he highlights that the surplus country is often in a stronger position because it has accumulated financial claims against the other – in this case, well over a trillion dollars of Chinese official holdings of US treasury securities. It is true that if the Chinese government dumped US treasury securities, the fall in their price would hurt itself as well as the US. Nonetheless, this does not nullify the point. For one thing, China does not necessarily have to decide to sell them. As the US debt burgeons and US interest rates rise – two trends which are virtually certain to continue this year – trade conflict could produce rumors that the Chinese might stop buying US treasury securities which, in turn, could be enough to lower US bond prices and increase interest rates.

Steven Englander thinks it is possible that China will use talk of such steps to make the Trump administration more flexible. However, he believes it is very unlikely that Beijing can follow through because financial measures such as depreciating the yuan or selling off Treasuries do as much damage to China as to the US, and several of them do tremendous damage to China’s neighbors and emerging-market countries that Beijing is courting in making the yuan an international currency.

US Treasury yields tend to lead Chinese yields, and an increase in US yields would spill over globally. The People’s Bank of China could change domestic policy to offset this, but that would not insulate the rest of the emerging markets and even the developed world. Nor is the Chinese stock market insulated from Wall Street. The currency implications are uncertain: selling US Treasuries and buying European bonds or Japanese assets will probably weaken the dollar thus putting downward pressure on China’s own currency. Emerging-market currencies would likely follow suit and decline against both the euro and the yen. If China went so far as to boycott US Treasury auctions, the dollar would fall sharply even as US yields climbed.

Neil Irwin writes that it would be a risky maneuver in which China could potentially have a lot to lose. Suddenly unloading some of its US debt holdings or even signaling an intention to buy fewer dollar assets in the future would probably cause long-term interest rates in the US to rise –  at least temporarily. But it would also drive down the value of China’s existing bond portfolio- meaning that China could lose billions- and it would tend to push down the value of the dollar relative to other currencies, which would actually help the US attain more advantageous trade terms. Even after all that, bond prices would most likely re-adjust over time as other buyers take advantage of the rise in interest rates. In the medium term, the performance of the US economy and the actions of the Federal Reserve do more to determine bond prices than the decisions of a single buyer or seller, even as large as China.

Edward Harrison thinks that China cannot use its Treasury holdings as a leverage because, if the Chinese really wanted to use Treasury bonds as a weapon, they would need to either float their currency or revalue it. And that, according to Harrison, is not at all what they want to do since revaluation would reduce Chinese exports and slow economic growth. He expects the ongoing trade conflict to escalate and for people to misdiagnose the constraints as well – with the result that misdiagnoses will ultimately increase the conflicts and not diminish them.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

View comments
Read article More on this topic More by this author

Blog Post

Something Putin and Juncker appear to agree on – the euro.

“It is absurd that Europe pays for 80% of its energy import bill – worth €300 billion a year – in US dollars when only roughly 2% of our energy imports come from the United States,” said President Juncker in his state of the union speech.* Europe’s largest supplier of energy – Russia, who accounts for a third of that bill – couldn’t agree more. Russia’s offer to switch to euros in trade with the EU will likely be costly to implement, but the US switch towards unilateralism is forcing its long-standing partners to question the dollar’s global dominance.

By: Elina Ribakova Topic: European Macroeconomics & Governance Date: September 25, 2018
Read article More on this topic More by this author

Blog Post

Inequality in China

After amply discussing income inequality in Europe and the US, economists are now looking at the magnitude, implications and possible remedies for this phenomenon in the context of the Chinese economy.

By: Silvia Merler Topic: Global Economics & Governance Date: September 24, 2018
Read about event More on this topic

Upcoming Event

Oct
3
09:00

International trade and the EU-Japan Economic Partnership Agreement

This event; jointly organised by Bruegel and the Graduate School of Economics, Kobe University, will discuss the EU-Japan trade deal and asses its impact.

Speakers: Sonali Chowdhry, Gabriel Felbermayr, François Godement, Hiroo Inoue, Sébastien Jean, Yoichi Matsubayashi, Tamotsu Nakamura, Masahiro Nakata, Luis Portero, André Sapir, Alessio Terzi, Agata Wierzbowska and Guntram B. Wolff Topic: Global Economics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read article More on this topic More by this author

Opinion

Japan must boost R&D to keep rising Chinese rivals at bay

As China shifts into a more advanced industrialised economy, Japan has slowly but surely lost to some of its comparative advantages to its rival. One possible solution to help the government keep pace would be to concentrate research and development efforts on a few key sectors where Japanese players still hold a large competitive lead.

By: Alicia García-Herrero Topic: Innovation & Competition Policy Date: September 20, 2018
Read article More on this topic More by this author

Podcast

Podcast

Backstage: Developing the EU-China relationship amid rising global trade tensions

Bruegel director Guntram Wolff is joined by Alicia García-Herrero, senior fellow at Bruegel, and Zhang Weiwei, director at The China Institute of Fudan University, following up a Bruegel conference focused on the potential for closer economic links between China and the EU.

By: The Sound of Economics Topic: Global Economics & Governance Date: September 20, 2018
Read about event

Upcoming Event

Oct
11-12
20:00

Policy responses for an EU-MENA shared future

In the third edition of the "Platform for Advanced & Emerging Economies Policy Dialogue" we will discuss trade flows and trade policy between Europe and MENA, integration of developing economies into global value chains, and regional energy relations.

Speakers: Mounssif Aderkaoui, Karim El Aynaoui, Marek Dabrowski, Uri Dadush, Giuseppe Grimaldi, Badr Ikken, Joanna Konings, Zahra Maafiri, Pier Carlo Padoan, Visar Sala, Nicolò Sartori, Nathalie Tocci, Simone Tagliapietra and Guntram B. Wolff Location: Rome
Read article More on this topic More by this author

Opinion

China Made Two Promises in Africa. Can It Keep Them?

China has committed to a market-driven relationship with Africa, as well as a new $60 billion investment plan on the continent, following the recent China-Africa summit. In this light, the author assesses the China-Africa economic relationship, suggesting those new objectives may not be so easy to achieve.

By: Alicia García-Herrero Topic: Global Economics & Governance Date: September 19, 2018
Read article More on this topic More by this author

Opinion

China real estate developers: a grey rhino in the jungle of financial risks

The author assesses the Chinese real estate industry’s liquidity concerns and its leverage, which is estimated to be four times higher than its global peers.

By: Alicia García-Herrero Topic: Global Economics & Governance Date: September 18, 2018
Read article More on this topic More by this author

Blog Post

Reforming the EU fiscal framework

Researchers have often highlighted the problematic nature of the currently very complex EU fiscal framework. Here we review economists’ views on how it should be changed.

By: Silvia Merler Topic: European Macroeconomics & Governance Date: September 17, 2018
Read about event

Past Event

Past Event

China's digital economy

How to measure China's digital economy?

Speakers: Alicia García-Herrero, Claudia Vernotti and Reinhilde Veugelers Topic: Global Economics & Governance, Innovation & Competition Policy Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: September 17, 2018
Read about event More on this topic

Past Event

Past Event

Perils and potential: China-US-EU trade relations

We are hosting a number of Chinese and EU experts to discuss trade relations between the three forces.

Speakers: Miguel Ceballos Barón, Alicia García-Herrero, Wei Jianguo, André Sapir, Herman Van Rompuy, Zhang Weiwei, Guntram B. Wolff, Zhou Xiaochuan, Zhang Yansheng and Ruan Zongze Topic: Global Economics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: September 17, 2018
Read article More on this topic More by this author

Blog Post

Lehman Brothers: 10 Years After

Ten years after the bankruptcy that shook the world, we review economists’ take on the lessons learned from the global financial crisis.

By: Silvia Merler Topic: Finance & Financial Regulation Date: September 10, 2018
Load more posts