Full Economic Warfare – China v US

There was more turmoil in markets overnight as the US-China trade war continues to flare up, this time with a further clamp down on Chinese tech giant Huawei.  In the background we also saw reports that President Xi is considering banning rare earth metal exports to the US (critically affecting many tech manufacturers as China produces 80% of the world’s supply) and the US brazenly (and again) taking a naval destroyer within 12km of disputed Chinese territories to “challenge excessive maritime claims and preserve access to the waterways as governed by international law” but which the Chinese described as a repeat of “provocative actions”.

There are no shortage of articles out there about how history demonstrates where such super power trade wars can end.  Some talk to the ‘economic war’ threat of China ‘dumping’ its $1.1 trillion of US Treasuries.  Some analysts argue that would be too damaging to China itself for them to enact such an all out declaration of war.  Long time China analyst and expert, David KO Chin of Basis Point begs to differ and penned this very interesting article discussing that very point and aptly titled “Till debt do us part. What happens to their matrimonial assets when the US and China decouple”.  We thought it unique and insightful enough to publish for you verbatim.  Whilst reading it, it’s worth remembering China is likely the world’s biggest holder of gold, despite not (and likely strategically so) disclosing this officially.

“Speculation about China selling its US treasury holdings in retaliation to US tariffs has resurfaced in recent days.

While most pundits and polls dismiss the idea, it pays to take a contrarian view.  As stated my 17 Oct 2018 email, it will happen when China has ‘no choice but to sell’ ie when the 25% tariffs on all Chinese exports to the US are implemented.

When that happens, there is no further hope of Chinese exports to the US (it’s no longer profitable), no need for a thriving US economy to buy Chinese goods, and no need for a cheap Chinese yuan to make its exports more viable.

Selling US treasuries is a weapon of last resort.  China will seek an ‘Argentina 2001/2002 type crisis’ for the US, a triple whammy when the US$ collapses, US interest rates double/triple and US inflation surges….on the basis that the US is deeply mired in debt but only the world’s faith in US treasuries and US$ as safe-haven assets has prevented a melt-down.

But before it sells, China will reveal, but not play, its hand.  The US will either poo-poo the idea that it will materially impact the US and thus continue its fight, or back-down and restart negotiations.

China needs a trade deal (for reasons see my past newsletters –it needs time for its Belt & Road and Made in China 2025 strategies to bear fruit, and to maintain the ‘jobs, jobs, jobs’ that its export industries generate)

China’s US treasury holdings are currently in profit.  A back-of-the-envelope calculation suggests China’s $1.1 trillion holding of treasuries was bought at an average of 3.3% yield over the past decade (for ease of analysis, I’ve benchmarked their holdings to 10-year-T bonds, although they will have a range of T-bond and bills –from months to 30 years), and at a currency exchange rate average similar to today.

With 10 year T-bonds currently at 2.4%, China could sell $700b of its $1.1t holding before pushing yields to its breakeven of 3.3%. 

The $700b figure is based on Russia selling around $81b of US Treasuries (84% of its US bond portfolio) in March-May last year and pushing yields (temporarily) from the low 2.80s to high 2.90s  (2.74 -3.06 at the lowest-highest points during that time)

However, global bond traders will sense China’s activity and will ‘jump on the back of the trade’ accentuating the fall of the US bond market, and reducing China’s break-even target.  Chinese financial institutions in particular will likely be the first to short the US T bond market to drive the market down further.  Where will the buyers come from?  Only higher yields will attract them but Chinese mass selling will make these buyers fearful, hold off, and worsen the fall.

(Market forces are not linear.  Multiple new factors will arise to influence the outcome. See my further analysis here.  (Eg While China’s $1.1t portfolio is only 5% of the total US debt, it’s the power of the marginal seller/buyer that will move the market; PetroYuan vs PetroDollar influence; US counter-actions to overcome China’s strategy, EU reaction; lessons from the 2008 GFC; Chinese hard assets in dollars; China own financial black swan/grey rhino risks; etc)

China would sell the rest of its $400b at a loss but netted off against its profits from its earlier sales, would be hurt but not as hurt as the US economy facing 6%-9% interest rates.  (its mutually assured destruction – a financial MAD instead of a nuclear MAD)

China will also sell US dollars for Yuan, seeking to engineer a collapse in the USD to end its status as the hegemonic currency.  (China will also sell some USD for Euros and other world currencies/commodities to lessen it impact of a strong Yuan on Chinese exports to those nations –this is China’s Achilles heel for this dump US treasuries/dollars strategy….a low USD will help US exporters… but with a likely recession/depression world-wide, who will they sell to…certainly not China) 

It’s a reverse of the Plaza Accord of the mid 80s when the US forced a then rising Japan to strengthen the Yen, hurting Japan’s export industry and resulting in Japanese investors going on a global asset buying binge in the late 80s. (remember the Japanese investment wave to Qld?).  In China’s case, there are no longer exports going to the USA anyway and Chinese capital controls will direct Chinese buying of global assets, driven by a high Yuan, into Belt and Road countries to secure a higher return on investment including geopolitical benefits for China. 

A key force in this ‘dump US treasuries/dollars strategy’ will be those Chinese corporate borrowers who have been borrowing in USD in the past few years (An estimated US$3 trillion of US dollar-denominated Chinese corporate bonds have been issued).  Repaying in cheaper US dollars when the bonds mature will benefit these Chinese borrowers.  (China’s central bank will flood its domestic market with Yuan to lower Chinese interest rates as this US dollar corporate bond market dries up)

With China, US and Europe all mired in debt, it’s a I die, you die harder scenario as the US and China de-couple.

Anyone know of a good divorce lawyer?  Or a marriage counsellor if there is still hope for reconciliation?”