Devaluating the Yuan and dumping US treasuries regular pop up as ‘nuclear options’ China has in its trade war with the US. Financial and political analyst Victor Shih explains why that might be a wrong idea. “These options are not credible, because they conflict with other important policy objectives of China,” he writes at the China File.
As the trade conflict between the U.S. and China heats up, observers in and out of China have speculated on two potential “nuclear options” that China may deploy: substantial devaluation of the yuan, and the dumping of China’s roughly U.S.$1 trillion in U.S. treasuries. Yet these options are not credible, because they conflict with other important policy objectives of China’s. Also, they would likely cause more financial harm to China than to the United States. Although Western policymakers generally underestimate the pain that authoritarian leaders can impose on their citizens with hardly any political repercussions, substantially slower growth would undermine Xi’s own ambition for China to be a great power.
Yuan devaluation would severely jeopardize the relative stability in the foreign exchange market that Chinese regulators have tried hard to restore after 2015’s near crisis. Given that an exchange rate above 7 yuan to the dollar has not occurred at the end of a trading session for over a decade, devaluating the yuan past that point would be considered a “black swan” event by most of the trading algorithms, throwing the entire emerging market into turmoil. Devaluation to 25 percent would bring about even more dire consequences. For the past several years, Chinese banks and firms have borrowed close to two trillion dollars from offshore counterparts. Since much of this borrowing is in currencies linked to the dollar, a 25 percent devaluation would mean that Chinese debtors would need to pay 25 percent more in yuan to service their debt. Given the high domestic debt burden of the Chinese corporate sector, such a sudden increase in debt servicing would likely trigger a sizable wave of defaults by Chinese firms and even some financial institutions. Without a truly massive government bailout, which would deplete China’s foreign exchange reserve, many Chinese companies would be shut out of the global credit market for years—contravening Xi’s dictate to “hold the bottom line of financial stability.”
Unwinding China’s roughly U.S.$1 trillion holding in U.S. treasuries would cause temporary turmoil in the treasury market and a temporary decline in the price of treasuries. However, as the lone determined seller, China would likely bear the brunt of the losses. If China decided to upset the treasury market, it would have to keep selling—even as treasury prices begin to decline. Thus, sellers in this initial period would bear the bulk of losses. Once market participants determined that China was selling for political reasons, they would begin to buy in earnest, taking advantage of the unusually high treasury yields. The Federal Reserve would then likely step in to buy, extinguishing any panic. China would bear the brunt of the losses in the initial period, and besides making headlines for a few days would gain nothing of consequence while losing billions. And what would China do with all the cash? If it invested the money in a dollar money market, U.S. banks would borrow the cheap money to buy up treasuries, which would also extinguish the panic.
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