On June 22, in Setser vs Rosenberg: China's "Nuclear" Option of Dumping Treasuries, we discussed competing theories on how China might respond to a trade war with the US.
Setser discussed three alternatives, then thoroughly debunked option three.
- Imposing new limits on U.S. firms operating in China, and taking actions that limit their sales in China. Apple and GM sell a lot of made-in-China phones and cars that wouldn’t be impacted by tariffs.
- Weakening China’s currency to offset the drag on China’s economy from far reaching tariffs. A standard, empirically well-grounded, rule of thumb is that a 10% depreciation (against a basket) raises net exports by about 1.5 percentage points of GDP—which could effectively offset realistic estimates of the economic drag of a trade war on China. This option isn’t without risks—it could reignite now contained capital outflows from China, and China might ultimately end up with a bigger-than-initially desired depreciation.
- And the perennial threat that China would sell its Treasuries. That could happen as a byproduct of a decision by China to push its currency down—if China signals that it wants a weaker currency, the market would sell yuan for dollars, and controlling the pace of depreciation would require that China sell reserves. Or could happen even if China maintained its current basket peg and shifted its portfolio around—selling Treasury notes for bills, or selling Treasuries and buying (gulp) Bunds (if it can find them—it might end up buying French bonds instead) or JGBs.
"Treasuries sales in a sense are easy to counter, as the Fed is very comfortable buying and selling Treasuries for its own account. I have often said that the U.S. ultimately holds the high cards here: the Fed is the one actor in the world that can buy more than China can ever sell," said Setser
I agree with Setser that option three poses few problems for the US while creating problems for China.
However, I also noted that China sold US dollar assets to shore up the yuan and stop capital flight. Parts of points two and three conflict.
Here are further explanatory Tweets from Setser.
Selling Treasuries to Limit Depreciation (Strengthen Currency)
Treasury Sales Required to Weaken Currency
Sell Bonds For Cash
The Tweets still seem contradictory. Does China sell treasuries to both weaken and strengthen the yuan?
The answer seems to be the third Tweet: What does China do after it sells treasuries? To strengthen the Yuan, China sold Treasuries and bought Yuan.
Setser main concern is option number 2: devaluation.
"If the National Security Council ever was convened to discuss China’s options for asymmetric retaliation, I would encourage it to spend most of its time worrying about the consequences of a Chinese exchange rate move ," said Setser.
Devaluation in Play
Two Standard Deviation Slide
Here is one more article to consider: China's Role as Market Anchor at Risk With Rapid Yuan Slide.
For some, the yuan’s drop has even evoked parallels to the deliberate devaluation in 2015 that roiled global markets, though China watchers discount the idea of depreciation being deployed as an outright trade-policy tool.
“The yuan now is a source of volatility, not stability,” said Michael Every, head of financial markets research at Rabobank Group in Hong Kong. Further weakness in China’s currency would be expected to “hit the whole emerging-market complex, and to wallop commodity prices,” he said.
The yuan has slumped 2.7 percent against the dollar since June 14, when a raft of economic data came in below expectations. Selling deepened along with President Donald Trump’s threat to keep escalating tariff hikes until a potential $450 billion of Chinese shipments are targeted. The offshore yuan fell the past nine days, the longest losing streak since 2014; it was little changed in early trading Wednesday.
“There’s some risk now the depreciation of the yuan may feed back into other dollar-Asia” exchange rates, said Cliff Tan, Hong Kong-based East Asian head of global markets research at MUFG Bank Ltd.
“They have learned their lesson,” said Jean-Charles Sambor, deputy head of emerging market debt at BNP Paribas Asset Management in London. “There could be some downward pressure on the RMB, but not a massive depreciation risk, because they know it could change sentiment toward the RMB and trigger additional outflows again,” he said, referring to the renminbi, the official name for China’s currency.
Sue Trinh, head of Asia foreign-exchange strategy at Royal Bank of Canada in Hong Kong, calculates that the drop over the past month has now reached a two standard-deviation depreciation event -- for only the fourth time since the 2015 devaluation.
China has learned its lesson?
Seems to me the evidence is in. China will keep at it until something breaks.
Mike "Mish" Shedlock