Nuclear Option of China Dumping US Treasuries vs Devaluation: Take II

The alleged "nuclear" option of China dumping treasuries is Much Ado About Nothing. A devaluation is another matter.

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.

  1. 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.
  2. 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.
  3. 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

RT reports Beijing signals yuan devaluation to protect its exports from Trump’s tariffs

Opinions Vary

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

Comments (4)
No. 1-4
RobinBanks
RobinBanks

Looks like Kyle Bass is about to cash in big time with his huge bet against the yuan. Professor Steve Keen has highlighted China's private sector debt of 260% of GDP as the main problem (anything above 170% tends to spark a crisis as per 2008 in the US and UK). He highlights China, Australia, Canada, Sweden, South Korea as the ones to watch due to excessive private sector leverage.He got the 2008 crisis spot on in 2006!

goldenbadger
goldenbadger

Your story suggests you believe the Chinese government is purposely devaluing the yuan, which they would accomplish by buying U.S treasuries (i.e creating yuan to buy dollars to acquire treasuries), not selling U.S. treasuries.

May I suggest the falling yuan more likely stems from private capital flight from China as worries that the Donald in the China shop with his tariff tirades will be the pin to prick the Chinese ponzi. The idea that U.S. treasury sales by China weakens the yuan (a Setser title) is nuts. U.S treasury sales by the Chinese government to provide the Chinese banks with dollars replacing private capital flight, with the capital flight the cause of the falling yuan, makes far more sense.

Ambrose_Bierce
Ambrose_Bierce

Whatever China does will be done with regard to stability in the markets, the nuclear option is a nuclear reactor, not an atomic bomb. For instance if selling US T Bonds causes US rates to rise they might sell into the current weakness. As for the Fed buying those bonds that is ridiculous. It makes no sense for them to buy bonds while they are trying to reduce their balance sheet. The Feds purpose is to prepare the bond market for pending auctions of government bonds, to facilitate more spending. Its also possible that the GOP congress will throw 45 out of the WH and go back to their budgetary restraint. Stranger things have happened. Once the fiscal spending myth is dispelled new bond issues at higher yields can be deployed in order to gradually transition the market away from that mountain of debt, all of it highly stimulative in its own right. The money is there it has already been printed and it is just lying fallow in the stock buyback plans, and dividends. China knows this too, and the rush to dump debt for cash in not prudent if the debt market has supply constraints. It's like suddenly we cut the amount of oil being pumped in half, what does that do to the oil in storage which is a liability that has to be serviced? The key to all this is the flow of new credit and government deficits.

thimk
thimk

trade wars morph into currency wars . currency wars morph into ???