What Would Happen if China Started Selling Off Its Treasury Portfolio?

The bond market doesn't currently seem terribly worried about the risk that China will sell Treasuries. Rightly I think.

The trade war between the U.S. and China is starting to get serious. President Trump is now threatening tariffs on up to $450bn of Chinese imports, or about 90% of what the U.S. imported in 2017. Tariffs have now been imposed on around $35 billion of Chinese goods, so the threat isn’t entirely hypothetical either—even though the administration has yet to go through all the legal hoops needed to implement the full $450 billion in tariffs.

As the Trump administration has said, China cant match the U.S. by putting tariffs on $250 billion, let alone $450 billion in U.S. exports. The U.S. just doesn’t export that much to China. China reports goods imports from the U.S. of $150 billion, and if you add in goods exports to Hong Kong, the U.S. data would suggest no more than $170 billion in exports (the reported $130 billion in exports is clearly a bit too low, but only a bit).

China could try to match the U.S. by putting higher tariff rates on its imports from the U.S. than the 10 percent that the U.S. has proposed on most imports from China—but that’s rather artificial, and even self-defeating. For commodities, any tariff will redirect Chinese purchases toward other suppliers. And for manufactures, the goods China imports tend to be weighted heavily toward goods China either doesn’t make at home (wide body aircraft for example) or inputs into China’s export machine (where tariffs would encourage firms to shift assembly elsewhere).

China also could respond asymmetrically, and look toward other levers that it may have over the U.S. Three stand out:

  • Imposing new limits on U.S. firms operating in China. Apple and GM sell a lot of made-in-China phones and cars that wouldn’t be impacted by tariffs. I do though wish there was a bit more rigor in separating out the impact of Chinese action on the profits of U.S. companies from the impact of Chinese action on the U.S. economy: if China makes it harder for Starbucks to make coffee in China or McDonalds to make hamburgers in China, there won’t be much impact on the overall U.S. economy. Chinese made hamburgers aren’t the same as U.S. made planes. In 2017 U.S.firms earned around $13 billion (according to the U.S. data) in China on around $200 billion in sales.*
  • 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. But it isn’t beyond China’s capabilities to engineer a weaker currency (see 2015-16 for a playbook—all it would take is a surprise one-day depreciation, and the market would do the rest until China resists and signals the depreciation has gone far enough).
  • And the perennial threat that China would sell 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..

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