Will China turn its US holdings into a Weapon of American Destruction?

What Could Happen if the Trade War Escalates?

As the trade war between the US and China continues, I have had many conversations with people about what it will mean long term and many people have speculated how things will ultimately shake out. In this modern-day cold war, one of the common speculations I have heard is that "The US is now owned by China, if China makes the decision to call them on their debts, they could wipe them out!"

With China holding approximately $1.3 trillion of US treasuries, there's no doubt they hold a lot of their paper but what is the actual likelihood that they would or could use this against the US if the trade war were to escalate? Let me share with you my thoughts on this.

Expensive Currency Would Hurts The Competitiveness of Chinese Exports

In the early 2000s, as Chinese growth was taking off with more exports there was a massive amount of upwards pressure put on the Chinese yuan. As Chinese companies sold their goods to US importers, they received USD in exchange for the exported goods.  The Chinese companies wouldn't want to keep those dollars though as they will want to exchange them back into Chinese Yuan so they could spend them in China.  Like anybody else, they would take their dollars to their bank. Once the USD were deposited into the Chinese banking system the Chinese banks had a choice. They could sell the USD back into the market, which would cause a rise in the Yuan vs the dollar.  This would have been undesirable for an export driven economy like China's as a more expensive currency would hurt the competitiveness of Chinese exports.  

Keeping the USD and Investing Them

So instead the Chinese banks chose to keep the USD and invest them.  By doing so they could maintain the Yuan at an attractively low price level relative to the USD. In order to invest such large sums, the Chinese pretty much only had one option, US Treasury bonds.  By buying treasury bonds, the Chinese essentially took the profits from their export economy and lent the money back to the US Government. At the time this first began it seemed like a 'win win' scenario as it also provided the US with cheap funding to cover off their massive expenses being incurred in foreign wars and funding Bush era tax cuts. China's treasury purchases were small at first but as with many things, over time they added up to huge sums climbing from $100 billion in 2002 to over $1.3 trillion in 2013.

At that level of debt, China is now a huge creditor of the US, but the sheer size of their holdings may be exactly what prevents the Chinese from really pressuring the US with their debt holdings.  As the famous quote from John Getty goes, "If you owe the bank $100, it's your problem. If you owe the bank $100 million, it's the bank's problem."

What America Needs to Fund it's Debt

In order to fund its massive needs, America's debt needs to be continually rolled over and added to with its deficits which reach over $1 trillion per year. They need investors to keep buying and for now that hasn't been a problem. But what would happen if China decided to flood the market with $1.3 trillion worth of treasuries and increase the supply well beyond the demand of investors? As stated, the US cannot function without rolling over its debt so this may force them down a few paths.

First

They may look at increasing their rates in order to make the bonds they are selling more attractive, but this could come at a cost. The higher borrowing cost may ultimately force them to choose between austerity or facing a financial crisis. Either one of these scenarios is not economically promising but the funny thing about US treasuries is that no matter what the reason for the crisis, people tend to continue to invest in the US as a safe haven, even if they are the source of the crisis. This demand would then potentially alleviate the pressure on US borrowing rates and bring things back to where they were before.

Second

Another reason why China wouldn't sell off their US holdings is that by selling US dollars and converting it back to the yuan, they would dramatically increase the value of their own currency which would make them less competitive for exporting goods. Although this would make President Trump happy, it's something China is desperately trying to avoid.

Now, rather than converting US dollars back into the yuan, couldn't they convert that money into another country's currency? They certainly could but the reality is that there is no other market out there that is either big enough or safe enough to park that large amount of money. Take Germany for example, German bonds are some of the safest in the world but are in too short of supply. There are other large economies out there but they come with far more risk (France, Italy, Japan), and all of these countries wouldn't be too happy if China targeted their currency sending it skyrocketing higher and destroying their competitiveness against the US dollar and the yuan in particular. It's likely these governments would respond with tariffs against China which is not something the Chinese are looking for more of.

What Does this Mean Going Forward?

Well in short, it's unlikely that China will use their US holdings as a weapon against the US because it's likely that any action on that grand of a scale will end up backfiring against them, and they know this. Today China is buying very little US debt as they don't want to compound their problems further and what we have seen recently is that China has been selling off treasuries but only in small quantities, likely so they can keep depreciation in check. If their pace of unwinding their assets remains slow, they can likely continue to sell off treasuries and not anger other governments around the world.

In the Short Term

America's position as the global safe-haven and reserve currency of the world will likely allow them to continue their current path and protect them from China from using their assets against them. In time, China may look to become an alternative to the US in this area, but it will likely require them to have more open markets and ensure their financial institutions are acting in a transparent manner.

I don't think China has the appetite to do so but in time this could change and having an alternative may force the US to rethink some of their international policy if there were more competition out there. For investors today, I wouldn't expect to see anything so dramatic any time soon.

- Grant White, CIM, CFP

Grant White is an award-winning Portfolio Manager/Investment Advisor at Endeavour Wealth Management with Industrial Alliance Securities Inc. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.

This information has been prepared by Grant White who is a Portfolio Manager for Industrial Alliance Securities Inc. (iA Securities) and does not necessarily reflect the opinion of iA Securities. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Portfolio Manager can open accounts only in the provinces in which they are registered.