Trump's tariffs may push China out of the US Treasury market; here's what it could mean

In October 2000, the then US President Bill Clinton signed the US-China Relations Act, granting normal trade relations to China. Before the passage of this bill, China was subject to an annual review of its trade status with the US. In the aftermath of the legislation, Chinese exports soared, cementing the country's position as the shop floor to the world. Multinational companies started manufacturing in China on account of low labour costs, adding to their profits, and also to China's foreign exchange kitty.

In the time that has elapsed since then, China has accumulated substantial holdings of US Treasuries. It has accumulated over $1 trillion in US government securities, almost a fifth of all such issues. This is inclusive of US Treasury bills, notes and bonds.

On September 17, US President Donald Trump slapped tariffs amounting to 10 percent on $200 billion worth of imported Chinese goods, raising the stakes in the ongoing trade war between the two nations. Following the announcement, he released a statement saying that the US would "immediately" impose tariffs on another $267 billion worth of imports if China took retaliatory action against the American farm sector. This sparked widespread fear of a selloff of US government bonds by China.

While a selloff would be mutually detrimental, China could exercise this option to take the sting out of a resilient US economy and consequently cause a rethink of US' trade policy. Brad Setser, a former economist at the US Treasury, believes that if China were to exit from the US securities market, the yield of the 10-year government bond would rise 30 basis points.

According to data released by the Federal Reserve Board on September 18, China's holding of US Treasuries dropped to a six-month low of $1.17 trillion in July. The US Treasury has been issuing new bonds to pay for the $1.5 trillion that will be foregone on account of Trump's new tax law. The rise in supply of bonds as a result of persistent selling by China could lower prices and drive up the yield above the 3-percent mark.

If Trump ratchets up tariffs, a selloff of US government bonds by Beijing is not entirely unlikely. The impact will be felt on interest rates and bond prices. Higher yields will drive up the cost of borrowing for consumers and companies, causing the economy to slow down.

China has manipulated its currency in the past to make exports competitive. But the yuan has already slid 10 percent against the dollar since March 2018. Before the latest round of tariffs, China said that it would not allow its currency to depreciate further. It has $3.11 trillion in foreign exchange reserves, including in the form of US government securities, and has not made any new purchases in the last couple of years. If Trump carries forward his threat of slapping tariffs on all Chinese exports, China could end up shedding some of its holdings.

Source: Reuters

If Beijing decides to tread this path, Trump would have to recalibrate his strategy as the tariffs will be nullified to a large extent, depending on the stance taken by the People's Bank of China. While China's economic growth has been subdued, Trump's tariffs are yet to have a significant impact on Beijing's coffers.

Fears of a slowdown in 2015 spooked global markets. Beijing devalued its currency by around 2.5 percent. Alternatively, it could have pruned its portfolio of US securities, which Americans are wary of in any case. In fact, queries in the US for "China selling Treasuries" on Google peaked in 2015, at the height of the downturn in China. And now, with the trade war acquiring new dimensions with each passing tranche of tariffs, Google searches for the same by Americans are at their highest level since August 2015.

However, in a research paper he authored in June, Setser argued that a 60-point rise would have tangible impact, but was not something that the US economy could not bear. Even in the unlikely event of a complete selloff of Chinese holdings, the US may have the necessary wherewithal to cushion the blow.

The US remains China's biggest export market. Trump's grouse with China is that it has engaged in unfair trade practices by undercutting prices to build a trade surplus with the US. He is not entirely wrong. Over the course of the last two decades, China has raked in trillions of dollars in trade with the US, which was used to acquire US Treasuries and stockpile dollar-denominated foreign exchange reserves.

This helped keep bond yields low and spur consumer spending in the US market. Greater household spending in the US, in turn, is in China's best interests, as Chinese exporters have an advantage in foreign markets on account of lower costs. However, China's position is not what it was in the years immediately following the ratification of the China Trade Bill. Its trade with other countries has also increased by leaps and bounds.

Beijing could wind down its portfolio of US Treasuries as a next step if Trump follows up with tariffs encompassing all of China's exports to the US. However, the tariffs could be a bargaining chip to make China to agree to a new trade deal. Tit-for-tat tariffs for specific goods has not yet translated into substantial losses for either party. Trump said he would be happy to talk with his Chinese counterpart to wring out a trade deal. All eyes will be on the bond market if China decides to call Trump's bluff.