Optimism surrounding a phase one trade truce between the US and China created a sanguine investment climate at the start of 2020. Including plans to rollback tariffs and address concerns regarding intellectual property rights, the deal assuaged anxieties that global supply chains would unravel and disrupt trade flows.
But as major economies contract while the prospects of a Covid-19 vaccine remain months away, the US and China are eagerly hoping to resume business activity to offset the slowdown. In doing so, both have also reignited bellicose rhetoric that had consumed global investors before the outbreak.
Political pressure over the pandemic is becoming increasingly hostile, as the two nations are also accusing the other for failing to manage the fatal health crisis as it permeates into an economic dilemma. From reneging on the trade truce to the Trump administration considering cancelling US debt owned by China, exactly what Washington will do becomes an investment risk.
“The threat to cancel its foreign debt obligations is political noise, but it simply can’t be ignored,” said Eric Ritter, a former Asia equities hedge fund manager and current adjunct professor of economics for Lakeland University in Tokyo. “Doing so would be a threat to the credibility of the US financial system, but again, we’ve been saying that a lot lately,” explains Ritter who expects the sabre rattling to grow louder during an election year in the US.
However, political analysts point to China’s leverage in the form of its $1 trillion holdings in US treasuries, as its main line of defense. Year to date, Beijing has already sold $28 billion in treasuries, below the $32 billion sold in August last year.
The argument goes that selling US treasuries increases the supply of government paper, lowering bond prices and thus raising borrowing costs (bond prices and yields move in the opposite direction). Since yields are trading near historical lows, selling US debt translates to market gains for Beijing, but the political message is louder.
Higher borrowing comes as the US is hoping to keep yields low to combat the economic disruption caused by the novel coronavirus. Even with $2 trillion already allocated, expectations are that more borrowing is on the periphery following April’s 15% unemployment figure.
A Paucity of Options
Thus far, Beijing has shown restraint on this front, hopefully aware that dumping its US debt is counterproductive, creating more problems than it solves.
Despite more than a $1 trillion in treasuries, China accounts for less than 5% of total outstanding, with the figure below what Japan holds. Given the large, liquid, and secured asset class of US treasuries, finding a buyer is relatively easy, considering that nearly $11 trillion in government paper trades with a negative interest rate. Amid the economic stagflation, liquid assets that maintain value becomes a priority according to Ritter. There are few viable alternative options to park capital.
Accumulating US treasuries also supports Beijing’s efforts to manage its RMB since China’s capital account is closed. Stabilizing the currency proves crucial as China is opening its $13 trillion debt market to foreign investors, who currently account for less than 3%. Incremental gains have occurred as China’s debt was included into global indexes and the launch of Bond Connect in Hong Kong.
Even slowing the purchase of US treasuries is challenging given the trade surplus with the US. When Chinese exports are sold in the US, goods are purchased with dollars, which are then parked in US treasuries or into US banks, where the latter is likely to purchase low yielding government debt.
China is better placed to expand the RMB’s use, such as increasing its clearing banks network to accompany exporters. Expanding fintech and payment settlements also shelter China against US sanctions and possibly minimize tariff threats. But until an alternative asset class surfaces, suggesting that China’s $1 trillion treasuries act as leverage is misplaced.
