Is it wise to pick a fight with your biggest creditor and trading partner? That is one of the more intriguing questions posed by the prospect of US President Donald Trump. During the campaign, the man who will shortly hold sway over the world’s main reserve currency threatened to brand China a currency manipulator and to impose punitive tariffs to curb the country’s bilateral trade surplus with the US, which is running at close to $400bn a year.
Since China’s official foreign exchange reserves amounts to $3.1tn, much of which is invested in the US Treasury market, there is scope for devastating retaliatory action that might destabilise global bond markets and inflict serious damage on the world economy.
The nature of this mutual dependency is that Americans have, in effect, been borrowing from the much poorer Chinese at exceptionally low rates of interest in order to buy the cheap goods that they turn out. Yet the benefits of this subsidy to the American consumer have been won at the cost of lost jobs in mature industries across the US.
This malign consequence of globalisation was so much at the heart of Mr Trump’s electoral appeal that it is hard to see how he can retreat from taking action of some kind against the Chinese. So the risk that Beijing might seek to sabotage the US Treasury market in retaliation by dumping its Treasury holdings merits exploration.
There have in the past been suggestions in the state-controlled Chinese media that this financial weapon should be used to influence US policy, most notably in response to arms sales to Taiwan. Such a policy would cause the dollar to fall and interest rates to rise, thereby threatening the US with recession. Yet this would also inflict heavy losses on China’s dollar-denominated investments.
And finding somewhere else to put the money would be problematic. Newly issued government bonds in Europe and Japan are substantially absorbed by the asset purchase programmes of the European Central Bank and the Bank of Japan. More important, with global economic growth anaemic and the Chinese economy struggling to address the problems of excessive investment and spiralling private and public debt, invoking an economic cold war would be monumentally dangerous for China as well as the rest of the world.
The US defence department has weighed these risks and found them untroubling. In a 2012 report, it concluded that using US Treasuries as a coercive tool would have limited impact and would do more harm to China than the US. Given the size of this market of nearly $14tn, and the pool of global savings available to provide alternative sources of finance for the US budget deficit, this has some plausibility. Yet in an astonishingly low-interest rate world, where central banks have been systematically rigging bond markets, there is a bond bubble. Current bond prices are thus unusually vulnerable. And, after Mr Trump’s victory, the US and global bond markets have become an even more dangerous place.
The president-elect is promising fiscal expansion - a combination of tax cuts, infrastructure spending and defence spending, pointing to larger budget deficits and higher interest rates. Given Mr Trump’s attacks on the Federal Reserve, the future of central bank independence in the US is in question. So markets will inevitably demand compensation for the increased inflation risk, as well as for the higher geopolitical risks inherent in Mr Trump’s undermining rhetoric on Nato and the US security guarantees for Japan and South Korea. That means much higher bond yields. The great bond bull market that has endured since the early 1980s is now surely over.
Of course, campaign rhetoric is one thing, presidential office another. It is in the US interest that this master of the deal should orchestrate a suitably fudged trade deal with China. The snag is that the hard-headed Chinese know a thing or two about dealmaking. As so often, the most likely outcome is muddle-through. Yet the risks remain. And a trade war would probably strengthen the arms of hardliners in Beijing who oppose the capital market liberalisation that many in the west would like to see.
The irony is that China’s currency manipulations have latterly been addressed at holding up the renminbi in the face of heavy capital outflows rather than weakening it. And the devaluation of the euro against the dollar has been far greater than that of the renminbi. But if the need is for a scapegoat, the Chinese undoubtedly fit the bill.