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Financial warfare: China and the US T-Bills

22 Nov 2016 - 16:34
Source: Jed Sullivan / Flickr.com

The new President Trump appears to be making a confrontation with China the core of his trade policy. If China does not conduct trade in a fairer manner, the US will proceed to introduce import tariffs on Chinese products. This change to American trade policy is interesting in itself, but becomes even more interesting if we also consider American budget policy under Trump. As a result of lower taxes and extra expenditure for infrastructure, the American federal debt will increase by seven trillion (= 7,000 billion) dollars in the next ten years. This additional American financial demand will have to be met by the (international) capital markets. China is a major player in this and since 2000 has bought a vast fortune in American Treasury Bills (T-bills). The reserve is now almost 1.2 trillion dollars so that China possesses almost 8% of the American federal government reserves[1].

What has led to China investing such a huge sum in T-bills? To answer this, we must go back to the trading relationship between the US and China. Since as far back as 1985, the US has had a trading deficit with China. This means that the Americans buy more Chinese products than vice versa. At present, the commodity trading deficit comes to around 30 billion dollars a month[2].

Put simply, this comes down to the following: Chinese exporters receive 30 billion USD nett a month. They exchange these dollars for renminbi at the Chinese Central Bank. China’s Central Bank in this way gains control over large quantities of American dollars, and it does not offer these dollars on the foreign exchange markets. It keeps the dollars in its possession and by this means builds up its exchange reserves. The advantage for China is that, in this way, its own currency, the renminbi, remains low in value, while the dollar’s exchange rate stays high. By this means, Chinese import products remain cheap for the Americans and China can sell even more products.

The Chinese Central Bank then invests the dollars to gain interest from them. The safest investment is in treasury bonds from the American government, because it underwrites these. This market is also secure, large and liquid. Due to this, China has now become owner of a mountain of 1.2 trillion dollars in T-bills.

The Americans are sometimes wary that the Chinese possess so many securities[3]. There is a fear that China could employ these assets in economic and non-economic disputes. After all, if China should sell a large part of these financial obligations in the short term, then their value would fall rapidly and the American interest rate would rise. Also, the value of the dollar would drop rapidly – certainly if other investors follow. In this way, China could put a spanner in the US’s financial works. The question is whether China intends to use its accumulated exchange reserves for geopolitical purposes.

The use of financial instruments for a country’s foreign policy is a regular topic of discussion. Some contend that exchange rates and financial assets can be employed effectively to achieve geopolitical objectives. A good example is the Chinese general Qiao Liang who made a public statement at the Chinese National University of Defense in Beijing in 2015[4]. He contended that the US has been manipulating the dollar exchange rate ever since the inauguration of the Bretton Woods system in order to achieve its own aims. He also argued that China should use financial weapons against the US. And this hawk is not the only one in China arguing for this. For example, an editorial comment appeared in the People’s Daily Online in August 2011 entitled: ‘China must punish US for Taiwan arm sales with financial weapon’[5]. Here, a direct link was made between geopolitical objectives and the use of ‘financial weapons’.

However, the Americans are not really afraid that the Chinese will actually use the financial weapon. In the first place – as said earlier – rapid sale of the bonds would lead to a severe drop in the value of the remaining bonds. This would affect the Chinese badly because they are the greatest investor in these bonds. They would then be confronted with a sharp drop in the value of their investment portfolio. Also, ‘having the American economy seize up’ would have consequences for Chinese exports to the US and for economic growth in the rest of the world. If this led to reduced growth in China, this could threaten the political and social stability in China – a development that the Chinese leaders want to avoid at all costs. Finally, all this would not do China’s reputation as a responsible great world power any good.

The great mountain of American bonds has probably become more of a burden to the Chinese than a financial weapon. They are afraid that an untenable American federal debt could lead to a rise in American interest rates and a drop in the value of the remaining bonds. This happened in 2011 when Standard & Poor reduced the rating of American long-term bonds from AAA to AA+. The Chinese Premier referred to this problem as early as 2009: ‘We’ve lent a huge amount of capital to the United States, and of course we’re concerned about the security of our assets. And to speak truthfully, I am a little bit worried. I would like to call on the United States to honor its words, stay a credible nation and ensure the safety of Chinese Assets’[6].

President Trump taking office with an associated possible increase in the federal debt by seven trillion dollars has caused alarm to the Chinese. Added to this was when Trump created unrest in June 2016 by stating that he intends to refinance the outstanding American federal debt. It is unclear whether he means actual restructuring or the purchase of outstanding government bonds – financed by new bonds. Such remarks naturally also make investors in American government bonds restless.

In the escalating confrontations between the US and China, geopolitical use of the Chinese possession of US financial obligations will be argued for increasingly by Chinese hawks such as General Qiao Liang. There are still sufficient arguments for the Chinese not to use this financial weapon, though the situation is changing. Through China’s transformation from an export-oriented industrial economy to a service economy with its focus on domestic consumption, China can make good use of a rise in the renminbi and a fall in the dollar. Also, the trust of the Chinese in the tenability of the American national debt under Trump will diminish. They will then in any event want to reduce their possession of American government bonds. And if Trump opts for a tough confrontation with the Chinese, for example by introducing high import tariffs, it cannot be excluded that the world’s number two economy and America’s largest creditor will want to show its muscles. A slump in exports to the US would no longer matter – Trump would already have ensured that.



[1] Congressional Research Service, ‘Foreign holdings of federal debt’, March 2016, https://www.fas.org/sgp/crs/misc/RS22331.pdf

[2] http://www.census.gov/foreign-trade/balance/c5700.html

[3] Congressional Research Service, ‘China’s Holdings of U.S. Securities: Implications for the U.S. Economy’, August 2013, http://www.fas.org/sgp/crs/row/RL34314.pdf

[4] For the general’s entire argument, please see: http://temi.repubblica.it/limes-heartland/one-belt-one-road/2070

[5] See http://en.people.cn/90780/91342/7562776.html

[6] Financial Times, ‘China Calls for a New Reserve Currency’, 24 March 2009