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China, Trade and Retaliation

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By: Trevor Hunnicutt & Kate Duguid – reuters.com – April 4, 2018

Graphic: Top U.S. trade partners & foreign holders of Treasuries – reut.rs/2CUqQB0

It took China just 11 hours to retaliate against the United States for proposing tariffs on some 1,300 Chinese products, but Chinese officials are holding back on taking aim at their largest American import: government debt.

In a tit-for-tat response to the Trump administration’s plan for 25 percent duties on $50 billion of Chinese imports, China hit back with its own list of similar duties on key American imports including soybeans, planes, cars, beef and chemicals. But officials signaled no interest for now in bringing their vast holdings of U.S. Treasuries to the fight.

China held around $1.17 trillion of Treasuries as of the end of January, making it the largest of America’s foreign creditors and the No. 2 overall owner of U.S. government bonds after the Federal Reserve. Any move by China to chop its Treasury portfolio could inflict significant harm on U.S. finances and global investors, driving bond yields higher and making it more costly to finance the federal government.

Jeffrey Gundlach, the chief executive of DoubleLine Capital LP, said China can use its Treasury holdings as leverage, but only if they keep holding them.

“It is more effective as a threat. If they sell, they have no threat,” said Gundlach, known as Wall Street’s Bond King.

“It would only escalate the situation and eliminate their leverage.”

Prices on benchmark 10-year U.S. Treasury notes slipped on Wednesday, giving back earlier gains on the trade news. Their yield edged up to about 2.81 percent Wednesday afternoon.

China’s Treasury holdings have dipped in recent months, declining by about $30 billion from $1.20 trillion last August, and they are down about 11 percent from their record high above $1.3 trillion in late 2013, according to U.S government data. In all, foreign governments own $4 trillion, or more than a quarter, of the $14.7 trillion in Treasury securities outstanding.

Asked by a reporter on Wednesday if China would reduce its U.S. Treasury holdings in retaliation, Vice Finance Minister Zhu Guangyao reiterated China’s long-standing policy regarding its foreign exchange reserves, saying it is a responsible investor and that it will safeguard their value.

China’s foreign exchange reserves, the world’s largest, stood at about $3.13 trillion at the end of February, with roughly a third of it held in Treasuries.

“If they wanted to pull the nuclear switch, if they committed to dumping Treasuries, it would have an immediate and temporary impact on money markets in the United States,” said Jeff Klingelhofer, a portfolio manager who oversees more than $6 billion at Thornburg Investment Management Inc. “But I think it is a bigger hit to the sustainability of what they’re trying to accomplish.”

Brad Setser, senior fellow for international economics at the Council on Foreign Relations in New York, said China can sell Treasuries and buy lower-yielding European or Japanese debt.

But the effect would likely be to strengthen the yuan against the dollar, weakening the relative desirability of its exports, analysts said. The sale could also tank the value of the Treasuries China retains, with nothing to show for the aggression.

More likely, if China wanted to turn up the heat it would let the yuan depreciate against the U.S. dollar, according to CFR’s Setser, a move that could kneecap the Trump administration’s goal of jump-starting U.S. manufacturing. The yuan weakened by about 0.25 percent on Wednesday but remains near its strongest in two and a half years.

Even if the likelihood of a change in Chinese policy regarding its Treasuries portfolio remains low, investors are sensitive to the risk any big shift would pose to world financial markets, where Treasuries are a global benchmark asset.

A January report that China might halt its purchases of Treasuries forced yields higher, but China disputed the news and said it was only diversifying its foreign exchange reserves to safeguard their value.

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Source: China, holding Treasuries, keeps ‘nuclear option’ in U.S. trade war