US-China trade war: China’s $1 trillion economic weapon

China doesn’t have the ability to whack tariffs on the US in the same way Trump can, but it has a massive weapon up its sleeve that would devastate global markets.

As US President Donald Trump continued to stoke the trade war fire by ramping up tariffs on Chinese goods, China responded by devaluing the yuan as a means to limit the losses of its own currency.

The yuan fell to levels not seen since the global financial crisis earlier this week, sending world markets into a tailspin and prompting the US to declare China was manipulating its currency.

But as hostilities escalate, Beijing holds a far more lethal weapon at its disposal.

In the last 17 years, China has positioned itself as the US Government’s biggest creditor, splashing out on US Treasury bonds - a US government backed debt instrument that is virtually risk free.

In 2002, it owned just $80 billion worth of the US government bonds but that has rapidly increased to $1.1 trillion.

This gives China the option to dump a huge portion of US Treasuries on to the market, which would collapse its value, distort interest rates, cause American borrowing costs to soar and lead to further mayhem on global markets.

“Essentially it would be a way of retaliation,” Westpac senior currency strategist Sean Callow told news.com.au.

The US has accused China of currency manipulation. Picture: Nicholas Kamm/AFP

WHY DOES CHINA OWN SO MUCH US DEBT?

Over the last 17 years, China has been intervening in foreign currencies to limit the appreciation of its own currency, said Mr Callow.

This has allowed the yuan to be weaker than it otherwise could have been, which is also related to the recent accusations of currency manipulation.

“They intervened on the dollar in the foreign exchange market by buying US dollars and selling their own currency,” the currency expert said.

“They sell the yuan, they receive US dollars which are used to buy US Treasury bonds.

“That’s where this incredible hoard of treasuries came from.”

HOW CAN OWNING TREASURIES BE WEAPONISED?

China has positioned itself from wanting to weaken its economy to being concerned its currency is getting too weak.

To contain these fears, the eastern power can dip into this stock of US Treasuries to sell.

There is already evidence of it doing this.

According to official US Treasury data, accounts based in mainland China have sold $64 billion worth in the last five months.

And in the 12 months to May, it sold $100 billion of US Treasuries.

“That’s an indication that for the past couple of years it’s been more likely that China has been trying to prop up its currency and not to weaken it, which means selling Treasuries,” Mr Callow said.

“Overwhelmingly it’s due to activity in the foreign exchange market, altering the value of the currency, but it is also an option to be weaponised during a trade war with the US.”

Because China’s imports from the US are low, their ability to respond to President Trump’s tariffs with tariffs of their own wouldn’t have the same impact.

Therefore, devaluing the US currency would present a far more damaging response.

Devaluing its currency caused global markets to tailspin. Picture: Philip Fong/AFP

‘MUTUALLY ASSURED DESTRUCTION’

But, dumping a large amount of US Treasuries would negatively impact China as much as it would its enemy.

A spike in US yield would hurt because it would raise the costs of the country’s borrowing, “but this would be like burning down your house and your neighbours’ at the same time,” Mr Callow says.

“They would cause damage to the US, but in doing so they would hurt themselves greatly because it would drive down the value of their own treasuries.

“If the whole point is to drive up US yields to hurt the US, then that means you’re driving down the price of the very asset that you own. So you’re just taking a huge loss.

“Effectively they would just be crystallising a massive loss on their own holdings.

“It’s a bit of mutually assured destruction.”

Mr Callow said China had “painted themselves into a corner” by intervening with foreign currencies on such a massive scale and building up an enormous stock of treasuries.

“It does give them lots of ammunition to support their own currency in the future,” he said.

“When you have more than $1 trillion in Treasuries then you can reduce the pressure on your own currency if it’s under selling pressure.

“But as far as using that pile as a geopolitical tool, it’s a very self-defeating one.”

WHAT WOULD THE NUCLEAR OPTION MEAN FOR AUSTRALIA?

Such a move from China would be a whole other level of antagonism between the two largest economies.

Mr Callow said the mere fact China would be blowing its own economy up to strike a blow at its enemy would be viewed “very negatively” by global markets, including Australia’s.

“If they started to take that sort of step, the turmoil in markets would be very damaging for the Aussie dollar and probably Aussie stocks too,” he said.

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