Pelosi’s Taiwan adventure will ramp up the rift between the US and China

Nancy Pelosi’s trip to Taiwan infuriated China and rattled markets, momentarily, until the threat of something bigger than China’s sabre-rattling appeared to recede. That doesn’t mean that the visit won’t have longer-term economic and financial consequences.

China responded to the US House Speaker’s provocation with aggressive rhetoric – “those who play with fire will get burned,” warned Xi Jinping in a call with Joe Biden – and large-scale military exercises in the waters surrounding Taiwan. So far, however, the response has been more subdued than the threats ahead of the visit might have suggested.

Nancy Pelosi in Taiwan on Tuesday.Credit: Getty

Financial markets had been nervous in the lead-up. Sharemarkets, which had enjoyed a strong bounce last month, slid. Bond yields rose, as did the US dollar, as funds flowed towards the traditional safe haven of the US Treasuries market. Copper, a barometer of economic health and geopolitical stability, fell.

There was an almost tangible wave of relief when Pelosi, the most senior US politician to visit Taiwan in a quarter of a century, flew out and headed for South Korea. On Wednesday, sharemarkets edged back up, bond yields edged back down and the US dollar and copper were steady.

In the near term, the Chinese military exercises – planned until Sunday – are continuing and are as close to Taiwan’s territorial waters, if not infringing them, as they have ever been.

International air traffic has been diverted after being warned off by China, and shipping in one of the world’s busiest sea lanes (and the key route for trade between Asia, Europe and the US) has been disrupted. If that disruption of seaborne trade were to continue, it would exacerbate the existing dysfunction within global supply chains.

The longer-term implications of a significant step-up in the already-fragile and tense relationship between the US and China are likely to be a broadening and an acceleration of the decoupling of the economic relationships that was already underway, as well an intensification of the geopolitical competition that was heightened by Donald Trump’s trade war and, more recently, by the Biden administration’s “Pivot to Asia”.

Absent military conflict, China’s ability to respond to Pelosi’s defiance of its threats, which have so far proved to be more rhetorical than real, is limited.

There has been some discussion among financial market participants of the potential for China to weaponise its massive holdings of US Treasury bonds in response to Pelosi’s inflammatory trip.

A large-scale selloff of China’s holdings could push US interest rates higher, increase the servicing costs of US government debt, destabilise the greenback and generally create chaos in the world’s most important bond market.

That is, however, extremely unlikely.

China has been reducing its holdings of US bonds, which topped out at more than $US1.3 trillion nearly a decade ago. Earlier this year, its holdings of US debt fell below $US1 trillion (to $US980 billion, or $1.41 trillion) for the first time since 2010. That’s about $US100 billion less than a year ago.

The now-biggest owner of US government debt, Japan, has also trimmed its exposure slightly as the US Federal Reserve Board’s series of interest hikes got underway this year. As interest rates and the yields on bonds rise, the market value of the bonds falls.

China has more reason than Japan to reduce its reliance on the US market to store its foreign exchange reserves.

The unprecedented financial sanctions on Russia in response to its invasion of Ukraine, which included the seizure of a large proportion of its dollar-denominated foreign exchange reserves, would have rung alarm bells in Beijing.

Taiwan is such a sensitive issue for China that it will inevitably widen the existing fissures within the relationship between the US and China.

But China can’t just dump its US bond holdings without incurring horrendous financial losses and significant damage to its own economy and financial system.

The country has run big trade surpluses with the US over the past four decades. That generates US dollars for its exporters. They exchange them for renminbi to pay their domestic workers and suppliers.

At a macro level, the People’s Bank of China accumulates the dollars in exchange for printing renminbi and then invests the dollars in the safest and most stable assets available – US Treasuries. Buying US dollars and selling/printing renminbi helps keep the US dollar strong and its own currency relatively weak, enhancing the competitiveness of China’s exports.

Weaponising China’s US holding would see the renminbi appreciate significantly, the dollar fall and the country’s trade surplus with the US significantly diminished, if not wiped out.

Beijing might want to diversify its foreign exchange reserves, but that will have to take place over a very lengthy timeframe and in relatively modest increments if it is to avoid significant self-inflicted damage.

Nevertheless, nervousness about China’s response to the embarrassment – domestic and international – generated by Pelosi’s defiance of China’s threats will continue.

China is likely to try to quicken the pace of the reduction in its exposure even as the start of quantitative tightening in the US – allowing the Fed’s $US8.9 trillion hoard of US bonds and mortgages to run off as the securities mature – has removed a major buyer and investor from a market that the US government relies on to sustain its record $US30 trillion of debt. Any Chinese selling could add to the rise in US interest rates.

Taiwan is such a sensitive issue for China (and of personal importance for Xi Jinping as he seeks a seamless path to an unprecedented third term as party leader later this year) that it will inevitably widen the existing fissures within the relationship between the US and China.

The frictions on trade that became overt and very aggressive under the Trump administration haven’t narrowed under Joe Biden. Indeed, they continue to widen.

The US had already banned the sale of the advanced semiconductor chips that are critical components in most modern technologies, including military technology, and convinced or coerced the Dutch and Japanese makers of the most sophisticated equipment for manufacturing the chips not to sell their technology to China.

Only last month, the US tightened those restrictions to include less advanced chips and chip-making machines.

The US Congress has just passed a $US52 billion program that will subsidise the research, design and production of domestic chipmaking – but only for companies that don’t provide advanced chips to China.

The world’s bigger chipmakers, including the leading global manufacturer of advanced chips, Taiwan Semiconductor Manufacturing Co (TSMC), are already building new plants in the US. They would have to return any subsidies they receive if they breach the restrictions on sales to China.

Semiconductors are the most strategic piece of the continuing trade war and longer-term contest for economic and geopolitical supremacy between the US and China, as the impact of the current shortage of chips on production and deliveries of vehicles, for instance, illustrates.

It’s not a coincidence that during her fleeting visit to Taiwan Pelosi made time to have dinner with TMSC’s senior executives, underscoring the strategic importance of Taiwan and advanced semiconductors to US national security interests, at least until it can build a self-sufficient manufacturing capacity of its own.

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