China should not sell off US bonds as retaliation

For Chinese capital, the escalation of the Sino-US trade war has led to a significant deterioration of the US investment environment and the risk of uncertainty in regulatory policies.We cannot rule out the possibility that the US will treat China’s forex reserves as a retaliation target. China should stay alert to this possibility. With the Fed’s interest rate hikes and the rise in US government borrowing, there are clear risks for dollar assets held by China from interest rates, inflation and the exchange rate.

Given the huge gap between China and the US in science, technology and finance, the escalation of the trade war is significantly detrimental to China. Hence, a long-term plan to contain the scale and scope of the trade war should be made by China so that a stable and relaxed international environment can be created. China will need to hold US Treasury bonds at a stable level, rather than making large-scale sales.

China should reassess the investment risks of the US, adjust methods of forex reserve management according to China’s economic endowments, significantly reduce dollar assets and promote the diversification of forex reserve asset types and currency structure.First, China should make proper concessions to limit the scale and effects of a trade war and strive to avoid deterioration of the situation.Although this trade war is highly in line with US President Donald Trump’s right-wing populist style, China’s long-standing high trade surplus with the US also matters.

As the world’s second-largest economy, China cannot continuously rely on external demand to promote economic growth. We can take this opportunity to make overall adjustments to the export-led growth model. Second, forex reserves should not be used as retaliation against the US. At present, investment in US Treasury bonds should maintain basic stability, but not undergo substantial reductions. Some have argued that China should punish the US by selling off large amounts of US government bonds to
suppress their prices, which is obviously wrong.The US Treasury bond market is the most liquid and largest bond market in the world.

A sharp sell-off by China would only have a slight impact on it. US Treasuries are safe-haven assets, and China’s massive sell-off would prompt a large amount of capital to flow to its national debt market in panic, which would likely cause a price decline in US private equity assets, but the price of US Treasury bonds would rise.If the Fed stepped in, it would offset the impact of China’s sell-off on the US financial market. Even if the sell-off could successfully suppress the price of US Treasury bonds, China would also suffer large losses of assets. Moreover, it would provide more excuses for US financial regulators. The US government could impose sanctions on Chinese investment in US government bonds in order to protect economic security, endangering the safety of dollar assets in which China has invested. China can instead unload US Treasury bonds bit by bit in a gradual and proper manner without being exposed under the international spotlight.

Thirdly, China must assess the investment income and risks of the US market, accelerate the diversification of forex reserves, and optimize the currencies and asset structure in the basket in the near future. A lesson learned from this Sino-US trade war is that China’s dependence on the US market is too high, and China should readjust its methods of forex reserve investment. The goal of managing forex reserves is not only to maintain the stability of local currency, but also to distribute domestic economic risks.Lastly, the scale of China’s forex reserves is expected to decline, so we must be alert to the repayment risk of foreign loan projects. The scale of reserve entrusted loans should remain stable. Regardless of the outcome of the Sino-US trade war, China’s trade surplus with the US will fall sharply, and China’s overall trade surplus will shrink with forex reserves experiencing a
possible decrease.

In the construction of the Belt and Road initiative, China’s forex reserves have provided strong financial support by injecting capital into financial institutions.Taking into account the shrinking of forex reserve sources and the high risk of countries in the Belt and Road initiative, China’s credit support for related infrastructure projects should remain generally stable. To avoid negative influence on the quality of forex reserve assets, credit aid should not grow too fast. The author is a research fellow with the Institute of World Economics and Politics at the Chinese Academy of Social Sciences.

This article provided by NewsEdge.