Why China Has Very Little Leverage Over Us

Posted: May 21, 2019 10:50 AM
Why China Has Very Little Leverage Over Us

Source: AP Photo/Andy Wong

In life, we decide things emotionally and then we try to justify them intellectually. This is the best explanation that I can make for those people, like myself, who have worried about the consequences for America of a trade war with China.

I, myself, have recently faced the fact that if we’re talking about facts, China has very little leverage against the United States in a trade war.  

America will be the clear cut winner in this war, and it won’t be close.

We have been told for so long by the nexus of Washington and Wall Street that a trade war would result in disaster for the United States that we have come to believe that it’s true without critically thinking about it.

As a confirmed free-trade guy, I’ve had to come to grips slowly that perhaps a “trade war” with China is the only way to restore true free trade. 

The amount of business that China will lose in a trade war is indisputably larger than the US. We have understood this by existing, well-known facts and figures. But there are still other arguments that worry ardent free-traders.

A standard argument has been that since China is the largest foreign creditor with $1 trillion worth of US Treasury securities, the United States cannot afford to make our foreign banker angry. Often referred to as the nuclear option, the trade-war Chicken Littles think that China could resort to wholesale dumping of US Treasury securities, thereby raising US interest rates, and depressing the demand for US government debt. The consequent rapid increase in interest rates would be a shock to the US economy and would send it into a recession, according to the naysayers.

That argument might have been true eight years ago, or even six years ago, or even four years ago. But the world has changed a lot in just four years. And those changes have changed my thinking. 

The most substantial change is that Donald Trump is now president, and Barack Obama is not. The US no longer needs to sacrifice its foreign policy and its economy in order to keep its banker happy.

The US economy is still expanding, and expanding at a faster rate under Trump than it was under Obama. The dollar is stronger, and the US government bond market is in demand. 

Currently the yield on the 10 year US Treasury is 2.37% thanks to the beginnings of normalization of interest rate policy by the Federal Reserve. The higher interest rates do not reflect actual demand for US Treasury securities. Instead, they reflect a strong organic economy, not dependent on quantitative easing or artificially low interest rates.

Much of the world cannot say the same thing.

By contrast interest rates on the 10 year Hong Kong treasury note is 1.36%. In Singapore it’s 2.13%. In more developed countries like Germany and Japan, the 10 year government notes are yielding negative interest rates as of Friday. 

In short, if you want to buy government bonds, the United States is the best value out there. So, regardless of what the Chinese do with their US debt, there will still be buyers for United States Treasury securities because:  1) US Treasuries have high relative value compared to other countries; 2) the dollar is strong; and 3) the US economy is strong, even without super-low interest rates. 

Besides the high relative value US Treasuries offer, there are other reasons why China lacks leverage as a foreign banker. 

The Federal Reserve has reduced their balance sheet by about $1 trillion since quantitative easing. Under Obama it reached a high of about $5 trillion. Since the end of quantitative easing, that position has been reduced to about $4 trillion. If the Chinese were to sell $1 trillion worth of US government securities the Federal Reserve could buy them at any price China asks. 

Maybe the Fed wouldn’t want to buy them, but consider this: 

Imagine a tweet where Trump asks America if they want the Federal Reserve to buy back $1 trillion of American debt from China, thereby 1) reducing our foreign debt; and 2) guaranteeing a Chinese loss on the debt by their own actions. 

Democrat heads would explode, the Chinese would be apologetic, Europe would condemn Trump, economists would huff and say harumph, but the mass of people would be with him.

And in this, you can see what I meant. People decide these things emotionally. But in this case, Trump’s argument is also backed up by facts. 

And under any circumstances I can imagine intellectually, I see America coming out a winner.