Yuan Devaluation: An Uneven Trade War

Updated: Aug 6, 2020

Earlier this month, trade tensions between the U.S. and China escalated to a new degree with the addition of an extra ten per cent on $300 billion worth of Chinese goods. Asset prices fell across the board, as equities, bond yields and oil all tumbled. It is clear that Trump’s hard-line stance on Chinese trade poses threats to the already dampened global level of growth.

Chinese reactions to this blow was muted and reserved, as officials note that the Chinese government is likely to prolong negotiations through to the U.S. elections in late 2020. The ability of China to do this reflects the differences between the two sides of the negotiation table. The tightly integrated economy that China possesses allows for further strategic tools the country can use that would otherwise be unavailable to the US.

One such tool at the Chinese government’s disposal is time. The absence of democratic processes in China allow for President Xi Jinping to wait as long as he wishes, while the United States has to negotiate around policy changes and election cycles every four years. This centralisation of power that President Xi holds means that he can focus on staying true to any negotiation strategy and does not need to pander to third parties as Trump must in order to appease lobbying groups and uphold voter confidence.

Additionally, the tight grasp the Chinese government has on its currency, the Yuan, is enforced through capital controls and close ties to state-owned banks. The ability for China to move the value of the Yuan so easily is something that is out of the realm of possibility to the U.S., with the Dollar’s position as a global reserve currency, thus meaning that there is very low concentration of power in the market for Dollars and is hard to move. As seen from the recent aggressive fall in the value of the Yuan, China is not afraid to depreciate the value of its currency in response to additional tariffs implemented by the America.

Not only would the U.S. struggle to depreciate its currency, as much as President Trump would like a weaker dollar to support his focus on American manufacturing exports – the bondholders would not accept seeing their principal investment lose purchasing power. On the other hand, Chinese state-owned banks are by far the largest investors in Chinese government debt and will be far more willing to accept the debt being inflated away given the close ties to the government.

Furthermore, China’s position as the largest single holder of U.S. treasuries, accounting for 17.9% of total foreign debt holdings, poses a potential threat should China decide to sell US debt. Officials are downplaying the likelihood of this happening, and calling it a “nuclear option” for China, due to the large ramifications which could occur. Should China decide to sell American debt (as has already been seen over the course of the trade talks), yields for treasuries would rise substantially and push up borrowing costs for the U.S. government.

Given the large proposed expansion of public spending plans under Trump, and no presidential candidates pushing for austerity measures, higher borrowing costs could balloon the public debt which has already risen above $22 trillion. The debt, in relation to GDP, is also expanding sharply, implying that the U.S. is getting less GDP growth for every Dollar of debt added into the economy, approaching the point at which it could be unsustainable to pay back the debt, due to its benefits to the real economy falling.

It is clear from these factors that the Sino-American trade negotiations have much larger and far-reaching consequences than at first glance. The array of tools at the Chinese disposal over and above what the US has at its disposal is a reflection of the two completely different economic, financial and governance systems trying to negotiate. Market participant should be watching these negotiations extremely carefully due to the ramifications that will be felt through asset markets globally.

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