China’s trade-war trump card: The US bond market

President Trump’s remark that trade wars are “easy to win” sent a chill down my spine. Anyone with a passing knowledge of economic and diplomatic history, I imagine, felt the same way.

One of the major precursors to World War II was the round of massive tariff hikes imposed at the beginning of the Great Depression. The infamous Smoot-Hawley Tariff Act of 1930 is often cited as a crucial and highly unfortunate U.S. move in this rush to protectionism.

{mosads}Retaliation was quick in coming, contributing to an astonishing two-thirds reduction in U.S. trade with Europe between 1929 and 1932.

Now that we have reached another moment of escalation in this trade war, it seems like a very good time to look at the ways that the U.S. economy may be vulnerable to Chinese retaliation.

I am not going to dwell on the obvious fact that U.S. firms and consumers pay higher prices due to tariffs. Nor will I delve into which U.S. businesses will be most hurt by decreased sales in China.

Instead, we’ll explore an issue that was fairly prominent in discussions about “global imbalances” during the mid-2000s and intensified during the financial crisis.

One of the major U.S. vulnerabilities with respect to China is the fact that the U.S. owes the Chinese a whole lot of money. Chinese investors, mainly the People’s Bank of China, hold some $1.2 trillion of U.S. government securities. That is roughly 5 percent of U.S. GDP. 

How could China’s holdings be weaponized? In the global imbalances discussion back in the day, the nightmare scenario was that U.S. trading partners would lose confidence in the dollar due to our endless sea of current account deficits.

The fear was that the transformation of the U.S. from the great exporter after World War II to a great importer and chronic deficit nation after the early 1980s would lead other countries to look for a different currency to anchor the international monetary system.

Additionally, the fear was that, as the dollar weakened, investors might try to get rid of their holdings of U.S. government bonds, lowering bond prices and thereby raising interest rates sharply.

A key point in this vision is that crises of confidence can happen rapidly, with little warning. All sorts of events could trigger panic selling, leading to a collapse of the dollar and a spike in U.S. interest rates.

Clearly, these are risks, hard to predict but impossible to dismiss. Could China precipitate such a crisis all by itself?

A look at the number of bond holdings provides some clues. China is the largest single holder of U.S. Treasury debt. It holds about 5 percent of outstanding U.S. debt with almost all of the holdings in long-term securities.

Suppose that China could dump most of its holdings. Much would depend on whether other investors would join in. Just for the sake of argument, imagine that a fire sale initiated by China raised interest rates on Treasury securities by half a percentage point.

Interest costs would increase by half a percentage point, costing the federal government roughly an additional $100 billion a year. Congress would be faced with a choice between allowing the deficit to increase by this much or trying to raise taxes or cut spending to offset the increase. The latter alternatives would slow the U.S. economy.

To be clear, this half-percentage-point figure is provided just to give a sense of the possible magnitude of the effect. I do not have a firm estimate of how large the interest rate shock might be.

To trace the full effects of a sell-off, we need to look at other credit markets. Many interest rates, particularly some home mortgages, are linked to Treasury rates. Many borrowers would find their interest payments rising by the same percentage.

Finally, China is a significant investor in U.S. Agency Securities, including those issued by housing giants Fannie Mae and Freddie Mac. These massive, publicly owned institutions would also face higher borrowing costs.

Back in 2008, it was widely reported that Treasury Secretary Hank Paulson was under substantial pressure from the Chinese not to let Fannie and Freddie fail because of the losses China would have faced on its Agency bond holdings.

{mossecondads}This is a telling indication of how dependent the U.S. financial system has become. And China touted its stimulus programs in 2008-09 as providing crucial help to the U.S. and the West in recovering from the Great Recession. Interdependence is quite real.

In short, one can imagine a scenario in which China could inflict considerable short-term expense on the U.S. economy. China itself would lose a great deal of money in such a maneuver, but in an economic war, this might be a cost China would be willing to suffer so as to inflict pain on its adversary.

History shows that trade wars often spill over into broader economic, diplomatic and even military conflict. Before engaging in a trade war, it would be wise to assess one’s vulnerabilities to forms of pressure and modes of conflict beyond the narrow field of trade. Have our leaders done this?

Evan Kraft is the economist in residence for the Economics Department at American University. He served as director of the Research Department and adviser to the governor of the Croatian National Bank.