The trade war opposing the US and China and the swelling of debt levels across the world to an all-time high are currently the two main risks for the world’s economy that could bring about a new global crisis. The problems of bilateral trade and excessive debt burdens are intertwined for the US and China, which makes things only worse. If the US escalates the trade war, which evolved in an economic war after the Huawei ban, or if the debt market loses its balance, the economic ripple effect will be felt all across the world. The financial market can easily become an operational theater in itself. According to Bloomberg, the new US tariffs could prompt China to sell-off $1.13 trillion in US Treasury bonds. The international media were naïve in believing that this would be a “blow for the US dollar.”
In reality, this scenario is unlikely to materialize, and if this does happen, the dollar, on the contrary, would gain in value against other currencies.
If China decides to dump massive amounts of US Treasury bonds, the US could face high bond yields, which would result in higher interest rates across the market, instantly making it much harder to service debt. This would be a major blow for the US economy, budget and households whose aggregated debt stands at $73.9 trillion. The US equity market would also suffer since share capital is being replaced by debt.
At the same time, higher interest rates would make the dollar more expensive compared to most other international currencies on the back of carry trade, as capital flows toward the US for higher yields, which would lead to an even higher trade deficit.
However, the Chinese and US economies so far remain interconnected. China still has to pay for energy imports, raw materials and parts in US dollars. After all, the global supply chains remain in place. The People’s Bank of China will have to stock up sufficient amounts of dollar reserves to serve the country’s foreign trade.
In addition to this, the trade war together with economic (and political) restrictions imposed by the United States could give rise to a massive capital outflow from the Chinese market, as it happened in 2015. This outflow would be a major impediment in terms of financial stability, increasing the risk of many Chinese companies with excessive debt burdens going out of business. The biggest danger for China, however, is that it could undermine investment, since fixed capital and technology investment accounted for 40 to 45 percent of economic growth in China.
China will have to somehow offset the foreign capital outflow, as well as service the dollar-denominated debts of its companies. Accordingly, China needs a substantial reserve of dollars.
The simplest solution for China would be to slightly depreciate the yuan against the US dollar to boost the competitiveness of Chinese companies in the global industry and trade, partly offsetting the losses from the new US tariffs.
However, there is only so much value the yuan can afford to lose against the dollar, since a weaker national currency can also lead to higher capital outflow, and most importantly, makes imported components more expensive for Chinese manufacturers, raising the price of the end products and undermining competition. According to the OECD, imported components account for about 20 percent of China’s added value. For this reason, it can be argued that depreciating the yuan would not justify higher manufacturing costs.
The dollar’s volatility can be affected by currency interventions, but the dollar’s ability to influence US interest rates matters a lot more. For now China is not ready to do it on its own, but could succeed in the long run.
For this reason, China could opt for softer, longer-term and more effective retaliatory measures by refusing to buy US Treasury bonds. This in turn would lower the overall demand for these bonds, slowly bringing up yields alongside interest rates and debt service fees. China’s refusal to fund the US economy where services, including financial services, account for 78 percent of GDP would be a serious and damaging retaliatory measure.
Next on the list of the moves available to China in its trade war with the US is replacing parts, machinery and equipment imported from the US with similar European or Japanese products, while also making more settlements in euros or Japanese yen.
Paying for raw materials in national currency would greatly reduce the global demand for dollars and increase the demand for the yuan and the euro. Russia could be part of this process since it also faces geo-economic pressure from the US. However, this would hardly end the dollar hegemony, since China would not be able to offer an alternative to global governance institutions such as the IMF, the World Bank, the US Federal Reserve, WTO, etc.
Finally, the strongest move China could make is to close its buoyant domestic market to US corporations. In fact, the share prices of US companies will fall unless they can demonstrate high growth rates, as was the case last year with the internet giants. As unfortunate as it may be for US companies, the Chinese market is their last and quite often only growth territory.
In addition to this, being a global factory, China has a special place in global value chains. It would be disastrous for US corporations that have not moved their production back home not to be able to manufacture their goods in Chinese plants, since these manufacturing capabilities cannot be replaced overnight. The US will also face curtailed business opportunities and lower competitiveness compared to European or Japanese companies.
In this scenario, the US stock market is up for a major meltdown that would dwarf the drop of S&P500 and Dow Jones in December 2018 (the biggest drop since the Great Depression). Since the financial market operates on a global scale, the ripple effect from asset sales will deal a devastating blow to stock markets in other countries as well. Beyond the United States, the global market will also suffer, considering the debt burden and the dependence of transnational corporations on China’s assembling capability.
This is how a global economic crisis can break out. We can only but hope that China has a number of other strategies and non-conventional moves up its sleeve in case the trade war escalates in order to achieve results without leaving the global economy in tatters.
