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What will China do in a trade war?

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Many people still seem to believe that the recent saber-rattling is just of the normal type, that both sides scream a lot but will eventually see the light and settle down to talk. But the mood in both the US and China are a lot more somber this year. Call me a pessimist, but I think a showdown in trade is inevitable.

What Washington will do is quite obvious. What’s the point of labeling someone a currency manipulator if you can’t stick punitive tariffs to its exports? The question is what China will do in retaliation. The folks calling for blood now seem oblivious to the cost right now. Maybe they don’t know, or maybe they just want to lash out at the “culprit”.

Would it hurt China? Oh, you bet! Despite all the talk of developing a domestic economy, the Chinese economy is 40% export. Although China is a lot less dependent on the US as a key customer now compared to a decade ago, any MAJOR customer is still important in this environment.

The question is at what cost? What will China do to retaliate? The natural suspect of dumping Treasuries is usually brushed off as not feasible since it will cost China in terms of capital loss to its existing holdings. What this argument fails to note is that the Chinese do NOT buy treasuries out of their kindness, out of love for Washington, or even out of their freewill, but out of necessity from holding too much excess US dollars coming from their trade surplus. If export to the US is slapped with punitive tariffs, China’s trade surplus will naturally shrink, leaving it with less dollars which in turn will translate into less purchase of treasuries.

Now of course, lost business to China will naturally go somewhere else. So someone somewhere will eventually end up with excess dollars and buy treasuries. But this trade adjustment will take some time and there’s no telling how much they actually save up from the trade to buy treasuries. Theoretically they could have spent it all. Vietnam, a most likely beneficiary, actually runs a trade deficit. On the other hand, the impact on interest rate will be immediate, especially given the aggressive borrowing schedule from the Treasury. Already China is reporting its first trade deficit since 2004 for March, and we are seeing turbulence in 10-yr yield. Could this be a harbinger of catastrophe to come?

In this scenario, China doesn’t even have to do anything. This is just the natural outcome from diminishing trade surplus. As for the hope that economic pain will push China to revaluate, keep on dreaming. If trade collapse, the natural order of things is to devaluate, isn’t it?

In the end, it will come down to a masochistic competition of pain tolerance, and I’m not holding my breath for a people steep in entitlement.


Written by Cindy Luk

March 25, 2010 at 12:42 pm

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