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The Ace Up China’s Sleeve

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Last week, Pres. Trump said US markets might have to endure some short-term pain if the trade war with China escalates. But never fear, in the long run, everything will be great!

We have to do things that other people wouldn’t do. So, we may take a hit, but you know what, ultimately, we’re going to be much stronger for it.”

Peter Schiff agreed there is going to be short-term pain. And we’re also going to suffer some long-term pain.

Peter wasn’t focusing so much on the trade war, but a scenario certainly exists where Chinese retaliation could lead to some serious long-term pain for the US economy. It could pull out the ace up its sleeve.

The Chinese can’t out-tariff Trump. The US imports far more products than the Chinese. In other words, there is a lot more stuff coming into the US from China than vice versa. Emerging markets economist Alex Wolf told CNN if China “were to try and respond in kind, there would not be enough US goods to tariff.”

But that doesn’t leave the Chinese without weapons. It could target education and tourism. In fact, the Chinese have a history of using tourism as an economic weapon. That would certainly hurt the US. It could also crack down on US companies operating in the country through selective enforcement of regulations. During a period of high tensions with South Korea, Chinese officials closed down dozens of stores belonging to Lotte, a South Korean company, and the sale of Hyundai and Kia plunged due to a national PR campaign the government ran.

But beyond that, the Chinese have an ace up their sleeve. They could start dumping US Treasuries.

And there are a lot of Treasuries to dump.

China holds more US debt than any other country. It currently owns about $1.2 trillion in US Treasuries. If China started dumping all of the debt on the market, interest rates would soar and the dollar would plunge. That’s not a good scenario for a country that just cut taxes while trying to finance millions of dollars in new spending.

A lot of pundits call this a nuclear option. It would be a disaster for the US economy. But it also comes with a significant amount of risk for the Chinese. As CNN put it, “A fire sale would also hit the value of China’s Treasury holdings and may even end up destabilizing China’s currency against the dollar.” Most analysts don’t think China would go to that extreme.

But the Chinese don’t have to hold a fire sale to hurt the US. They don’t necessarily have to sell at all. China could just slow down its purchase of Treasuries, or stop buying altogether. In fact, reports came out earlier this year China was considering doing just that.

We’ve already asked the question: who is going to buy all of the Treasuries the government needs to sell in order to fund its massive deficit? The US Treasury Department reportedly plans to auction off around $1.4 trillion in Treasuries this year, and the department expects that pace of borrowing to continue over the next several years. The US government depends heavily on three major buyers to finance its debt – China, Japan and the Federal Reserve. The Fed is trying to shrink its balance sheet, so it’s ostensibly not buying. If the Chinese suddenly get out of the US debt market, how is Trump going to finance his bloated government?

Palisade Research used an analogy that put the whole thing into a more personal perspective.

Imagine if you are investing in a friend’s business. He plans to expand in the short run with much more debt with hopes to jump-start long-term growth. But all of a sudden, he gets into a fight with his creditors and the bank who is financing his business. It’s not a good idea for investors to be putting more money into a business that needs substantially more loans from the very person they’re fighting with. China has that over the United States – it’s the ace up their sleeve.”

Who knows if China will slap down that ace. It could. It’s just another bit of uncertainty in an increasingly uncertain economic climate.

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