As the United States widens the conflict with China into the realm of finance, raising the possibility that Washington will use the US dollar payment system as a weapon, analysts are wondering whether China will shift how it uses its US$3.1 trillion in foreign exchange reserves in anticipation of extreme financial volatility.
China, analysts said, may consider preparing itself against a possible US financial attack by shifting towards a more defensive stance, such as using its foreign exchange reserves to support the yuan's exchange rate while diversifying its investments out of US dollar assets to limit exchange rate and financial market risks.
The People's Bank of China (PBOC) has maintained the world's biggest pile of foreign exchange reserves at a stable level of around US$3.1 trillion in recent years thanks to the country's capital controls, providing confidence and stability to its financial and economic systems. But memories are still fresh after the central bank was forced to burn through US$900 billion of its reserves from mid-2014 to 2016 to defend the sliding yuan as the equity markets crashed.
"Currently, foreign exchange has already become a target of the US to launch trade attacks or financial warfare," said Chen Yuan, former chairman of the China Development Bank, the country's biggest policy lender. Therefore, we should consider shifting strategic thinking on foreign exchange reserves, from being our national wealth to becoming the focus of a financial battleground."
According to Chen, the US wants to see the decoupling of the financial markets and exchange rates of the two countries, which could lead to unexpected risks to China's US dollar reserves and yuan's exchange rate, which in turn, could result in even larger economic damage to China.
While the US announced on Tuesday a three-month delay in the implementation of a new 10 per cent tariff on more than half of the US$300 billion of Chinese imports that was originally expected to take effect September 1, concerns are still lingering that the American President Donald Trump will eventually raise tariffs on all Chinese imports to 25 per cent.
One of the primary goals of US policy is to maintain the advantages that comes from the US dollar being the main reserve currency of the world, with all other countries having to trade in US dollars for essential commodities such as oil and food products, helping fund the twin US current account and budget deficits, analysts agreed.
"China's economic rise and power is a threat to the current US situation. But there can be only one 'top dog' in this world," said David Chin, the founder of Basis Point Consulting in Sydney. "[So to Trump], a no deal or 25 per cent tariff situation is fine as long as China crashes far more than the US."
China's ability to access a sufficient supply of US dollars to pay for its massive imports and growing foreign borrowings, as well as to fund its signature Belt and Road Initiative, is now especially vulnerable after a series of financial attacks made by the US in the past month.
Last week, the US Treasury designated China as a currency manipulator after the yuan's value fell below the key level of 7 to the US dollar, raising the prospect of a global currency war, in which other countries in Asia and elsewhere would take steps to lower the value of their currencies in a vicious cycle of competitive devaluations to gain advantage for their exports.
The yuan was changing hands at 7.04 against the US dollar on Wednesday, with the PBOC expected to let it gradually slide to 7.30 per dollar this year.
Early this month, the Trump administration seized Venezuela's US dollar assets held in America, and threatened penalties on China and Russia for aiding the government in Caracas, in an attempt to pressure Venezuelan President Nicolas Maduro to turn over power to opposition leader Juan Guaido. The move was also a reminder that Washington has the ability to freeze a nation's assets in held in the US, including China's US$1.1 trillion in US Treasury securities.
That follows a US judge's decision in late June to hold three commercial banks in mainland China China Merchants Bank, Bank of Communications and Shanghai Pudong Development Bank " in contempt of court for failing to comply with subpoenas in an investigation into their possible breach of American sanctions against North Korea, pointing to the susceptibility of Chinese banks to being cut off from the US dollar international financial system.
"The US already has a long history of using access to the [US dollar] as a tool to achieve other objectives," said Richard Yetsanga, ANZ Bank's chief economist. "Only for the reserve currency is it meaningful to threaten prohibiting another country from accessing that currency as payment."
Despite the security and liquidity of US government securities, market talk continues to swirl on whether China would offload its US Treasury holdings or cut back further on the portion of US dollar-denominated assets in its reserves portfolio.
Figures released last month show China reduced the percentage of US dollar assets in its reserves to 58 per cent in 2014, the latest data available, from the 79 per cent in 2005.
"China will trigger a US decoupling when it has no choice, dumping US Treasuries and dumping dollars," Basis Point Consulting founder Chin added. "Such a worst-case scenario has been building with progressive plausibility as each trade war punch and counterpunch ratchets up tensions."
Kevin Lai, chief economist for Asia excluding Japan at Japanese investment bank and securities brokerage Daiwa Capital Markets, said that a sliding yuan may prompt Chinese companies to sell their yuan-denominated assets to the PBOC in exchange for US dollars to repay their overseas debt, ultimately causing China's US$3.1 trillion in foreign exchange reserves to fall.
Chinese government data showed the nation's external debt rose 12 per cent year-on-year to US$1.97 trillion in 2018, due largely to increasing US dollar borrowing by Chinese companies.
"If the PBOC refuses the dollar demand of Chinese debtors, the companies could scramble to get US dollars from the market, causing domestic liquidity to tighten and the yuan to fall even faster," added Lai. "That would be a nightmare scenario that the PBOC would want to avoid."
Natixis Bank said that China's net capital outflows increased sharply from US$21 billion in the first quarter of 2019 to US$85 billion in the second, due mainly to a surge in US dollar outflows, even though they are still small compared to the peak seen in 2015.
This article originally appeared in the South China Morning Post (SCMP), the most authoritative voice reporting on China and Asia for more than a century. For more SCMP stories, please explore the SCMP app or visit the SCMP's Facebook and Twitter pages. Copyright © 2019 South China Morning Post Publishers Ltd. All rights reserved.
Copyright (c) 2019. South China Morning Post Publishers Ltd. All rights reserved.