Powerful weapons, yes ..... but are they two-edged swords ?

ref :- "China Is Armed With Powerful Market Weapons in Duel With Trump" , Bloomberg Economics

So ..... at one minute past midnight NYT the US duly raised the tariff on $200bn worth of imports from China from 10% to 25%. What's more, President Trump has been pouring more petrol on the fire by suggesting that he might widen the range of the 25% rate to include just about all of the $540bn worth of goods sells to the US each year.

Cue market meltdown ? No, not really ..... no more than we've seen throughout the week and in fact China's battered equity markets have managed a noteworthy bounce this morning. Well, we were saying earlier in the week that the tariff hike today would not have been unexpected and may very well turn out to be short-term in nature  --  they are still talking, after all. There's definitely a perception that the super-aggressive bargaining style and the public rhetoric of this particular US administration doesn't rule out the likelihood of more constructive negotiations taking place behind closed doors.

NOTE : See Gillian Tett's Opinion in the Financial Times today to learn how much of corporate America (though they might not all admit it) and many Democrats are backing the President's tough stance on trade with China. Of course, it would be reasonable to assume that certain areas of manufacturing industry and farmers, in particular, might not agree.

Anyway, assuming for a moment that no breakthrough is reached, what will be China's response ? Beijing has already told us to expect retaliation, but the question Bloomberg seeks to answer is what form it would take. They have options for sure, but all of them would seem to have considerable drawbacks. The idea that China might simply apply the same tariffs on imports from the US is given shortish shrift, largely because many of those goods go into the manufacture of other products which are then exported out again. Making US imports more expensive would thus have the effect of making their own exports less competitive. Besides, bearing in mind the much heavier flow of exports going from China to the US, such a straightforward tit-for-tat swapping of penalties would have limited appeal for Beijing.

Bloomberg has focused on three areas :

Devaluing the Yuan :  Hardly rocket-science .....  as the value of any exporting nation's currency falls, it's exports become more attractive. Any significant drop in the value of the Chinese Yuan is absolutely guaranteed to get right under the skin of President Trump, which of course the Chinese might consider both unwise and highly satisfying at the same time. The Yuan dropped 5.5% against the dollar in 2018, which predictably infuriated Mr Trump and increased the heat of what was then still just a trade dispute. Regulars will know that we visit this quite a lot and there's always a fascination in watching the President railing against a market move that is largely the result of his own (effective) policies  --  namely, a US Dollar strong across the board. Whatever the Chinese authorities have been guilty of in the past, there is little or no evidence recently of the kind of currency manipulation that Mr Trump accuses them of.

Devaluing the Yuan would of course help Chinese exports but brings dangers that burnt China in 2015, and is an experience that they are unlikely to want to repeat. Currency depreciation inevitably prompts capital outflows and undermines domestic confidence. Arguably, a falling Yuan brings as many problems as benefits and is unlikely to be Beijing's chosen route. The US negotiating team has been seeking something more binding than that, a Yuan stability pact. China responds that any management of its currency addresses stability with a basket of the currencies of all its major trading partners. The difference in the two positions may remain a stumbling block.

Stopping the purchase of US Soybeans :  In the greater scheme of things, such a move might be considered a relatively minor measure. Maybe so .... but it's not minor at all if you're a farmer in the US Midwest and that's rather the point. Midwestern states and their rural, farming demographic were crucial to President Trump's election. He swore to improve the farmer's lot and desperately needs their votes in 2020. China's purchases of US soybeans is crucial to their price, and the fall in Chinese demand has already seen prices at 10-year lows.

China could stop buying US soybeans completely, which unless Mr Trump wades in with the government subsidies to compensate would really devastate soybean farmers who are already in pain. Soybeans may not be the biggest chapter in any textbook of macro-economics, but because of the political implications, it's an issue that punches well above its weight. What's more, as retaliatory measures go it would be comparatively simple to implement.

Dumping US Treasuries :  The so-called "Nuclear Option". China is the largest foreign owner of US government debt  --  $1.1 trillion of a $15.9 trillion market. The threat of a move to start unloading that holding is a potent weapon, given the scale of US borrowing and the harmful effects across the board to the US economy of the resulting upward shift in yields. We've already seen wobbles in bond markets at the mere unsubstantiated rumours of Chinese selling (all of them untrue ... so far)..

The trouble is that China needs somewhere to put its $3.1 trillion hoard of foreign reserves, and the size, safety and (comparatively) decent yield of the US Treasury market means that it the best area in which to park a sizeable chunk of it. Where else ? In addition, if China started to dump Treasuries the crash in prices that it would cause would put a severe dent in the value of the rest of their holding, whilst the rise in yields would almost certainly, strengthen the Dollar  --  which brings us back to the Yuan devaluation/capital outflows thing. It's another case of bringing more problems than benefits, and in this instance it could be on enormous scale.