For China, devaluation is a bad idea

Selling US Treasuries and driving up US interest rates will ultimately hurt the value of China’s overall holdings. There are also limited alternatives for diversification given the size of China’s reserves. 

"In our view China’s best strategy is to further open up its economy.” – Raymond Yeung & Khoon Goh

China’s best strategy is to further open up its economy. This appears to be the path the Chinese government is taking, with President Xi Jinping pledging to reduce import tariffs and PBoC Governor Yi Gang reinforcing the message of financial liberalisation.

On the cards

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The trade spat between the US and China is an ongoing concern. China imposed temporary anti-dumping deposits on US sorghum imports in April and the US will likely consider further retaliatory measures such as restrictions on high tech sectors;.

These developments show the spat is spilling over from the US’s initial planned tariffs on $US50 billion worth of Chinese imports. The International Monetary Fund (IMF) in their latest World Economic Outlook said recent escalating trade tensions present a growing risk to the global outlook.

The extent to which China is willing to go remains to be seen. News last week China may devalue the yuan as a retaliatory tool sent the currency lower although it has more than recovered since then.

We believe it is unlikely China will use the currency or its US Treasury holdings as bargaining chips in the trade dispute.

Chinese policymakers have been trying to lift the value-added content of their exports and make a push into the advanced-technology sectors. There is thus no appetite among policymakers to rely on a weak exchange rate as a competitive advantage.

We do not expect anything which would threaten RMB stability or cause a resurgence of outflow pressures.  

Yuan volatility would also be a huge setback for RMB internationalisation as investors will be reluctant to transact directly in the yuan or hold RMB assets.

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Alternatives

As of February 2018 China has the largest direct holdings of US Treasuries (USTs) at $US1.18 trillion It also has another $US126 billion in USTs via its Belgium holdings. China has a reduced need to purchase USTs at the present time given they have refrained from active FX intervention since early 2017.

With capital flows largely in the balance and Chinese authorities allowing the yuan’s exchange rate to be more market determined, they do not need to accumulate reserves and thus make further purchases of USTs other than for the purpose of portfolio rebalancing.

There are also practical limitations in selling down China’s US Treasury holdings. The US debt market is the largest and most liquid in the world. There are few other options for re-allocation of the bulk of China’s FX reserves at this stage.

In addition, China does not benefit from a sell-off in the US Treasury market as this will hurt the overall value of their holdings.

The scope for further foreign buying of onshore China assets is large but hinges on continued reform progress.

Steady capital inflows from liberalisation will be an important counter to a narrowing current account surplus as China continues to shift towards a consumption-driven economy.

Ultimately, a tit-for-tat retaliatory response from China including via FX policy will run counter to the country’s interests. We see a further step-up in reforms and opening up to be in the best interests of China in the long term.

Raymond Yeung is Chief Economist Greater China & Khoon Goh is Head of Asia Research at ANZ