Our Trade Relationship with China is Complicated

The potential for a trade war with China has dominated the financial news lately. The media has largely focused on two primary risks from a potential trade war: an increase in the price of goods imported from China and the risk of declining U.S. exports should China enact retaliatory tariffs. Other commentators have worried that China will dump its vast holdings of U.S. Treasury securities, thus forcing up interest rates and sending asset prices into free fall. But China and the U.S. have certain interdependencies when it comes to trade and the nuances are important to consider.

Let’s begin with the U.S. current account deficit. A country’s current account measures money flows from trade, net investment and wage income, and direct transfers. The U.S. has a persistent current account deficit, driven mostly by a large trade deficit. The U.S. can fund persistent deficits in the current account partly because the U.S. dollar is the world’s reserve currency, i.e., the currency most widely used as payments in international trade and currency markets. In other words, the rest of the world wants to hold U.S. dollars, and this demand for U.S. dollars has allowed the U.S. to finance its obligations at interest rates lower than would persist otherwise.

It is no coincidence then that China is both the country with which the U.S. has the largest trade deficit and the largest foreign holder of U.S. Treasury securities. China has had a policy of export-led economic growth, and the Chinese government has promoted this policy by keeping its currency, the Yuan, artificially low relative to other major currencies, most notably the U.S. dollar. The Chinese central bank, The People’s Bank of China, manages the yuan’s exchange rate by purchasing dollars / selling yuan at the official pegged rate. To manage this policy, the Chinese government needs massive U.S. dollar reserves. China’s purchase of U.S. Treasury securities is not just a preference, it is a necessary component of their export-driven policy.

China is unlikely to engage in a fire sale of Treasury securities. Doing so would lead to losses in their sizable Treasury securities portfolio. The overall levels of U.S. debt and fiscal deficits are a bigger concern than the amount borrowed from China. The longer-term risk is that the dollar loses its status as the world’s reserve currency, thus forcing up U.S. borrowing costs. And while this is unlikely in the short-term, it may be a long-term eventuality, especially as the yuan rivals the U.S. dollar in global markets.

About the Author:

Matthew DePaola is a long-time practitioner of the deep value investing approach. He cofounded Tortuga Capital after having concluded that few institutional money managers follow a true value investing approach. Matthew has broad experience in business finance and asset valuation, and has engineered the leveraged purchase and recapitalization of several small businesses. Matthew has also spent several years as a financial analyst in the residential real estate development field. He earned his MBA from the University of Florida’s Hough Graduate School of Business and holds a BS in Finance from Florida Gulf Coast University.

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