Beware of a “financial war”

Concerned about the rapidly shifting balance of economic power and unfair trade practices, the Trump administration began a deliberate policy of trying to constrain China’s economic progress in mid-2018. It “weaponized”US economic policy to target China – first with tariffs, then spreading to technology, people-to-people exchanges, and, most recently, finance.

It is therefore good news that a phase I trade deal seems in the offing. But this deal amounts to a cease fire at most. Indications are that it covers only a limited number of issues, including tariffs, intellectual property, access to China forUS financial services, and trade in agricultural products. The most serious disagreements are left on the table, including industrial subsidies, market access, and the role of Chinese state firms.

At this time, both sides seem eager to deescalate the conflict, since economic pain is slowing down both economies andUS elections are looming in late 2020. Nonetheless, there is considerable uncertainty about whether the truce being negotiated will prove stable and enduring. Over the past few months, it seemed as if the Trump administration was looking for whatever vulnerabilities China might have and exploit them. Finance became the latest target area.

Financial sanctions exist at a different level of complexity than trade tariffs. The direct economic effects of tariffs are rather easy to calculate. Indirect effects are more difficult to ascertain, as can be seen in the slump in business confidence the tit-for-tat tariffs have created, ultimately triggering a global manufacturing recession. If financial sanctions are the next battle field in this economic war, they promise to create many more unintended consequences than tariffs.

The prospect of theUS-China economic war spreading to finance has most commonly been mentioned with respect to China “weaponizing” its large holdings ofUS treasuries and other debt instruments. Often referred to as the “nuclear option,” China could choose to dump a large pool ofUS assets. This would likely destabilize world financial markets and drive American interest rates higher.

However, such a move could also very well be self-defeating. China dumping treasuries and other securities would mean that their prices would go down, causing a loss for China. Even more importantly, such a move would unlikely reach its desired objective – massive economic pain in the United States – for several reasons. Firstly, the Federal Reserve could use quantitative easing to stabilize markets. Additionally, because of America’s “exorbitant privilege,” instability in financial markets would likely trigger flight-to-quality flows, which tend to support theUS dollar. Finally, China has few choices on where to put its foreign-exchange reserves other thanUS Treasuries. Government bonds in most other developed economies are either ultra-low or negative-yielding.

In the end, the “nuclear option” could hurt China more than the United States. Most financial analysts thus see an aggressive reduction of Beijing’sUS holdings as a remote possibility. No one takes this prospect very seriously, though it does pop up now and then in the news cycle.

This time, rather than China acting as the aggressor, the Trump administration is reportedly considering a variety of financial measures, including a push to restrictUS government pensions from investing in China, pressure onUS stock index providers to limit exposure to Chinese assets in their indices, and efforts to increase scrutiny of Chinese companies listed in the United States with the threat of forcing them to delist. Such efforts are in conjunction with the EQUITABLE Act, a bipartisan/bicameral bill making its way through Congress.

The discussion of potential financial sanctions on China is one more example of how the Trump administration is leveraging theUS dollar’s dominant position to advance geopolitical objectives. TheUS dollar continues to hold a near monopoly, since there is truly no viable alternative at this point. But Washington would be playing a risky game if it started a financial war with the largest foreign holder ofUS treasuries and, even more importantly, the second largest economy globally, the world’s largest trading power, and the globe’s biggest oil importer.

Trump’s repeated leveraging of theUS dollar undermines trust among holders of American assets. For example, if Chinese firms face the threat of being delisted fromUS exchanges, how many foreign companies from other countries will be willing to list on aUS stock exchange? Similarly, repeated threats to non-U.S. residents to freeze their assets could drive money away from American shores. No wonder calls are growing globally for an alternative to theUS dollar.

China has been advocating for such an alternative for the last decade. If the Trump administration puts sufficient pressure on China, it will greatly speed up Chinese efforts. While the euro and Chinese renminbi each have their problems, history shows that change in the international monetary system can come very rapidly. TheUS dollar, for example, rose from near global irrelevance before 1913 (the year the Federal Reserve was established) to become the world’s most important currency around 1925.

In other words, too much pressure on China could accelerate the creation of an alternative monetary system and hasten the decline of theUS dollar as the world’s sole reserve currency – one of the foundations ofUS preeminence. Already, the Trump administration’s moves have encouraged both friends and competitors alike to search for means of circumventing theUS dollar. Anne Korin from the Institute for the Analysis of Global Security recently noted how “very powerful countries” are seeking to undermine theUS dollar’s importance. “Major movers” such as China, Russia, and the European Union have a strong “motivation to de-dollarize.”

Once an alternative monetary system takes root, China could hypothetically declare its unwillingness to holdUS dollar assets and even bar its citizens and corporations from doing so. While this seems like a far-fetched prospect at present, such moves could fundamentally destabilize theUS economy. American politicians should not forget that the United States runs large current account and fiscal deficits, a recipe for “sudden stops” that tend to cause extreme financial disruption.

Expanding theUS-China economic war to finance therefore encompasses massive risks, both for China and the United States. But it is Washington especially that needs to think through the potential ramifications of any financial aggression. A financial war would deepen Chinese mistrust of the United States and hasten the search for an effective means of circumventing theUS dollar. By picking a short-sighted fight with China over finance, the administration could be vitally undermining American power in the long run.

The author is a professor of political economy at Chaminade University.