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May 10, 2019 11:45 AM, EDT

China Armed With Powerful Market Weapons in Duel With Trump

Qilai Shen/Bloomberg News

China has a powerful financial-market arsenal for its trade tussle with America, including a hoard of Treasuries and its currency. But using those weapons is not without cost.

Beijing said it will be forced to retaliate — but didn’t specify how — after U.S. President Donald Trump followed through with his threat to raise tariffs May 10 on $200 billion of Chinese imports to 25% from 10%. But simply responding with its own tit-for-tat tariffs isn’t China’s most likely move, said Brad Setser, a former Treasury official who’s now a senior fellow for international economics at the Council on Foreign Relations.

“Matching the U.S. dollar-for-dollar on the U.S. tariffs would imply raising a 25% tariff on all U.S. imports, including those that go into China’s exports,” Setser said. “China certainly could do that, but it would in many cases damage China directly.”

Trump pays attention to financial markets. He has often tweeted about stocks as they’ve zoomed to record highs. After Trump announced the tariff hike on May 5, the S&P 500 dropped four straight days.

China, the world’s second-largest economy, has market levers it can pull to escalate the battle. Here are some of them:

Chinese policy makers could devalue the yuan to offset the impact of U.S. duties on China’s economy. The offshore yuan weakened 5.5% against the dollar in 2018, drawing Trump’s ire and fueling speculation that the country was deliberately weakening its currency. While it has fallen 1.8% this week, the currency rose May 10 after the People’s Bank of China set its daily fixing at a stronger-than-expected level.

However, China’s painful experience with devaluing the yuan in 2015, which prompted capital to flee the nation, is likely to dissuade a similar move, according to Tao Wang, UBS Group AG’s chief China economist and head of Asia economic research. “China doesn’t like the self-fulfilling outflows that come as a result of depreciation, which tend to diminish domestic confidence,” she said. “In addition, yuan depreciation last year angered the Trump administration and led to higher U.S. tariffs.”

Currency has been a focal point in the trade talks. The U.S. has sought a yuan stability pact as part of an eventual deal, according to people familiar with the matter.

China owns $1.1 trillion of U.S. government debt, more than any other foreign nation. If it pared back its holdings in that $15.9 trillion asset class, that could be a potent weapon. Bond markets were jolted last year by a report that Chinese officials recommend slowing or halting Treasury purchases.

However, China doesn’t really have other good options for where to park its $3.1 trillion in foreign-currency reserves — the world’s largest stockpile — making this an unlikely path, according to Ed Al-Hussainy of Columbia Threadneedle Investments. In addition, if China dumps Treasuries, that could cause prices to plummet, driving yields higher and devaluing whatever U.S. debt the country is still holding. So far, bonds have rallied, not fallen.

“Any sharp moves higher in U.S. yields both adversely impact the valuation of their existing Treasuries stock and could spark a dollar rally,” the strategist said. “The financial and FX stability risks of this policy could outweigh the benefits.”

China, the biggest buyer of U.S. soybeans, has already slapped a 25% duty on them. Much of the crop is grown in Midwestern states that make up Trump’s electoral base, making its fate even more important to the president.

Before the trade negotiations soured, China made what U.S. Agriculture Secretary Sonny Perdue described in February as some “ good faith” purchases. Now, future buying might be up in the air. While devaluing the yuan or dumping Treasuries would be harder to pull off, balking at soybeans would be a relatively easy move, Setser said.

“There are some easy things for China to do,” including withdrawing from soybeans, he said.

Futures on the crop have dropped 11% since April 10.