How Can China “Go Nuclear” in Response to Trump’s Tariffs?

Gold Alliance disclaimer

Since Trump imposed tariffs on aluminum and steel imports a couple of weeks ago, the rhetoric has become hostile between China, and a true trade war may be impending, according to Treasure secretary Steve Mnuchin.

Mnuchin remains cautiously optimistic, but the odds of a trade war have just increased. Last Thursday, the Trump administration declared that they are looking into imposing a further $100 billion in tariffs on China in retaliation for China’s retaliation for Washington’s retaliation… At this point, it’s becoming increasingly blurrier who started the provocations.

Politics are driving the markets

The tensions and increasing uncertainties are driving the markets mad as investors are scrambling to make sense of the rhetoric coming from Beijing and Washington. As can be seen in the chart below, the S&P futures dropped at 3:45 a.m. ET on Wednesday (right after China proposed its retaliatory measures) and on Thursday (when the Trump administration aired the idea of an additional $100 billion in tariffs).

The tariffs aren’t just about trade and the economy. China is clearly also playing a political game—their proposed tariffs on soybeans are aimed directly at Trump and the GOP to hit them where it hurts most politically. By targeting soybean farmers—who, understandably, are furious at the idea of Beijing’s tariffs—Chinas is displaying great awareness of the political dynamics in the US, obviously hoping to neutralize any points Trump might hope to score in a potential trade war. Goldman Sachs released a statement about this:

“We view the inclusion of soybeans in [Wednesday’s] announcement as political in nature and reflective of the escalation of the trade dispute with the US. Soybean tariffs impact US Midwest political swing states and come at a cost that China appears willing to pay.”

In 2017, US exports to China amounted to $131 billion and imports from China totaled at $506 billion. If the US decides to impose tariffs of $100 billion, China would be unable to respond purely through retaliatory tariffs as US exports to China are simply too small to realistically handle such tariffs (total Chinese tariffs would amount to $150 billion). Therefore, China would need to put other measures in place.

China’s financial “nuclear options”

Instead of tariffs, China might opt for a financial “nuclear option,” and it has four “weapons” at its disposal:

  1. Sell off US Treasuries. Beijing holds large amounts of US Treasuries, officially $1.2 trillion. If it chooses to sell them off, it would lead to tightened financial conditions in the US. However, China would be cautious using this option since it would cause Chinese losses too, and potentially lead to chaos in the world’s bond market and destabilize the yuan-USD ratio.
  2. Depreciate the yuan. To offset some of the effects of the tariffs, China could depreciate the yuan. If the US goes ahead with the additional tariffs—or even just releases further details on its proposition—Beijing may feel like they are being backed into a corner and see no other option than to “fix” the yuan to solve this issue.
  3. Target Chinese tourism to the US. The US has a $39 billion surplus in services with China, most of which is generated by Chinese tourists to and students in the US. China has used its significant tourism as a weapon before, most recently against South Korea.
  4. Limit access to China for US companies. China used this against South Korea as well. When South Korea deployed its Made in USA–missile system, lots of Lotte stores (a major South Korean conglomerate) were shut down by Chinese officials, and Chinese’s state-run media’s campaign against South Korea severely impacted the sales of Hyundai and Kia. China is an increasingly important market for major US brands, and Beijing could choose to limit access for their products and services should the tensions escalate.

We are witnessing how the global financial markets are significantly impacted by international politics instead of relying on market fundamentals. If this goes on for too long, we can just hope that the markets are able to stabilize once the tensions subside.