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China has a $1 trillion trade war weapon. Will it ever use it?
London (CNN Business)In the US-China trade war, it's been a week of rapid escalation. Beijing devalued the yuan after the Trump administration threatened to slap tariffs on just about every Chinese export. The United States then labeled China a "currency manipulator," deepening the rift.

The exchanges have rocked global markets and threaten the global economy. What happens next is anyone's guess.
China has said it is prepared to fight, if necessary. And it has one hugely powerful weapon up its sleeve: it's the American government's biggest creditor.
In theory, Beijing could trigger a panic in bond markets by dumping some of the $1.1 trillion in US Treasuries that it owns.
By releasing a flood of US Treasuries, the price would collapse, sending yields (or interest rates) soaring and causing American borrowing costs to rocket.
But there are very good reasons why China is unlikely ever to pull the trigger. First, it may not have the desired effect. Second, it could backfire badly on its own economy.
"It's likely not the most effective tool available," said Brad Setser, a senior fellow at the Council on Foreign Relations and former US Treasury economist.
The nuclear option
China has taken steps in recent days to prop up the yuan, signaling that the depreciation was intended as a warning sign. But President Donald Trump could still hit back, even as the administration sticks to its plan for more trade talks in September.
Trump's trade war with China is starting to get out of hand
Trump's trade war with China is starting to get out of hand
It's a combustible situation that's ripe for further escalation. That's where concern about China's holdings of US bonds comes in.
If China really wants to rattle the United States, the thinking goes, it could trash the value of US Treasuries by pushing them into the market.
That would cause yields to spike. And since Treasury yields serve as a benchmark for business and consumer credit, the price of corporate debt, mortgages and auto loans would then rise, putting the brakes on US economic growth. The dollar could also suffer as alarm spreads.
Beijing's conundrum
In reality, such a move carries big risks, and doesn't align with China's current strategy, according to Michael Hirson, the China practice head at consultancy Eurasia Group. He previously served as the US Treasury's chief representative in Beijing.
"We're clearly in an escalatory cycle," Hirson said. "But I think Beijing's primary motivation right now in the trade war is to be able to withstand pressure from Trump. You can think of it as 'resilience comes first.' "
If China weaponizes Treasury holdings, that sends a very alarming message to global investors."

MICHAEL HIRSON, CHINA PRACTICE HEAD AT EURASIA GROUP

In that respect, ditching US Treasuries could be counterproductive. If Beijing kicks off a fire sale for US bonds, it would gut the value of its remaining holdings.
It needs that stash to defend its currency. Experts think China will try to engineer a controlled fall in the yuan in coming months, allowing it to soak up some of the pressure on the economy without sparking an exodus of capital from the country.
Another deterrent: a sell-off of US Treasuries would undermine China's push to attract foreign investment to its equity and bond markets.
"It needs that foreign inflow to cushion its currency during the trade war," Hirson said. "If China weaponizes Treasury holdings, that sends a very alarming message to global investors."
Questionable impact
There's also the question of whether abandoning US Treasuries would hit the United States in a real way. Setser said he's skeptical.
"The moment it starts to have a big negative impact on the US, the Fed would likely react," he said.
In a 2012 report to Congress, the Defense Department pointed out that the Federal Reserve is "fully capable" of purchasing US Treasuries that China pumps into the market to rein in the economic consequences.
Furthermore, China has few alternative places to park its $3.1 trillion in foreign reserves.
German and Japanese bonds would typically be an option, but they offer zero return at best. A 1.63% yield on 10-year US government debt looks much better than the 0.59% negative return on the equivalent German bonds, which hit another record low on Wednesday. That means effectively paying the German government for the privilege of lending to it.
The threat of dumping US Treasuries remains on the table. But for China, it still isn't very appealing.
Matt Egan contributed to this report.


China has a $1 trillion trade war weapon. Will it ever use it?

 
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