Is China Playing Puppet Master to the Global Markets?

This morning, the UK Telegraph published an article titled "China Threatens ‘nuclear option? of dollar sales. This has received more than the usual press because shifts in Chinese Policy are typically announced through government sponsored think tanks or academics. This time however, the warning was given by two government officials which is a reflection of how serious this threat is. With $1.3 trillion in foreign reserves, most of which are held in US dollars, China has what it takes to cripple the US economy.

Selling US treasuries would mean selling US dollars, which may not so bad, but falling bond prices also leads to rising bond yields. At a time when the stability of US economy is hanging by a thread, any further shocks could have widespread consequences - and China knows this. Bond prices and the US dollar have already sold off on the back of the warning. The dollar is trading less than 50 pips away from its record lows against the Euro at the time of publication.
[B]China Refuses to Bend to International Pressure[/B]
The main reason for China?s threat is continued calls for the government to revalue the Chinese Yuan. The Senate Finance Committee recently backed a bill that allows the government to impose trade tariffs on Chinese goods if they brand China as a currency manipulator. US Treasury Secretary Paulson was never in favor of pressuring China into a move, but the new bill will make it more difficult for the Treasury to avoid labeling China as a currency manipulator. The bill also allows the Federal Reserve to actually intervene in the currency markets to force an appreciation in the Chinese Yuan if necessary. Senator Hillary Clinton has also recently called for restrictive legislation to prevent the country from being “held hostage to economic decisions made in Beijing, Shanghai and Tokyo.” The US as a whole has been cracking down on heavily on the safety of Chinese made products. Since the beginning of the year, we have had scandals involving Chinese imports ranging from toothpaste to seafood to toys. China however refuses to bend to international pressure. They have always marched only to their own tune and whenever they get pushed to make a move, they only push back. Remember the trade sanctions that US Senators wanted to impose last year? China responded by threatening to take any necessary action and at this stage of the game, they have both the political and economic sway to cause a big blow to the US economy and the US dollar.

[B]The Power to set off a Dollar Collapse[/B]
China has the power to cause the dollar collapse from two angles. The first is an outright sale of US treasuries and correspondingly, the US dollar. The second is to cause the dollar to fall as a result of weakening US economic fundamentals. Right now, the US economy is extremely vulnerable. Defaults are rising in sub-prime and Alt-A loans. Mortgage lenders and hedge funds are blowing up left and right. Even though the Federal Reserve seemed to be not all that concerned, the heavy schedule of first time adjustable rate mortgage resets over the next few months could mean more defaults to come. The peak in mortgage resets will not be until October and after that, we will still be averaging $30 billion a month in resets going into September 2008. For the average American, this means that interest payments on both mortgages and credit cards will rise sharply. Given that American Express has already reported an increase in late payments, we believe that a continued rise in interest rates could be too much for the average consumer to handle.
[B]Will China Follow Through With the Threat?[/B]
However at the same time, we do not think that China will follow through with the threat since China and the US are interdependent. The US is a big importer of Chinese goods and China cannot stop buying US dollars. Their current bond market is one tenth the size of the US bond market. The average bond market valuation currently stands at approximately 95 percent of overall GDP while China‘s market only represents 30 percent of GDP. With the US dollar likely to comprise a big portion of its managed float, as much as China tries to diversify, some of their money will still be used to buy US dollars and US treasuries. The US on the other hand will back off its calls on China to revalue the Yuan given the severity of the consequences. A major slowdown in the US economy is in no one?s best interest and China will continue to revalue the Yuan, but at their own pace. Therefore even though the US dollar has fallen on the news, further weakness for the time being should be limited. With the 2008 Olympics just around the corner, China will do all they can to make sure they show on their best “face” to the world. This includes ensuring economic stability both domestically and globally.

[B]By Kathy Lien, Chief Strategist[/B]