- Effect on Chinese equities and the renminbi would likely be minor
- A restriction could impede Sino-US trade negotiations and add to currency war tail risk
- Possible fragmentation of global financial system and technology linkages
Media reports on 27 September suggested the White House is considering restricting US public pension fund holdings of Chinese assets. Should such a move be implemented, it would reduce inflows to Chinese assets by limiting foreign demand for Chinese shares and eroding support for the renminbi. The impact on China’s asset markets would centre on portfolio inflows into China’s onshore capital markets since the bulk comes from non-US official institutions’ demand for Chinese fixed-income instruments.
The market impact
Foreigners hold only 3% of China’s A-share market capitalisation. Some brokers estimate that US public pension funds hold USD 5 billion to USD 8 billion of A-shares, which equates to less than 0.3% of China’s currency reserves. So, any reversal of inflows from US portfolios would have a quite minor impact on Chinese equities and the renminbi.
If offshore Chinese stocks are included, US pension funds hold another USD 55 billion to USD 92 billion of such shares. Their holdings of onshore and offshore combined thus equate to 3.5% to 6.0% of the MSCI China index, according to some market estimates.
A drop in US access to Chinese stocks at a time when those stocks are being included in international benchmarks would reduce total portfolio inflows to China, weakening support for the renminbi just when market sentiment is already negative due to global concerns over China’s domestic growth and the Sino-US trade war.
For financial markets, this would imply:
- that uncertainty over the trade war would run counter to ‘buying-the-dip’ if or when Chinese stocks react negatively in the short term to the US’s proposal
- an increased tail risk that the Sino-US trade conflict may lead to a currency war.
The latter would complicate Sino-US negotiations, which are set to restart soon. President Trump might be trying to use the proposed portfolio investment restriction to force China to come to an agreement, but the Chinese are not going to budge, in my view. Instead, it will likely lead to further renminbi weakness. This would mean that Trump’s plan would backfire.
Longer-term risks beyond inflows into China
Potentially more damaging over the long term is that a US restriction would further the momentum of the US decoupling from China by breaking supply chains. This would disrupt the world’s production ecosystem. To avoid being hit by US tariffs, many firms producing or assembling in China and exporting to the US are already considering moving their facilities to unaffected countries. With China standing at the centre of global supply chains, a wave of relocations would be highly disruptive.
Should major supply chains break down, it would lead to serious inefficiencies. The benefits of other countries capitalising on China’s industrial infrastructure and technology, as well as the size and skill of its labour force, would disappear. If we accept that globalisation has helped to reduce inflation by boosting efficiency, then clearly, de-globalisation would likely bring back inflation in the longer term.
Such disruption would slow China’s development, but not stop it. This is because China has a savings surplus (as well as a capital misallocation problem). Foreign portfolio inflows and funds from IPOs on foreign exchanges are helping to address this: they allow China’s private sector to access credit at a lower cost than the onshore shadow banks can. If the US were cut off as a source of funds, China would look harder at other markets.
Possible financial and technological fragmentation
More generally, the Trump administration has shown its ability to hurt targeted countries by using sanctions to deny them access to the USD-denominated international payments system. To hedge against this liquidity risk, the US’s strategic rivals, China and Russia, and even its ally, the EU, are trying to establish alternative systems, notably the China Cross-border Interbank Payment System or CIPS, which uses SWIFT messages and SWIFT standards and – perhaps ironically – is modelled on FedWire in the US.
Such financial fragmentation would also almost inevitably disrupt the global technological landscape. Restrictions on technology transfers and linkages, justified on a national security basis, would give rise to competing and non-compatible standards, just as the GSM versus CDMA mobile-phone network battle did some 10 years ago.
In my view, it is even possible that today’s internet would collapse into competing domains, giving rise to excessive or cut-throat competition, stymieing innovation and leading to higher costs, slower adoption and inferior products.
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