After President Trump killed the Iran nuclear deal in early May, US Secretary of State Mike Pompeo, later in the same month, announced that crushing new sanctions against Iran are coming in a speech at the Heritage Foundation – unless Iran effectively agrees to a ‘self regime-change’, in the words of Jonathan Cristol writing for CNN. While the commentariat has been preoccupied with the effects of these actions on the future of US-Iranian relations, US relations with its allies, and its potential for leading to a reconstitution of the Iranian nuclear programme, or EU-US relations, there is a case to be made that another target of what has been described as Trump’s ‘most consequential foreign-policy blunder yet’ is in fact China.
The underlying cause of most of the economic, foreign policy and numerous regional crises we can witness today is the ensuing great power conflict between a rising China and a declining United States. The US is particularly concerned about China’s success in slowly but surely building, increasingly together with Russia (and Iran for that matter), an alternative Eurasian system that would challenge the post-World War 2 liberal international order as well as, eventually, even the US Dollar’s (USDs) continued role as the world’s principal reserve and trading currency. This perceived challenge by China has led to a comprehensive counter-offensive by the United States with the aim to contain China’s rise and obstruct, or even undermine, its foreign policy and economic initiatives. Among other things, abandoning the Iran nuclear deal also seeks to further tighten the economic screws on China.
The change in US monetary policy, which commenced under the Obama administration when the Federal Reserve ended quantitative easing (QE) and started to slowly raise interest rates, a process that accelerated under the Trump administration, puts a severe strain on the Chinese currency and thus its economy. In addition, and very much related, the Trump administration has also taken fiscal and trade policy measures that create further upward pressure on US interests rates, such as the tax reform deal, the infrastructure investment plan and most prominently the threatening of punitive tariffs primarily directed at China. These measures have one thing in common: They will lead to sharply rising interest rates in the US and a potentially much stronger USD. Moreover, according to the economist Richard Duncan, ‘the combination of tax cuts and increased government spending – on top of Quantitative Tightening – is set to drain $3 trillion out of the financial markets over the next three years.’
Since this extreme form of tightening, leading to a huge global dollar shortage, comes in the wake of the longest and most dramatic period monetary easing the world has seen, and which has resulted in a situation where global debt is now exceeding $233 trillion, or 318% debt to GDP, this means that its effects will be even worse than would have otherwise been the case. Since a significant portion of this debt is in form of US-denominated corporate debt in emerging markets, which could and did borrow heavily in recent years as a result of easily available USD credit at near zero interest rates, many analysts are already warning that an emerging market crisis is on its way.
There has in fact already been a first casualty, i.e. Argentina, which saw its currency, the Peso, plunge, making yet another IMF bailout to stabilise the situation likely. Next in line, many expect, will be Turkey, “with its $450 billion [owed] to foreign creditors, of which $276 billion is denominated in hard currency, mostly dollars and euros”, as pointed out by Jim Rickards.
But China too is coming under increased pressure. The economic environment that the prolonged period of quantitative easing created also forced China to institute its own enormous credit expansion programmes in order to guarantee continued high levels of growth. As a result, China, like the US and Europe before it, is now sitting on a gigantic housing bubble, a severely extended financial market and huge corporate and household debt. China’s non-financial sector debt has surged to 257% of GDP in 2017 and its corporate debt has climbed to 165% of GDP. While most of China’s debt is denominated in Yuan, and China is also no longer as dependent on the US market, and indeed exports as such, as was previously the case, China nonetheless remains vulnerable to the combined monetary, fiscal and trade policy shifts instigated by the US.
This is because China is in the process of aggressively internationalising its currency, which requires a stable and in fact slowly appreciating currency to succeed. However, in order to manage the demands and stresses of its domestic economy and to avoid speculative onslaughts against its currency, China still has strong capital controls in place and still maintains a currency peg, albeit looser than before, to a basket of currencies (still prominently featuring the USD of course). So a rapidly appreciating USD puts severe pressure on the Yuan. If China were to keep its currency relatively stable in relation to the USD, this would mean having to raise interest rates, the last thing China wants to do, or instead selling large amounts of its foreign currency reserves. The first option would risk widespread bankruptcies and potentially even a banking crisis, and the second to significantly draw down its ‘war chest’ of USDs and other foreign currency reserves to keep the value of the Yuan stable.
The alternative would be for China to once again allow its currency to significantly devalue in relation to the USD, in a replay of what happened between late 2014 and late 2016 when the USD appreciated markedly against the Yuan. This would certainly alleviate many of the problems the Chinese economy is now facing, and especially give a respite to its overleveraged banking and corporate sectors as exports and growth would likely pick up and external debts are still a relatively minor issue for Chinese corporations. Doing so, however, would first of all require for China to purchase large new amounts of US securities, which it does not want to do, and also slow down its ambitions to internationalise its currency, as it would be regarded effectively as a form of default. It would also once more increase the risk of capital flight, in turn requiring China to further tighten its capital controls, and thus doing major harm in the eyes of potential foreign investors.
But let’s come back to the Iranian nuclear deal, which played a large part, together with US shale production, in markedly driving down the price of oil in recent years. With the Iran deal of the table, increasing tensions in the Middle East, and a worsening situation in Venezuela, there are clear indications that the price of oil could rise significantly in the weeks and months to come, of course only if Saudi Arabia and other OPEC producers are on board with such a US strategy. Since China’s industrial economy is extremely dependent on foreign sources of oil and since China, as of last year, surpassed the United States as the largest gross importer of crude in the world, rising oil prices would further sharpen China’s economic problems.
So the likely rise in the price of oil as a result of the US reneging on the Iran nuclear deal and the reconstitution of sanctions at a time of already severe pressures on the Chinese economy could be interpreted as yet another screw being applied by the US administration in its attempt to derail China’s attempt to create an alternative, Eurasian, international system, outside of the USD-dominated global financial and trading order.
Ironically, it could in fact have the opposite effect: Rather than achieving the intended results, killing the Iran nuclear deal might even aid Chinese efforts to undermine the petrodollar and strengthen the Yuan’s role in global oil trade. According to Henning Goystein and Meng Meng, writing for Reuters, killing the deal and instituting new sanctions ‘is supporting China’s newly established crude oil futures, and may spur efforts to start trading oil in yuan rather than dollars’. In the wake of Trump’s announcement, ‘traded daily volumes hit a record 250,000 lots…, more than double the day before’ resulting in the ‘Shanghai futures contract [now accounting] for 12 percent of the global oil market…, up from just 8 percent in week one.’