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Trading desks have been buzzing with the economic problems in the Eurozone but a much larger potential threat to the markets has recently emerged: the real prospect of China unloading its non-U.S.-backed foreign investments. Asia Times Online reports (hat tip, Zero hedge):

Dollar-denominated risk assets, including asset-backed securities and corporates, are no longer wanted at the State Administration of Foreign Exchange (SAFE), nor at China’s large commercial banks. The Chinese government has ordered its reserve managers to divest itself of riskier securities and hold only Treasuries and US agency debt with an implicit or explicit government guarantee. This already has been communicated to American securities dealers, according to market participants with direct knowledge of the events.

It is not clear whether China’s motive is simple risk aversion in the wake of a sharp widening of corporate and mortgage spreads during the past two weeks, or whether there also is a political dimension. With the expected termination of the Federal Reserve’s special facility to purchase mortgage-backed securities next month, some asset-backed spreads already have blown out, and the Chinese institutions may simply be trying to get out of the way of a widening. There is some speculation that China’s action has to do with the recent deterioration of US-Chinese relations over arm sales to Taiwan and other issues…

Those other issues could be related to the increasingly aggressive talk coming out of Washington related to our trade deficit. During the state of the union address, the President proposed doubling our exports over the next five years as a way of stimulating the economy and addressing the trade deficit. This is probably impossible without China dramatically increasing its U.S. imports. Andy Xie discusses this dynamic in greater detail in a piece for Caixin online today (hat tip, TBI):

U.S. trade policy will likely morph from political publicity to serious tool for economic expansion. With monetary and fiscal policies constrained, this is the only way to decrease unemployment. The administration's goal to double U.S. exports won't happen organically. U.S. exports rose one-third in the past five years. Even if we assume U.S. exports could rise another one-third over the next five years, exports to financial crisis-weakened overseas markets would fall short of Obama's goal by more than US$ 600 billion. China would become an obvious target for making up the difference, requiring that China appreciate its currency dramatically and make a major switch to consumption-oriented economy…

Without benefiting from China's growth, the United States lacks incentive to be China's biggest export market. So to pressure China, I expect many more U.S. protectionist measures this year. Before the November mid-term election, Congress could pass a bill that calls for a 30 percent tariff on all Chinese products unless China appreciates its currency by the same amount… Clouds are gathering over China's exchange rate policy. We've seen these clouds before. This time, however, the U.S. pressure is much more serious. Without careful handling, a stormy trade war could erupt, with negative consequences for all. So rather than playing defense, China should move soon to adopt constructive measures and prevent confrontation.

The new liquidation measures that China is currently rumored to be implementing seem far less “constructive” than I'm sure Xie would recommend. Due to the simple fact that China holds roughly $2 trillion in foreign assets (mostly U.S. Treasury securities) it would seem to me they hold most of the cards. If the President and Congress do, indeed, pursue a revaluation of the yuan while threatening protectionist measures the situation could get very interesting.

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