In May, China posted a record trade surplus of US$62.93 billion, largely down to a sharp drop in imports due to weak domestic demand. Analysts say the proposed national security law for Hong Kong could mark the beginning of a process cutting China’s access to US dollars. China recorded a current account deficit in the first quarter of 2020, meaning it was a net exporter of US dollars

by Karen Yeung

US President Donald Trump’s recent threat to penalise China and Hong Kong for Beijing’s decision to impose a national security law on its special administrative region could mark the beginning of a process to cut off access to US dollars, analysts said.

While the composition of the measures from the United States remains unclear, most analysts do not expect the Trump administration to impose extreme sanctions against Chinese financial institutions which would cut them off outright from the US dollar payments system, which is underpinned by the Swift network. In addition, avoiding a full-blown financial war with China over Hong Kong would preserve the phase one trade deal, in which US Trade Representative Robert Lighthizer expressed support for last week. But there is potential for increasing restrictions to reduce financial and trade ties with China, gradually choking off the supply of US dollars in China.

One possible step that Washington could take would be to sanction individuals in China and Hong Kong deemed to have violated human rights under the Hong Kong Human Rights and Democracy Act that was passed in the US last year.

Michael Every, Asia-Pacific senior strategist at Rabobank, said if this were to happen, a key question would be whether large, globally interconnected Chinese banks conducting business with those individuals would then be subject to the same sanctions.

Depending on the exact nature of the sanctions, this could force other international financial institutions to limit or even sever their relationships with these Chinese banks, cutting them off from much of the global US dollar market.

“Either China has to ensure that dollars keep flowing or the globalised dollar world excludes China, which is equivalent of putting a ‘bamboo curtain’ around the country,” said Every, a play on the Cold War term the Iron Curtain that described the separation of the free capitalist world and the Communist states of the Soviet Union and eastern Europe.

The sanction threats from the US over the national security law proposal in Hong Kong come on top of existing concerns that the nation may be running short of US dollars, which is still the primary choice for international trade, investment and payments.

The shock wave caused by the coronavirus has created an acute need for US dollars in China to pay for its massive imports and payments on US dollar-denominated debt because of its sharply reduced ability to earn foreign exchange income through exports, tourism receipts and foreign direct investments.

That led to China recording a negative current account balance – the difference between current receipts from abroad and current payments overseas – in the first quarter of 2020, the first deficit since 2018 when Washington and Beijing began their trade war.

For most of the last decade, China’s current account posted large surpluses, a key source of US dollars, but it fell to a deficit of US$29.7 billion in the first quarter, down from a surplus of US$40.5 billion at the end of 2019, making China a net exporter of US dollars.

China’s US dollar shortage may still worsen further as the US-China trade war moves ahead, with many analysts expecting China to shift to a near zero trade balance over the medium term.

China’s trade position could deteriorate further if the governments of the US, Japan and the European Union succeed in luring manufacturing firms out of China and bringing the production of goods back to their respective home countries in response to supply chain disruptions stemming from the Coronavirus.

In May, China posted a record trade surplus of US$62.93 billion, largely down to a sharp drop in imports due to weak domestic demand, but analysts warned this is unlikely to last, as exports deteriorate due to a sharp drop in orders from the US and Europe as the coronavirus outbreak ravages demand.

Partly to mitigate pressure from its US dollar shortage problem, and partly as a result of the terms of the US-China phase one trade deal, Beijing is pinning on hopes that its domestic financial reforms will boost portfolio investments inflows into its capital markets, especially through the Stock Connect and Bond Connect schemes for foreign investors.

Credit Suisse last week took control of its China securities joint venture, Credit Suisse Founder Securities, becoming the latest foreign bank to take advantage of Beijing’s relaxation of foreign ownership rules. It joins US banks JPMorgan, Goldman Sachs and Morgan Stanley, as well as Hong Kong’s HSBC, Switzerland’s UBS and Japan’s Nomura, as foreign majority owners of China-based securities firms.

Daniel Tabbush, founder of Asian bank research firm Tabbush Report, said the opportunities resulting from China's huge market and growth potential would likely continue to entice foreign capital from large foreign financial institutions to do businesses in Hong Kong and China despite the uncertain political climate.

“There might be some moral suasion [from the US government], but if there’s a big deal to be done, Wall Street investment banks are unlikely to give up on the deal,” Tabbush said.

Last year, American banks played key roles in some of the biggest listings in Hong Kong, helping many Chinese firms raise foreign capital. US banks accounted for 19 per cent of investment banking fees booked in Hong Kong last year, or about US$309.8 million, according to data provider Refinitiv.

The US, however, has begun ratcheting up scrutiny over such flows to China. At the end of May, Trump instructed a presidential working group of top financial regulators to study “differing practices of Chinese companies listed on US markets with the goal of protecting American investors”, particularly their practice of not complying with the auditing requirements for other listed companies. The comments followed his executive order in early May banning the main government pension fund from investing in Chinese stocks.

Another source of US dollars for China comes from the money raised by Chinese firms in the US. In total, Chinese firms have raised over US$1 trillion by listing their shares on US stock exchanges. But a bill passed by the US Senate with broad bipartisan support would require Chinese firms to comply with US auditing requirements, as well as make disclosures about government shareholdings in their firms and members of the Communist Party in management positions, which could lead to delisting of Chinese firms that do not comply, potentially preventing other Chinese firms from pursuing initial public offerings in the US.

On the surface, China should be the last country in the world to worry about a US dollar shortage – over half its US$3.1 trillion worth of foreign exchange reserves, the world’s largest, are believed to be held in US dollar-denominated assets.

But analysts said the huge foreign reserves do not reflect the underlying stresses of the economy. The reserves are maintained only because authorities are clamping down on outbound remittances through draconian capital controls on its citizens, which do not support China’s integration into a globalised, US dollar-dominated world, said Rabobank’s Every.

Beijing’s reserve assets cannot readily be turned into cash in the case of a major financial shock nor can a significant amount be drawn for payment of foreign debt without hurting market confidence, said Kevin Lai, the chief economist at Daiwa Capital Markets.

A combined total of US$9.38 billion in US dollar loans and debt issued by Chinese entities will mature in June and US$10.66 billion in July alone, according to Refinitiv.

“How long can China really sustain its economy [amid a US dollar shortage] by cutting back on its imports and depend on self-reliance?” Lai said.