How serious a threat is financial warfare?

China may be about to embark on financial war with Japan if the latter won’t back down over a chain of disputed islands. But what is a financial war, and could it work? James McKeigue investigates.

China may be about to embark on financial war with Japan if the latter won't back down over a chain of disputed islands. But what is a financial war, and could it work?

What's happened?

China and Japan are embroiled in a fierce row over a chain of disputed islands, known by Japan as the Senkaku, and China as the Diaoyu. While a military engagement still seems avoidable, some senior Chinese figures have advocated financial warfare.

Jin Baisong from the Chinese Academy of International Trade a branch of the commerce ministry said China should use its power as Japan's biggest creditor with $230bn (£141bn) of bonds to "impose sanctions on Japan in the most effective manner". A similar idea was mooted by Chinese generals during another dispute over the islands in 2010.

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What's the plan?

On paper it sounds like a potentially devastating attack. Japan has the largest public-debt-to-GDP ratio in the world, and yet pays miniscule interest rates to borrow, so a sudden firesale could trigger pandemonium. The flood of extra bonds would drive down the price and drive up the yield on Japan's debt, resulting in higher Japanese borrowing costs, which the economy could ill afford as it's already so heavily in debt.

If it wanted to avoid a mass sell-off of its bonds, reckons US financial blog ZeroHedge, the Bank of Japan (BoJ) would be forced to "monetise debt for dear life, buying up first hundreds of billions, then trillions in the secondary market to avoid a complete rout". This would lead to "soaring inflation".

Sounds scary would it work?

Probably not. China might be the biggest foreign holder of Japanese bonds, but its stake is still only worth around 2% of the overall debt. A large chunk of the rest, about 92%, is held by Japanese individuals. Indeed, one reason why Japanese borrowing costs have stayed low is the strong local demand. If the BoJ did "counter the move with bond purchases", the consequences wouldn't be so calamitous, says Ambrose Evans-Pritchard in The Daily Telegraph.

By creating reserves to buy the bonds being sold by the Chinese, the BoJ would, in effect, be launching another round of quantitative easing (QE). Given that the BoJ is a keen proponent of QE just last week it expanded its QE programme again it's unlikely to trouble policymakers too much.

Indeed, notes Evans-Pritchard, "any weakening of the yen" (the strong currency is hurting Japanese exporters, and the government is pressuring the BoJ to do something about it) "would be welcome".

Could China attack the US like this?

News of the Chinese threat has not gone unnoticed in America. America is also heavily indebted and, again, its largest foreign creditor is China. The country's $1.1trn of US Treasuries account for 7.5% of the American government's outstanding debt. Also, American citizens hold far less of their own country's debt than their Japanese counterparts. However, a recent US Department of Defence report concluded that China couldn't hurt America's economy without damaging its own.

Of course, as one of the biggest recipients of American government spending, the defence establishment may be pre-disposed to support further borrowing, but the report makes some valid points. For one, China needs somewhere to keep all those currency reserves no other bond market is large enough to satisfy its demand.

Of course, China could diversify into other assets, such as gold and oil. But if it did this on a large scale, it would drive up the prices of the assets it was buying, while lowering the prices of the assets it was selling, resulting in huge losses.

Dumping US dollars would also play havoc with China's fixed exchange rate. China's trade surplus means that huge amounts of dollars flow into the country. Normally this would force up the local currency (the renminbi). But China wants to keep the renminbi weak to help its exporters, so it counters this by mopping up excess dollars and exchanging them for a set amount of renminbi.

As a result, the People's Bank of China has accumulated $3.3trn of foreign-exchange reserves. If it tried to swap these reserves for renminbi, it would drive up its value against the US dollar.

So does financial warfare ever work?

China's problem is that it is intertwined with America. However, in 1956, America showed how financial warfare can be used against a weaker, less interlinked economy Britain. America was displeased when Britain, France and Israel invaded Egypt to gain control of the recently nationalised Suez Canal.

When Britain refused to back down, America began selling its huge pile of British debt. The sell-off triggered a slump in sterling, destroying the value of British reserves and reducing our ability to pay for imports. Britain was forced to withdraw from Suez a move that effectively signalled the end of the British Empire.

Might the dollar lose world-reserve status?

The US dollar is the world's reserve currency. Around 60% of foreign reserves of central banks and governments are in dollars; almost 85% of currency transactions worldwide involve dollars. This gives the US huge advantages. Chiefly it means that dollars will always be in demand, which allows the US to borrow heavily. It also means US monetary policy has a significant impact on the rest of the world.

There are signs of gradual change China and Russia have begun using local currencies for cross-border trade, while China has started to encourage more international use of the renminbi. But the dollar seems safe: the renminbi accounts for around 2% of foreign-exchange transactions, while the dollar's other rival, the euro, is struggling for survival. So the dollar benefits from there being no credible alternative, for the time being at least.

James McKeigue

James graduated from Keele University with a BA (Hons) in English literature and history, and has a certificate in journalism from the NCTJ. James has worked as a freelance journalist in various Latin American countries.He also had a spell at ITV, as welll as wring for Television Business International and covering the European equity markets for the London bureau. James has travelled extensively in emerging markets, reporting for international energy magazines such as Oil and Gas Investor, and institutional publications such as the Commonwealth Business Environment Report. He is currently the managing editor of LatAm INVESTOR, the UK's only Latin American finance magazine.