Sino-U.S. trade war spreads into financial sector

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As the Sino-US trade war steadily escalates, tensions are inevitably spilling into the financial sector. While much press coverage has focused on the U.S. naming China a currency manipulator - something that hasn't happened since 1994 - there has not been any punitive action following the designation. The decision by Washington looks more like a pointed criticism of China's long-stalled financial reforms. Remember when it was common to hear bankers speculate that China's capital account would be freely convertible by 2020?

Those were the days. Regardless, monetary policy is actually less of a flashpoint in the trade war than compliance. The alleged involvement of three major Chinese banks in the financing of North Korea's nuclear weapons program - in violation of sanctions on the Hermit Kingdom - has the potential to entangle some of China's largest lenders in a new front of the trade war.

According to the ruling of a Washington district appeals court, U.S. prosecutors believe that a North Korean bank used a Chinese front company to export huge shipments of coal and other commodities (valued in the hundreds of millions of dollars) and used the proceeds - in greenbacks, of course - to shop for Pyongyang's nuclear weapons program. U.S. prosecutors say that three Chinese banks, not named in the filing but which appear to be Shanghai Pudong Development Bank, Bank of Communications, have information in their records which "may clarify how North Korea finances its nuclear weapons program."

Washington has requested banking records from 2012-2017. The three Chinese banks have rejected the subpoenas, arguing that Chinese law forbids them from handing over client records for the purpose of an investigation by a foreign government.

The banks' argument failed to sway the court, which noted that two of the banks agreed to abide by American law as a condition for doing business in the U.S. when they opened U.S. branches. The third bank is in the same boat: It conducts transactions through a correspondent account at an American bank, Bloomberg noted in an August report.

Washington has long known of the involvement of Chinese banks in North Korea. After all, Beijing is Pyongyang's primary benefactor and by far by its largest trading partner. Given Pyongyang's reputation for financial misconduct - money laundering, currency counterfeiting, cash smuggling and even bank robbery through hacking - it would be unsurprising to find that Chinese banks doing business with Pyongyang got mixed up in some illicit activity.

The key is whether the Chinese banks knew that they were supporting Pyongyang's nuclear weapons program. If Washington finds evidence that they knowingly aided North Korea, it could sanction them or bar them from the American financial system. Alternatively, Washington could fine them billions of dollars as it did to European banks who violated sanctions on Cuba, Iran and Sudan. Such an approach would be less forceful than sanctions or restrictions from the U.S. financial system.

Still, even fines alone could strike a raw nerve in Beijing, where the leadership is under pressure to retaliate against any perceived U.S. provocation. Indeed, in this case, the U.S. is not dealing with European banks from countries whom it considers allies. Rather, the U.S. and China, the world's two largest economies, are locked in an intensifying trade war that could spread to every part of their commercial relationship. The fallout from the trade war is already rattling the tepid global economy. A full-on financial war between Washington and Beijing would almost certainly push the world into a recession.

For China itself, the risks of escalation are even higher. The Chinese economy is already feeling pain from Trump's tariffs, which have exacerbated a long-running economic slowdown. And yet Beijing would feel obliged to retaliate should Washington take punitive action against any of the three Chinese banks. The banks are not insignificant local lenders but three of the ten largest Chinese banks by asset size.

For the sake of the China, the U.S. and the global financial system, let us hope that cooler heads miraculously prevail in this new trade war front.