Many market commentators and conspiracy theorists are postulating that China might dump its rather significant holdings of US Treasuries as revenge for trade tariffs.
The chart below shows the amount of Treasuries held by foreign countries at present.
$1.22 Trillion. These Treasuries came into being as a result of China's export income from international trade with America. It represents the dollarised monetarization of decades of imports from China.
The Chinese have sent real goods and services to America and are happy to save the income as dollars.
The thousands of businesses that export to America all have an account with a US bank that in turn has an account at the Federal Reserve Bank [Fed]. In these American bank accounts, the dollars accumulate as goods and services from China are bought and paid for by domestic Americans. The dollars move from a domestic American's bank account to a US Bank account in the name of a Chinese entity. The Fed groups the bank accounts under a sub-account for China.
In theory, the Chinese entity could spend those US dollars and buy anything offered for sale in US dollars. The dollars could re-enter the US domestic economy in return for US goods and services or assets.
The point to remember is that the dollars never leave the Fed's spreadsheet. All that happens is that they change ownership in exchange for goods and services. The Fed marks accounts up and down to track the dollar movement.
US law prevents the Chinese and other foreigners from buying anything for sale in US dollars and have little choice but to put their excess dollar holdings into a savings account and earn some interest. Foreigners are encouraged to buy US Treasuries (that accrue a coupon payment like a term deposit savings account) with their surplus dollars rather than keep the dollars in their checking account earning no interest.
Since 1960 the United States has drawn on world resources through a novel monetary process: by running balance-of-payments deficits that it refuses to settle in gold, it has obliged foreign governments to invest their surplus dollar holdings in Treasury bills, that is, to relend their dollar inflows to the U.S. Treasury.
(Hudson, Michael. Global Fracture: The New International Economic Order (p. 17). Pluto Press. Kindle Edition.)
At the moment the Chinese export earnings are in a savings account known as a treasury instead of dollars in a checking account earning nothing. If they move their dollars from savings to checking, they get no interest earnings on their dollars, just like you would at your bank. The primary dealer bank that holds their US bank account for them would then have excess reserves and buy treasuries with them, and so the interest income would go to the primary dealer bank where the Chinese have their bank account. The interest income would go into the private domestic sector via the interest on excess reserves or interest on treasury deposits bank income channel and is a positive for the private domestic sector as it stops becoming external income and instead becomes private sector domestic income.
No sensible country with knowledge of reserve banking would choose to hold their dollar export earnings in cash rather than interest-earning Treasuries.
There would be no sudden interest rate change. The Fed's mandate is to maintain its Federal Funds target Rate [FFR] by buying and selling Treasury bonds. If the Chinese exited Treasuries, the excess liquidity would be immediately mopped up with a bond sale to whichever bank held the excess cash. If the Fed did not do this, the excess bank reserves sitting in the banking system would push the interest down below target.
There would be no exchange rate implications as the number of dollars and treasuries on issue remain the same. All that happens is a portfolio swap - paper assets for cash.
The most likely thing to happen from the Chinese, or any other primary holder of US Treasuries, exiting their Treasury holdings would be a brief market panic brought about by news headlines informing the public of the event and drawing the wrong conclusions from it and adding to the fear and misinformation.
So it is not going to happen and if it does it does not matter.
The worst thing that can happen is that the rest of the world decides to no longer send real goods and services to the US in exchange for dollar credits on the Fed's computer. Then we will have to make them ourselves.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.