China runs a managed floating exchange rate of its yuan vis-à-vis a basket of foreign currencies. The U.S. dollar forms a large component of the basket. In order to keep the yuan in line with the basket, Chinese authorities must have dollars. According to the U.S. Treasury, China held $1.1 trillion in Treasuries as of March 31, the majority of which were held as reserves to collateralize trade and to capitalize China’s highly leveraged banking system.
For the sake of argument, let’s assume that Beijing exercises the nuclear option: China abruptly sells all its Treasuries and converts the proceeds into another asset such as gold or government bonds from another country. How might the nuclear option play out? By irradiating China.
If the yuan came under pressure and needed support, Chinese authorities would need to intervene in the currency market by selling dollars, but to do so, they must first buy dollars from the sale of these other assets. This creates several problems.
In the case of holdings in foreign government bonds, the Chinese would need to sell the bonds, then translate the foreign currency into dollars. This could put further upward pressure on the greenback versus the yuan.
A yuan depreciation spiral could be just the start of China’s problems. The selling of the foreign assets, absent increased demand for them, would impair their value. This could create a feedback loop whereby foreign investors would sell the same assets. Such a decline in value of China’s reserve assets would raise doubts about the value of the country’s remaining reserve stock.
Meanwhile, the U.S. would not sit on its hands in the event of pricing dislocations of the Treasury market. The Federal Reserve would likely buy up Treasuries in another round of quantitative easing (QE), just as it did in response to the 2008 financial crisis. During its recent effort to reverse QE, the Fed has already shed $600 billion from its balance sheet. Jerome Powell no doubt would be loath to resume QE-sized asset purchases, but the Fed has the capacity to do so.
A sell-off would tighten financial conditions, which would put downward pressure on global risk markets. That includes Chinese assets and ultimately the yuan. To stem yuan depreciation, China would be compelled to allow domestic interest rates to rise. The higher borrowing costs would reduce credit availability and slow economic activity. Those headwinds would come at a time when Beijing is trying to prop up domestic employment and attract foreign investment.
In short, Beijing has no nuclear option in the Treasury market. Let’s return to a realistic assessment of China’s reserve requirements.