China owns more U.S. Treasury securities than anyone but the U.S. government itself. So when China’s foreign exchange reserves — after piling up steadily, year after year, to an astounding $4 trillion — fell by $153 billion in the second half of 2014, some people grew worried. They fear that if China starts selling off U.S. Treasuries, the market for them could collapse, driving U.S. interest rates up and the nation into a recession.
These fears are misplaced. To the contrary, China drawing down its reserves won’t tank the Treasury market, and is actually very positive for the American economy.
That might seem counterintuitive — after all, if China sells Treasuries, you would think their price should go down (and their yield up), since so much demand will drop out of the market. But it depends on what happens to the proceeds. If I sell a Treasury bond and use the money to buy a house, and the homeowner uses that money to buy a Treasury bond, basically we’ve just done an asset swap. Demand for Treasuries and houses remains the same, as do prices. On the other hand, if the homeowner goes and buys another house, preferences have actually shifted, and the price of Treasury bonds will fall. The point is, you can’t just look at one side of the equation, as though the dollars China receives from selling Treasury bonds just disappear.
Read Full Article HERE