The dollar bomb

According to The Telegraph of August 8, China could liquidate its vast holdings of U.S. treasuries if Washington imposes trade sanctions to force a yuan revaluation. (The Telegraph: “China threatens 'nuclear option' of dollar sales”)

Perhaps without too much exaggeration this is called the dollar “nuclear option”. Indeed, Beijing has gained a lot of leverage over the U.S. economy. It is holding huge amounts of U.S. treasuries. If it sells them, the dollar will certainly crash and the U.S. economy will descend into a severe recession.

But is such a scenario realistic? The Chinese government immediately denied that such plans exist. It reiterated that it is a responsible investor in the international capital markets and that it wouldn't take such reckless actions as suddenly selling dollar assets. So first of all, the Chinese government does not have the intention – at least for now. But if for example the U.S. would interfere in a conflict over Taiwan, China might also use economic weapons to coerce the U.S. to back off.

But there is a more fundamental problem. China cannot threaten to sell, because if it does, the value of its dollar assets will immediately start to plummet. The same will happen if it starts to sell them suddenly in significant quantities. Yes, China can bring the dollar down, but it would pay a high financial price. The question is, would it be worth it? Almost certainly not – in a non-war scenario.

If you drop a frog into a pot of boiling water, it will try to jump out. If you put it in cold water and slowly raise the temperature, it will boil before thinking of jumping out. China may opt to slowly sell dollar assets and diversify its foreign exchange holdings. That way, it will not lose too much by selling and the dollar will continue its downward slide. Before the U.S. knows it, the yuan will have become an important international reserve currency.

China isn't stupid. A dollar bomb doesn't work.