China's Treasury "Nuclear Option": Bluff or Reality?

If China were to sell its $761 billion in U.S. Treasury bonds, the immediate effects would be higher U.S. Treasury yields, which would rise by 30 to 60 basis points, raising the borrowing cost and cutting economic growth. The U.S. dollar will also weaken because of the instant increase in dollars in the marketplace, which will spur exports but increase import bills and even incite inflation. This action will most likely be accompanied by a significant degree of financial market turmoil, affecting the prices of shares and investor sentiments.

But a complete sell-off cannot be expected on account of economic interdependence between the U.S. and China. China relies on exports to the U.S., and an enormous sell-off of Treasury bonds will decrease the value of the rest of its holdings and make fewer Chinese products demandable. The U.S. Federal Reserve also has an intervention mechanism available that can tranquilize markets by altering monetary policy or buying Treasuries, thereby decreasing China's short-term impact.

China has been methodically unwinding its U.S. Treasury holdings in order to cut back on reliance on US financial instruments and promote "de-dollarization". Although there is potential for financial instability, the mutual economic harm and the risk of Federal Reserve intervention stop a precipitous, complete sell-off from occurring. Instead, China's methodical unwinding is a sign of a long-term policy of diversification of its financial assets