Currencies stay within their currency zone. Transactions denominated in dollars, euros, rubles, etc. transpire within that currency zone, where prices are denominated in that currency.
If someone holding dollars, for example, wants to participate in another zone, they exchange the dollars for that currency. The buyer of the dollars holds them and has the option of saving them or using them for purchases in the dollar zone, or eventually exchanging them for another currency. Foreigners don't "bring dollars home."
To use funds across currency zones it it necessary to exchange one currency for another, e.g., exchanging euros to obtain dollars in order to operate in the dollar zone, or vice versa. The world is running on a nonconvertible floating rate monetary regime. Currencies in demand are higher in value relative to currencies less in demand. This determines rates. Relative demand for currencies fluctuates based on a variety of factors. FX trading is about getting handle on this. Don't try this at home unless you are an expert. There are a lot of knives in the air.
The foreign exchange market is a huge market that is highly liquid, and all transactions clear easily with minimal volatility, unless there is a currency crisis, which is a relatively rare occurrence. Currency stability and exchange liquidity are required for international trade, so it is in the interest of nations to keep their currencies stable. This leads to the need for countries to maintain adequate foreign reserves to defend their currencies against excessive volatility, which would disrupt trade and ultimately the country's finances. Countries also use foreign reserves to neutralize inflation that might result from a strong net export position.
For example, one reason that China saves the dollars it receives from export sales is that it doesn’t want them exchanged for yuan for use in the Chinese economy, which they fear would drive up inflation at home. See Michael Pettis, What the PBoC Cannot Do With Its Reserves. While some of the dollars China gained from trade in the dollar zone are used to purchase goods and assets in the dollar zone while others are exchanged for use in other currency zones, most are saved at interest in US Treasury securities for future use, saving being defined as postponed consumption.
Whatever China decides to do with its dollars eventually, they will stay in the dollars zone and be saved or spent in the dollar zone by either China or someone else. There is a lot of fretting over what China may do with its dollars and very little talk of what the options actually are. Whatever China does eventually, the dollars will stay in the dollar zone one way or another.
Reserves currencies are currencies used for holding foreign reserves and to denominate international prices in global trade, e.g., oil is priced in US dollars. The dollar being the world’s reserve currency creates an incentive for holding it, but this advantage is relatively slight owing to floating rates and liquid exchange markets. There are also disadvantages to being the issuer of the reserve currency. The reserve currency is in demand and the issuer has to insure that enough is available. This may mean taking other matters into account in addition to national interests as a global leader.
Other countries save dollars as the reserve currency to build foreign reserves to manage and protect their own currencies in exchange markets. When China decides to abandon its peg, as it must do if it wants the renminbi to become a global currency, it will need foreign reserves to manage and defend it. Other Asian countries save strong and stable currencies as foreign reserves, after having gotten burned in the Asian financial crisis of '97-'98. Most Asians countries are US dollar savers presently for this reason.
Uses of Foreign Currency
When a country receives foreign currency from a trade surplus, it can use it to 1) buy goods in the currency zone of the currencies of the surplus, or 2) purchase assets denominated in those currencies, or 3) save it for later use, or else 4) exchange one currency for another currency, either for use or in defense of one's own currency. Of course, after exchanging one currency for another one just switches the same options 1-3 with someone else. Someone exchanging euros for dollars as these options in dollars, and the counterparty has them in euros. All that changes is the players. Of course, the relative demand for exchange affects floating rates.
What the US Owes China
Let's take China as an example, since China's holding of US Treasuries is a current topic of interest. Chinese companies sold goods to the US. Instead of promptly purchasing goods in exchange, China presently is saving in dollars, which is tantamount to "deferring consumption," that is, preferring to postpone making any decision to purchase goods or assets denominated in dollars, or, alternatively, to exchange dollars for another currency.
What the US "owes" China is represented by the claims on ownership of US goods or assets in exchange of goods already provided. In other words, instead of a direct exchange, China has postponed use of dollars gains from export sales, preferring instead to save them at interest in U. S. government securities rather than hold them in its deposit account at the Fed. China provided real resources to the US for dollars, and the dollars represent financial claims on US real resources. China can exercise those claims when it wishes. That's just how trade works.
What Happens Behind the Veil
When China desires to use the dollars instead of saving them, the Fed will simply mark up China's reserve account and mark down its securities account. It's just a switch in asset composition in accordance with China's current portfolio preference. What began as an increase in China's deposit account (reserve account at the Fed) due to sales of exports was subsequently switched into a time account (Treasury securities) and then switched back into China's deposit account for use as desired.
This is simply a matter of changing asset composition from zero maturity to non-zero maturity (higher interest) back to zero maturity. Really nothing to see here, let alone get worked up about. China is not controlling US policy or holding the US hostage because it is saving its trade surplus with the US in US Treasuries. Or if it is, then the people in charge of US policy are dolts and don't understand what is actually happening.
MMT's description of monetary operations makes clear that China is not funding the US by purchasing US Treasury securities. As the issuer of its own currency, the US funds itself without needing to tax or borrow to do so. Rather, China is saving its trade surplus with the US, through which it earned US dollars, in order to postpone future consumption.
When China no longer desires to save in dollars, it may choose to spend in dollars in the dollar zone, or exchange dollars for some other currency to spend in another currency zone, or exchange dollars for yuan and repatriate the yuan. For example, China might use some of its dollars to purchase oil for its own use. In that case, someone else has the dollars, and they stay in the dollar zone. Saudi Arabia might receive the dollars and decide to spend them to add to its military capability by purchasing fighters from a US manufacturer, or to save them as Treasuries for future use.
Balance of Payments
Changes in the balance of payments result in changes of foreign claims on real resources owned by the country of issue. The US is the largest recipient of foreign direct investment. Not all of it is welcome. For example, when Dubai desired to exchange some of the dollars accumulated from US oil purchases for US real assets, namely ports, there was strong opposition. China has also been shut out of deals deemed unfavorable to US national interest. Similarly, when Japan bought Rockefeller Center in the '80's from proceeds from exports to the US, many Americans complained that foreigners were taking over. People are happy to enjoy the benefits of imports, but they they are shocked when foreigners exchange them for assets, or now, save them as Treasury securities.
Countries can control the distribution of foreign ownership of real resources by restricting purchases of certain assets or asset classes. The US has prevented China from acquiring assets that the US deems vital to national interest. However, restrictions placed on use of a country's currency by foreigners may lessen foreign demand for the currency and may affect trade relationships. Free markets, free trade and free capital flow exist within limits.
This is my first post here. Thanks to Mike for the opportunity to share. This post is cobbled together from pieces of comments posted elsewhere, so if some of it sounds familiar that's why.
— Tom Hickey