China Says "No More Bullying"

The Chinese government has hinted that it may liquidate its vast holding of US Treasury bonds if Washington imposes trade sanctions to force a yuan revaluation. Henry Paulson, the US Treasury secretary, met with Chinese president Hu Jintao in Beijing last week. Two Chinese officials at leading Communist Party bodies have given interviews in recent days warning, for the first time, that Beijing may use its US$1,330bn of foreign reserves as a political weapon to counter pressure from the US Congress. Shifts in Chinese policy are often announced through key think tanks and academies. Described as China's "nuclear option" in the state media, such action could trigger a dollar crash at a time when the US currency is breaking down through historic support levels. This comes at a time when it looks like the bill looks to passed soon which would allow US to put trade sanctions against China goods. After being told, cajoled, pestered by US officials on how to run their Chinese economy - Beijng is basically saying enough is enough, if you are going to hurt my economy, I am going to hurt yours. Of course a selldown won't benefit anyone, its like cutting off the enemy's two legs after having your arm chopped off by the enemy.

Just the hint of a selldown could send US bond yields further up, probably destroyng the US housing market, sending the US ecnomy into recession, and exert a substantial correction in the US dollar (10%-20%). Can you imagine the repercussions? It is estimated that China holds more than US$900bn in a mix of US bonds. Xia Bin, finance chief at China's Development Research Centre (which has cabinet rank), kicked off what appears to be government policy, with a comment last week that Beijing's foreign reserves should be used as a "bargaining chip" in talks with the US. "Of course, China doesn't want any undesirable phenomenon in the global financial order," he said. He Fan, an official at the Chinese Academy of Social Sciences, went further yesterday, letting it be known that Beijing had the power to set off a dollar collapse, if it chose to do so. "China has accumulated a large sum of US dollars. Such a big sum, of which a considerable portion is in US Treasury bonds, contributes a great deal to maintaining the position of the dollar as a reserve currency," he told China Daily.

Already Russia, Switzerland and several other countries have reduced their dollar holdings. China is unlikely to follow suit as long as the yuan's exchange rate is stable against the dollar. The Chinese strategy is shrewd and basically gave Americans a strong reminder that the US and China economies are tied closer than you previously thought posible.

The yuan has appreciated 9pc against the dollar over the last two years under a crawling peg but it has failed to halt the rise of China's trade surplus, which reached US$26.9bn in June. Henry Paulson, the US Treasury secretary, said any such sanctions would undermine US authority and "could trigger a global cycle of protectionist legislation".

Despite all the talk, nothing much is likely to happen, but the pendulum has shifted to favour Beijing which will basically cause the Americans to give China more leeway and latitude to move the yuan stronger on China's terms.