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The Three Ways China Can Go

By William Patalon III
And Jason Simpkins
Money Morning Editors

Although there’s a veritable laundry list of obstacles that could blunt the U.S. government’s ongoing economic turnaround efforts, its single-biggest challenge may come from its single-biggest creditor – China.

When China announced a new array of stimulus measures earlier this month, this very important plan was overshadowed by China Premier Wen Jiabao’s concerns about the United States’ quickly growing debt load.

“We have lent a huge amount of money to the United States,” Premier Wen said. “Of course we are concerned about the safety of our assets. To be honest, I am definitely a little bit worried. I request the U.S. to maintain its good credit, to honor its promises and to guarantee the safety of China’s assets.”

China has cause to be concerned: As of December, the most recent figures available, China held $727.4 billion in Treasuries – about 26% more than the $578 billion in U.S. government securities the Asian giant held at the end of 2007. More than half of China’s nearly $2 trillion in foreign currency reserves are tied up in U.S. Treasuries and notes issued by other affiliated agencies of the U.S. government – including beleaguered mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE).

However, the value of U.S. Treasuries has dropped steadily since the government began selling record amounts of debt to finance its economic stimulus packages. Investors have lost an average of 2.7% in 2009, according to Merrill Lynch & Co. Inc.’s U.S. Treasury Master Index.

China’s leaders “are worried about forever-rising deficits, which may devalue Treasuries by pushing interest rates higher,” JP Morgan & Co. (JPM) analyst Frank Gong told The Associated Press. “Inside China there has been a lot of debate about whether they should continue to buy Treasuries.”

And as the U.S. debt soars as the government works to halt the worst financial crisis since the Great Depression, China’s concerns about this country’s growing deficits – and its creditworthiness – are escalating in kind.

Depending upon how it did so, were China to stop buying U.S. debt – or even worse, to start dumping it – the economic fallout could be widespread, and perhaps even catastrophic:

* The U.S. dollar would drop 15%-20%.
* U.S. stocks would get hammered.
* Inflation would spike and interest rates on Treasuries would jump into the 8% range.
* And the economy would end up flat on its back – where it would stay, with no rebound on the horizon.

Detailing the Deficit

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