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Yesterday, a day when the schizophrenic market's anti-psychotics finally kicked in, the scariest piece of news did not come out until very late, and this one has the potential to really throw the Treasury a curveball. Yu Yongding (cruel, cruel parents), former advisor to China's Central Bank is agitating China to seek guarantees on its $682 billion of U.S. Treasury Holdings, so that these do not get eroded by "reckless policies."

Bloomberg had the following to say:

"The U.S. should make the Chinese feel confident that the value of the assets at least will not be eroded in a significant way,” Yu, who now heads the World Economics and Politics Institute at the Chinese Academy of Social Sciences, said in response to e-mailed questions yesterday from Beijing. He declined to elaborate on the assurances needed by China, the biggest foreign holder of U.S. government debt.

In [upcoming] talks with Secretary of State Hillary Clinton, China will ask for a guarantee that the U.S. will support the dollar’s exchange rate and make sure China’s dollar-denominated assets are safe, [and that this] would be one of the prerequisites for more purchases.”

“The government will be a net buyer of Treasuries in the short-term because there’s no sign they have changed their strategy,” said Zhang Ming, secretary general of international finance research center at the Chinese Academy of Social Sciences in Beijing. “But personally, I don’t think we should increase holdings because the medium- and long-term risks are quite high.”

While China may be posturing after suffering $5 billion in losses on its $10.5 billion investments in Blackstone (BX), Morgan Stanley (MS) and TPG, this is a very serious threat. Granted, China does not have many options of where to invest its surplus cash, although refocusing on its own economy and expanding its fiscal assistance policies (a la what the U.S. is doing) is an option, thereby making it less of a sure investor in U.S. debt. Yu further confirms this threat:

A decline in reserves “isn’t likely because of China’s huge twin surpluses,” Yu said. China “should diversify its reserves away from U.S. Treasuries if the value of China’s foreign-exchange reserves is in danger of being inflated away by the U.S. government’s pump-priming,” he said.

Although this is most likely a preamble to a diplomatic escalation arising from Geithner's initial claims about currency manipulation by China, the threat that the U.S. may lose its largest foreign debt purchaser should be enough to make people in the administration very worried. China is currently in a position of strength relative to the U.S., and only an altruistic desire to cooperate from a game theory p.o.v. will prevent a huge blow to the U.S. economy (which would of course impact China as well).

In all likelihood, China is reminding the U.S. that it is no longer the big dog in the economic playground and that wisecracks like Geithner's, or a neo-unilateralist economic policy will no longer be tolerated.

Source: China to Ask for U.S. Treasury Guarantees