McCain's China-free debt plan seen unrealistic

NEW YORK (Reuters) - Suggestions by presidential candidate John McCain that the United States should not count on China to finance its debt are unrealistic and would trigger a Treasuries sell-off, undermining the dollar, analysts say.

The dependence of the world's biggest economy on foreign nations to fund its huge budget and current account deficits has become a campaign point in the 2008 presidential race.

Republican candidate McCain told Reuters in an interview on Thursday that "the first step that has to be taken is obviously we have to stop mortgaging our economy to China ... and asking them to finance our debt".

He did not give specifics on how this would be achieved.

McCain's remarks came a day before the U.S. Treasury won approval from Congress to spend $700 billion to remove illiquid mortgage assets from financial institutions, a plan that would be funded by issuances of more paper in the market -- presumably bought by China and other foreign investors.

Analysts were dismissive of McCain's suggestion and warned it would cause dislocation in U.S. financial markets.

"If we really did want to change that, we would need to make fundamental changes on the economy and stop generating a trade deficit. There is no simple solution for that," said Ward McCarthy, managing director with Stone & McCarthy Research Associates, in Princeton, New Jersey.

"On a short-term basis, (Chinese demand for bonds) is a blessing because our interest rates would be a lot higher than they are now if we didn't have overseas investors, including China, buying our various forms of debt."

China is the second-largest holder of U.S. Treasury debt after Japan. An estimated one-third of the U.S. trade deficit is with mainland China, analysts said.

CHINA SNAPPING UP U.S. TREASURIES

China's managed foreign exchange system means it is adding about $2 billion every trading day to its reserves. These funds end up invested in U.S. assets such as government bonds, agency and mortgage securities.

The United States's current account deficit was around $183.1 billion in the second quarter, about 5.1 percent of gross domestic product.

For the first 11 months of the 2008 fiscal year ended September 30, the government's budget deficit was at $483.35 billion.

If China stopped buying U.S. Treasury securities and bought more European government bonds instead, that would exert downward pressure on the dollar.

Furthermore, liquidation of U.S. government bonds would cause a spike in yields and push up borrowing costs, inflicting more damage on an economy that is on the brink of a recession.

"McCain's comments suggest support for American jobs and certainly as non-farm payrolls continue to show deterioration in the labor market, that's an expected stance to take," said Michael Woolfolk, senior currency strategist at the Bank of New York Mellon in New York.

"Unfortunately, the reality of the relationship with China is that most of the jobs that are bound for China have a already left for China."

One analyst saw some merit in McCain's suggestion, but acknowledged it would not work in the short term.

"Both Senators McCain and (Democratic candidate) Barack Obama have made a similar point. They are right. We need to rely less on China for finance," said Brad Setser, fellow for geoeconomics at the Center on Foreign Relations in New York.

"That means running a smaller trade deficit and that requires some adjustment in the dollar and some adjustment to spending relative to income in the United States. Ideally, this is what needed to be done several years ago."

Sester said a U.S. recession could bring the income and expenditure adjustment sooner than expected. That would narrow the trade deficit with China, leaving it with fewer dollars to plow back into U.S. debt.

(Editing by Dan Grebler)