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UPDATE 1-US-Sino tensions "dangerous game," U.S. panel told

* China might aggressively sell US assets if provoked

* Caution needed on both sides to avoid damaging trade war

* China hides some U.S. bond buys - Heritage expert

* Says China’s huge need locks it into U.S. bond market

(Adds former IMF economist comment on China currency)

By Doug Palmer

WASHINGTON, Feb 25 (Reuters) - China’s belief it now has the upper hand in the global economy creates a risky dynamic that makes it urgent the United States cut its mammoth debt, a former International Monetary Fund official said on Thursday.

At issue is China’s vast holdings of U.S. Treasuries. There are growing concerns China could wield its position as one of the country’s biggest creditors as a club against U.S. policy.

The United States’ huge budget deficit, which has ballooned due to government bailouts of financial firms and economic stimulus, makes the country dependent on maintaining the appetite of big investors like China for Treasuries.

“In fact, the bargaining strengths of the two countries are finely balanced. But the changing perceptions set up a dangerous game of chicken that could spin out of control,” Eswar Prasad, former head of the IMF’s China Division and now senior professor of trade policy at Cornell University, told the U.S.-China Economic and Security Review Commission, a U.S. government watchdog panel.

The panel’s hearing follows a Chinese military officer’s suggestion earlier this month that Beijing “dump” some U.S. bonds to retaliate against Washington’s decision to sell $6.4 billion worth of arms to Taiwan, which China considers a renegade province.

The threat, along with recent U.S. data that suggested China had scaled back purchases of U.S. Treasuries, added to concerns Beijing could use its growing economic clout to lash out at the United States over policy spats.

Prasad, also senior fellow at the Brookings Institution, told the panel in prepared remarks that China could not shift aggressively out of U.S.-dollar denominated assets without imposing some costs on itself.

But “China might well view these costs as worth bearing in order to preserve national sovereignty or if trade and other economic disputes with the U.S. come to a head,” he said.

CONFRONTATION RISKS

China’s holdings of U.S. Treasuries fell in December to $755.4 billion, according to the Treasury Department, causing it to drop behind Japan as the biggest holder of U.S. government debt.

The United States needs to reduce its vulnerability by cutting its budget deficit and rising public debt or it “will face a worsening balance of power in its relationship with China,” Prasad said.

The United States should be more assertive in standing up to Beijing on economic and political concerns, including human rights. It should work with developing countries to put pressure on China to raise the value of its currency, he said.

Washington must do this while building trust with Chinese leaders so low-level trade disputes don’t spin out of control.

“Pandering to domestic constituencies could lock the two nations into a cycle of confrontation,” Prasad said.

But Simon Johnson, a senior fellow at the Peterson Institute for International Economics, told the panel the United States should call China’s bluff on its threat to sell U.S. Treasuries. He said Washington should formally declare Beijing a currency manipulator in a report due to go to Congress on April 15.

“China is obviously a currency manipulator and should be so labeled by the US Treasury,” said Johnson, a former IMF chief economist. “China’s threat to react by selling Treasuries is ... at worst a bluff and at best a way to help the US with a depreciation of the dollar. This bluff should be called.”

HIDDEN PURCHASES

Also addressing the panel, Derek Scissors, a China specialist at the Heritage Foundation, said the U.S. government needed much better information on the extent of Chinese holdings of U.S. Treasury bonds.

Scissors said he did not believe the recent U.S. data that Chinese holdings of U.S. Treasuries dropped in December and barely budged in 2009, even though the U.S. federal deficit soared to $1.4 trillion.

“It is all but certain” that a doubling of U.S. bond purchases reported for Hong Kong and Britain were made by China’s State Administration of Foreign Exchange through its agents in both places, Scissors said.

China has a number of reasons for hiding its purchases of U.S. bonds. They include domestic criticism for wasting the people’s money in low-return investments and public outrage that it is somehow subsidizing the United States, he said.

“Due to many kinds of mercantilist policies, China runs by far the world’s largest balance of payments surpluses. These cannot be spent at home and are too large to put anywhere other than the United States. No other country has financial markets capable of absorbing them,” Scissors said.

“The PRC does not buy for leverage and does not sell for leverage. It does not act for any other reason than to recycle domestically unusable funds stemming from its currency peg and closed capital account,” he said. (Editing by Andrew Hay)

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