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Analysis: U.S., China Relations Already Strained

China recently surpassed Japan as the U.S. government's largest creditor; any decision by Beijing to move its money would deal a dizzying blow to an already tottering American economy.

WASHINGTON (AP) -- China recently surpassed Japan as the U.S. government's largest creditor. Any decision by Beijing to move its money would deal a dizzying new blow to an already tottering American economy. Yet relations between China and the new Obama administration are off to a rocky start.

For now, Beijing continues to loan Washington money by buying Treasurys and other U.S. government securities, helping to finance the ever-growing U.S. budget deficit. But there are signs its leaders may be considering trimming these holdings as that country experiences its own economic slowdown. Strains between the two economic powerhouses seem to be growing with the change in administrations.

The latest irritants are a "buy American" provision attached to White House-backed stimulus legislation moving through Congress and criticism of China's currency policies by Vice President Joe Biden and Treasury Secretary Timothy Geithner.

Geithner accused Beijing of "manipulating" its currency during his Senate confirmation process.

Biden, interviewed Thursday by CNBC, said that the Obama administration would "say to China -- which occasionally the last administration was reluctant to do -- 'You're a major player on the world scene economically, and you've got to play by the rules that everybody else plays by.'"

Their comments followed a move by Chinese censors to silence part of a live broadcast of Obama's inaugural address when he spoke of the U.S. struggle against communism.

And at an economic forum in Switzerland on Wednesday, Chinese Premier Wen Jiabao blamed China's economic woes on U.S.-led Western financial institutions, suggesting "a lack of self-discipline" and "blind pursuit of profit."

The pointed words from Geithner and Biden were widely seen as an escalation of old complaints that China artificially depresses the value of its currency to bolster its exports, even though the White House has sought to play down such comments and has denied increasing friction with China.

China has allowed the value of its currency to rise by 21 percent over the past two years. But American manufacturers complain the Chinese yuan is still significantly undervalued, making Chinese goods cheaper for U.S. consumers and American products more expensive in China.

China holds roughly $2 trillion in foreign exchange reserves and surpassed Japan in September as the biggest foreign holder of Treasurys. It also has the largest single-country trade deficit with the United States -- totaling $246.5 billion in 2008 through November.

With the Federal Reserve holding short-term interest rates at near zero and suggesting it may start buying longer-term U.S. securities to help drive down home mortgage rates, U.S. government securities are becoming increasingly less attractive to foreign investors.

Washington needs a continued flow of loans to help it claw its way out of the worst financial crisis since the early 1980s, perhaps since the Great Depression.

Much of this demand is being met by China, Japan, Britain and Arab oil-exporting nations. Of those sources of money, China is not only the biggest lender but perhaps the least predictable.

It has been hard hit by losses in U.S. holdings it thought were conservative low-risk investments. They include large positions in mortgage giants Fannie Mae and Freddie Mac, investment bank Morgan Stanley and in the troubled Reserve Primary Fund.

Analysts say the economic downturn in China has led leaders to put their top emphasis on protecting the domestic economy, including establishing a $586 billion stimulus plan to build new railroads, bridges and dams. China has already begun paring back its holdings in Fannie and Freddie bonds and is keeping tighter controls on its stash of Treasurys.

Efforts in Congress to attach a buy American provision to its $800 billion-plus stimulus measure threatens to further aggravate U.S.-Chinese relations.

The $819 billion stimulus bill passed by the House on Wednesday includes a provision that requires iron and steel used in public works construction projects to be from the United States. Even more stringent language requiring U.S. products and materials in all stimulus-funded projects is expected to be debated in the Senate.

President Barack Obama said Friday that a 3.8 percent shrinkage in the nation's gross domestic product in the final three months of 2008 shows the recession is deepening. He said he was pleased the House passed the stimulus package and "I hope we can strengthen it further in the Senate." He did not mention the controversial buy-American provision.

Despite its trade deficit with countries like China, U.S. exports last year were one of the few bright spots of a dire U.S. economic picture.

Trade restrictions have a history of inviting tit-for-tat retaliatory trade penalties on U.S. goods, and many economists and historians blame protectionist measures adopted in the 1930s for deepening and prolonging the Great Depression.

"Buy American provisions will no doubt inspire similar trade barriers abroad and will have the same effect of reducing global trade and therefore prospects for economic recovery," said Daniel J. Ikenson, a trade analyst with the libertarian-leaning Cato Institute think tank.

Steven Schrage, an international business analyst at the Center for Strategic and International Studies, said the exchange of sharp words between Beijing and Washington "is very disturbing. We're going to have to watch it very carefully."

Still, Schrage said he thinks it unlikely that China would pull its money out of U.S. investments because right now "we're still seen as somewhat of a safer bet than anywhere else in the world. It doesn't mean that the U.S. is doing well; it just means that there are not a lot of other options out there."

EDITOR'S NOTE -- Tom Raum has covered Washington for The Associated Press since 1973, frequently reporting on the economy.

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