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CHINA is learning the old banking adage the hard way: 'If I owe you $10,000, I lose sleep at night. If I owe you $10 million, you lose sleep at night.'
Beijing is being kept awake by IOUs worth a staggering US$800 billion (S$1.1 trillion) - and growing. The United States knows this well - and it is trying its best to reassure China. Last Wednesday, the US Federal Reserve offered a standard operating procedure to help China sleep a little better - the sale of more inflation-protected bonds.
This should soothe China, which had been clamouring for bonds offering protection against inflation - a key risk factor that could cause the value of its US$800 billion of US Treasuries to drop.
As the US' largest creditor, China is stuck in a co-dependent relationship. It may want to get out of America's debt trap, but is unable to do so. Instead, it finds it has to keep buying US Treasuries in order to keep the US economy - and its own - out of trouble. China is forced to stay put in what Harvard University professor Niall Ferguson has likened to 'a marriage on the rocks', between a spendthrift America and avid saver China.
During the boom years, the marriage worked fine, observed Prof Ferguson in a recent newspaper interview. America did the spending, importing and borrowing; China did the saving, exporting and lending. But the arrangement fell apart when the global financial crisis hit.
Now, Beijing is getting ready for a separation, amid criticism at home that it is being 'held hostage by the US' for its excessive holdings of US-dollar assets, noted Beijing finance academic Gao Jie.
The problem is Beijing does not appear to have any clear exit strategy mapped out yet.
'Even trying to cut down Treasury bond holdings is easy to say, hard to do. A long-term strategy and set of (investment) principles are needed first,' said Prof Gao.
Chinese analysts have characterised Beijing's recent moves - such as seeking to buy more inflation-linked bonds - as stop-gap measures to lower the risk of potential losses of its US-dollar assets.
Beijing's anxiety about this issue was high on the agenda at last month's talks between the two countries. Chinese officials gave the Obama administration an earful about its whopping US$1.85 trillion fiscal deficit. Even after the current downturn is over, the annual US fiscal deficit is likely to remain high at about US$500 billion for the next 10 years.
China fears that this red ink may trigger a depreciation of the US dollar, which will cause the value of its US-dollar assets to fall.
Or inflation may rise, as the Fed prints more money to finance the massive fiscal deficits. This would cause Treasury bond yields to rise and their prices to fall - and again affect the value of China's holdings.
To address this risk, Beijing has recently shifted from longer-term bonds - with maturities of 20 years or more - to short-term bills of one year or less. Of the US$38 billion rise in China's Treasury holdings in May, US$34 billion reportedly went to short-term bills.
Shifting to inflation-linked bonds - which the US Fed plans to gradually issue more of next year - is also on the cards.
The fact remains that China has 'little choice' but to keep buying bonds to help the US finance its economic stimulus measures, said Professor Qiu Zhaoxiang of the University of International Business and Economics in Beijing.
A weak American economy would dampen China's own growth, while a depreciating greenback would make its exports more expensive. This would in turn take an even bigger toll on Chinese firms, pushing up job losses and social instability - a nightmare scenario for Beijing.
In order to prevent the yuan from rising against the US dollar, China has continued to intervene in money markets to sponge up US dollars, causing its reserves to shoot up to a record US$2.13 trillion in June.
'It is now looking to diversify the investments in which it holds these reserves - such as gold, commodities and other resources abroad,' said finance professor Mei Jun of Renmin University.
In May, China unexpectedly broke a six-year silence to disclose that it had been buying gold from domestic producers, building up its reserves to 1,054 tons, up from 600 tons in 2003.
And last month, Premier Wen Jiabao told Chinese diplomats that the country will use its reserves to accelerate overseas expansion by local companies.
Once the go-ahead is given, China moves fast. A slew of new measures has been released - including a new rule allowing companies to purchase foreign exchange more easily in order to fund their foreign acquisitions, starting from Aug 1.
The move to speed up this corporate 'going out' strategy has already raised concern in countries whose resources and companies are the acquisition targets of China Inc. But it has pleased the home crowd, which has long railed against Beijing's use of the reserves to help foreigners instead of its own people.
Last week, China was conspicuously absent in two Treasury bond auctions. This sparked alarm that the US may be hard-pressed to find enough buyers for its new debt. But for now, the US can take heart in the comments of China's central bank economist Wang Yong last month.
In an article printed in the state media, he wrote that China should 'moderately' increase its holdings of US Treasuries this year, and trim its assets once the American economy recovers from recession.
But what happens after that? Will China tire of its sleepless nights and slash its holdings of US bonds?
Analysts can only respond with more questions. 'We come back to the same problem: China has way too much in Treasury bonds. Even if it wants to exit, where is the exit route?' asked Prof Qiu.
Additional reporting by Carol Feng
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