A lot of play has been given to the article “China threatens ‘nuclear option’ of dollar sales“.

The Chinese government has begun a concerted campaign of economic threats against the United States, hinting that it may liquidate its vast holding of US treasuries if Washington imposes trade sanctions to force a yuan revaluation.

Two officials at leading Communist Party bodies have given interviews in recent days warning – for the first time – that Beijing may use its $1.33 trillion (£658bn) of foreign reserves as a political weapon to counter pressure from the US Congress. Shifts in Chinese policy are often announced through key think tanks and academies.

Described as China’s “nuclear option” in the state media, such action could trigger a dollar crash at a time when the US currency is already breaking down through historic support levels.

It would also cause a spike in US bond yields, hammering the US housing market and perhaps tipping the economy into recession. It is estimated that China holds over $900bn in a mix of US bonds.

He Fan, an official at the Chinese Academy of Social Sciences, went even further today, letting it be known that Beijing had the power to set off a dollar collapse if it choose to do so.

“China has accumulated a large sum of US dollars. Such a big sum, of which a considerable portion is in US treasury bonds, contributes a great deal to maintaining the position of the dollar as a reserve currency. Russia, Switzerland, and several other countries have reduced the their dollar holdings.

“China is unlikely to follow suit as long as the yuan’s exchange rate is stable against the dollar. The Chinese central bank will be forced to sell dollars once the yuan appreciated dramatically, which might lead to a mass depreciation of the dollar,” he told China Daily.

Simon Derrick, a currency strategist at the Bank of New York Mellon, said the comments were a message to the US Senate as Capitol Hill prepares legislation for the Autumn session.

“The words are alarming and unambiguous. This carries a clear political threat and could have very serious consequences at a time when the credit markets are already afraid of contagion from the subprime troubles,” he said.

A bill drafted by a group of US senators, and backed by the Senate Finance Committee, calls for trade tariffs against Chinese goods as retaliation for alleged currency manipulation.

The yuan has appreciated 9pc against the dollar over the last two years under a crawling peg but it has failed to halt the rise of China’s trade surplus, which reached $26.9bn in June.

Henry Paulson, the US Treasury Secretary, said any such sanctions would undermine American authority and “could trigger a global cycle of protectionist legislation”.

Sure, the threat is there. But how likely is it? I asked a friend of mine “Trotsky” who I highly respect what he thought. Here was his reply:

I just had a long debate with someone else about this. Assuming China’s leadership hasn’t suddenly become totally irrational, this will not happen. (Besides, Ambrose Evans-Pritchard is an alarmist scoring a 10 on the Prechter Scale).

What could happen is that the situation’s inner dynamics eventually get out of hand by themselves. The big reserve holders are in a Prisoner’s Dilemma – selling means that they bring about what they fear most, but whoever sells first may get the best price.

The only thing that could make this ‘nuclear option’ a reality is if something not yet known or expected happens and imparts an irrational impetus to the situation’s dynamics. I’ve used the start of WW1 as an example describing such a situation.

It’s not impossible, but from a real-politik standpoint, it is highly unlikely. Sometimes China let’s an academic speak up in a newspaper in order to unveil threats, sort of reminding everybody of who’s who in the zoo….but these threats do not constitute actual policy.

In a second Email I received these additional comments:

Paulson was interviewed today, and inter alia this ‘nuclear option’ theme came up. I thought he had a very measured and rational response to that, noting that the economic relationship is in the interest and to the advantage of both countries, and generally taking a rather relaxed, and more importantly, anti-protectionist stance.

Paulson noted that the threat of Chinese t-bond sales is overstated, as their entire holdings amount to one day’s worth of volume in this market, which I think is an important point as well.

To this I would add that anyone who really thinks for a minute about trade should realize that since it is entirely voluntary, it must be to the advantage of all concerned, otherwise it wouldn’t take place. It follows therefore that it is beneficial.

The senate is trying to enact the ‘currency manipulation bill’ which is clearly aimed at China and is incredible nonsense. After all, who’s to tell what value the yuan should be at until it floats, and besides it’s already going up for quite some time now (even if not by much). Should the EU hit back with a bill of its own?

All the talk about a ‘strong dollar’ policy hasn’t kept the Euro from soaring after all. Also not to forget: back when Japan was the favorite whipping boy, its currency eventually went on a tear. Did that help the trade deficit with Japan any? These guys play ‘populist politics’ on the backs of US consumers and Chinese producers, but in reality it’s just a pretty transparent and cynical pleading for special interest groups (domestic producers who do not want to be subjected to competition).

As hard as it is to believe, on occasion, government clowns can occasionally make sense. Take for example Greenspan. In spite of all his serious and many faults, Greenspan did have one redeeming quality: Greenspan was an advocate of free trade from beginning to end. It might have been the only thing he had correct, but he did have that.

On free trade, Paulson too appears to be on the right side of things. Nonetheless the fact that Paulson was trotted out on the White House lawn to speak on this matter suggests they are far more concerned about the economy and about Congress than may be obvious. And Bush trying to reassure the markets by telling everyone how strong the economy is a sure sign that he is worried about how weak it is. If the economy was strong, everyone would not need to communicate that fact on an almost daily basis.

The general population can easily see how not contained this mess is. Containments spreads nearly every day. And making things harder to discern fact from fiction with Paulson is the repeated nonsense about a “strong dollar” policy when he clearly wants it weaker. Why else would Paulson head to China every month suggesting China should float the Renminbi if the US did not want a weaker dollar? But Paulson and Congress ought both be careful. Weaker is one thing but a disorderly decline is another, and a depression is still another. If Congress does pass a protectionist tariff bill and overrides the inevitable Bush veto of it, the only immediate effect will be a strengthening of the upcoming recession, just as the Smoot-Hawley Tariff Act did in the great depression.

Mike Shedlock / Mish/