U.S. intelligence community debates China's bond holdings

* Participants ask: Would China ever dump U.S. debt?

* Brainstorming possible defenses against economic attack

By Emily Flitter

NEW YORK, June 23 (Reuters) - U.S. intelligence officials and top academics last week debated the risk China could wield its massive U.S. debt holdings as a weapon aimed at influencing U.S. foreign policy, according to a person who attended the meeting.

At a National Intelligence Council meeting last week, held at a Washington, D.C. hotel, members of U.S. intelligence agencies and China watchers discussed potential outcomes if China chose to sell its $900 billion of U.S. Treasury bond holdings, pushing up interest rates and making life much tougher for U.S. businesses and consumers.

While considered a remote possibility, China's tremendous economic stranglehold over the United States remains much-debated as the world's third largest economy grows in leaps and bounds and the number one economy struggles to break free from a deep recession.

The meeting took place as the United States prepares to issue a report that could label China a currency manipulator. U.S. lawmakers are also arguing over a bill that would penalize China for any protectionist policies.

"The best offense is often a good defense and you must be prepared. This is something that allows the U.S. to consider what policy alternatives they might have when facing threats from the outside," said Paul Markowski, president of the Global Strategies-Analysis Group in New York.

"This is one of the government bodies that considers the risks to the United States, economically, geopolitically and militarily," he added.

The NIC is a think tank made up of academics and members of the U.S. intelligence community. Its website describes itself as an advisory council to senior policymakers and the President.

Some policymakers think China could exercise this power over the United States without mobilizing any military force to influence U.S. policy in areas -- from Taiwan to climate change -- where is has deep interests.

"This is obviously considered important," said the person who attended the meeting. "It's been an ongoing topic of conversation since the Chinese started amassing large sums of dollars."

A banker at a primary dealer, one of the 18 financial firms authorized to deal directly with the Treasury Department to buy and sell U.S. government debt, said the timing of the discussion seemed practical.

"I'm guessing the following: Maybe the U.S. is preparing itself that in the event the Treasury, for example, were to name China as a currency manipulator or Congress were to pass legislation that viewed China as protectionist, this could be how China would respond," said the banker, who did not wish to be named. "So as a way of brainstorming you would want to come up with what you would do."

The Chinese government on Saturday announced it would make its currency more flexible, loosening its peg to the U.S. dollar. But financial analysts and lawmakers alike said the change might be too gradual--or it might not occur at all.

U.S. Sen. Charles Schumer, a Democrat from New York who has proposed legislation that would impose trade tariffs on Chinese goods as punishment for China's undervaluation of its currency, vowed on Sunday to move ahead with the legislation, despite China's announcement.

China's Treasury holdings rose to $900.2 billion in April according to the Treasury Department reported on June 15.

Since it is the biggest player in the Treasury market, any visible move by the Chinese government to buy or sell large quantities of Treasuries could have profound effects on the rest of the market. It would either depress or drive up yields and impact the cost of borrowing for houses, cars and businesses.

"In doing that, what options does the Federal Reserve have; what options does the Treasury have?" said Markowski, a China expert. "If China were to be a large, large seller, then they would have to do something more significant."

Some China analysts have referred to China using its debt holdings as political leverage as a 'nuclear option,' because quickly selling Treasuries would not only hurt the United States; it would also depress the value of China's reserve holdings and impact its domestic economy.

At least one strong advocate for the view that China could indeed influence U.S. politics though Treasury purchasing or selling is Brad Setser, a member of the National Economic Council and the National Security Council. Before joining the Obama Administration in 2009, Setser argued this view on his blog, Follow the Money, and in papers he wrote for the Council on Foreign Relations.

Those arguments were discussed at the conference, with no clear resolution, the person said.

The NIC meeting was held a month after top U.S. and Chinese government officials met for an annual conference on economic cooperation, the Strategic & Economic Dialogue, held this year in Beijing in late May.

(Editing by Andrew Hay)