WASHINGTON -- U.S. President Barack Obama has set the stage for a possible trade war with China by branding the Asian giant a currency manipulator, a term his predecessor George W. Bush had skillfully avoided despite pressure from lawmakers.

"President Obama -- backed by the conclusions of a broad range of economists -- believes that China is manipulating its currency," his Treasury secretary-designate Timothy Geithner said Thursday in written testimony to senators quizzing him over his pending confirmation.

Obama, who took office only Tuesday, has pledged to "use aggressively all the diplomatic avenues open to him to seek change in China's currency practices," Geithner said.

Under the Bush administration, the Treasury had stopped short of identifying China a currency manipulator in its semiannual global currency reviews, acknowledging however that the yuan was relatively undervalued against the US dollar.

By directly branding China, Obama has laid the groundwork for trade friction between the key powers, both reeling from global financial turmoil that has slammed the brakes on growth and triggered a host of domestic problems.

"This is definitely setting the stage for some bad blood between the two countries and I anticipate that over the next year or so, trade fiction is going to become somewhat more heated," said Eswar Prasad, former China division head at the International Monetary Fund.

He said Obama's charges came as China used its competitively priced exports to fuel growth and check rising unemployment, disregarding international advice that it wean away from exports by using domestic consumption as a linchpin for economic expansion.

"It signals a much harder line I think the Obama administration is going to take in public," Prasad said, contrasting the new administration's policy with the Bush administration's strategy of prodding Beijing in private to allow the yuan to appreciate.

As an Illinois senator, Obama had co-sponsored legislation aimed at changing how the U.S. government formally determines currency manipulation and authorizes new trade reprisal measures.

During the presidential campaign, he had accused China of suppressing its currency's true strength to make its exports more competitive, echoing some U.S. lawmakers who blamed the snowballing U.S. trade deficit with China on the weak yuan and have sought sanctions against Beijing.

"If there is a rise in trade tensions, it is much more a reflection of deeper reality rather than anything else," said Brad Setser, a former U.S. Treasury official, citing the current economic crisis facing the two powers amid a global trade slump.

"Certainly, it is a signal that the Obama administration is going to put a focus heavily on the Chinese exchange rate regime and make that a key issue in discussions between the U.S. Treasury and the Obama administration and China."

Geithner, who is expected to be confirmed as Treasury chief, hinted that any moves to tighten laws against currency manipulation would ensure that "countries like China cannot continue to get a free pass for undermining fair trade principles."

"The question is how and when to broach the subject in order to do more good than harm," he added.

But heavy U.S. dependence on Chinese capital may limit Obama's options against Beijing.

China has overtaken Japan as America's biggest foreign creditor, and as of October 2008 held 652.9 billion dollars in U.S. Treasury bonds, according to the latest Treasury Department figures.

"To engage in any action that would lead the Chinese to misunderstand actions by the U.S .and therefore sell these holdings would be dangerous," warned Andrew Busch, global forex strategist with BMO Capital Markets.

Busch said that the United States has been reluctant to brand China a currency manipulator for two reasons -- "One, China doesn't meet the Treasury's narrowly defined criteria. Two, China owns a lot of U.S. Treasury, agency and overall debt securities."

U.S. lawmakers had previously proposed legislation aimed at imposing steep tariffs on Chinese products entering the United States if Beijing refused to make its currency flexible.

They also wanted currency manipulation to be classified as an illegal subsidy under U.S. trade law, paving the way for American companies to demand "countervailing duties" on Chinese products.

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