Undervalued yuan

U.S. Treasury Secretary Henry Paulson underscored the need for China to move, over time, to a flexible currency. China's government keeps its currency, the yuan, fixed to the dollar, with a tight trading band. Amid intensifying international pressure, China has allowed the yuan to appreciate, albeit slowly. China has let the yuan, currently trading at about 7.365 yuan to the dollar, rise about 6% in the past year, and 12% since July 2005. Many analysts say the yuan would appreciate to at least 5.50 yuan to the dollar, or perhaps even more, if allowed to float freely.

The United States and the European Union argue that the yuan's low level is the main factor in the U.S.'s trade deficit and in Europe's rapidly rising trade deficit. The two argue that the fixed yuan creates an unfair competitive advantage for China by allowing the nation to price goods for export at a lower level than they would be if market forces set the price.

Conversely, China argues that it needs a fixed, low currency to stimulate trade, build wealth, and protect young industries. China also says the best way to reduce the U.S. trade deficit is for U.S. consumers to save more and consume less, among other U.S.-based changes.

Currency reform win-win?

Still, Paulson underscores that letting the yuan appreciate faster is not a one-sided win for the U.S. There would be benefits for China.

"China's leaders have voiced concerns about China's macroeconomic stability, in particular mounting inflation, growing asset bubbles and possible overheating." Paulson said according to the BBC News. "A flexible exchange-rate policy is especially important to China now, given these risks."

China countered that recommendations for rapid currency appreciation were irresponsible.

"We are not in favor of excessively fast appreciation of Chinese currency," said Chen Deming, China's vice minister of commerce, who is scheduled to become minister next year, the International Herald Tribune reported. He warned against unspecified "repercussions" if China's currency rose too fast, adding, "I don't think it will serve all of us any good."

After a dinner and ceremonial events Wednesday night, U.S.-China trade talks will continue on Thursday.

Economic Analysis: Call it modest progress with China regarding currency reform. It appears China is beginning to sense rising protectionist sentiment in the European Union and the United States. That protectionist sentiment is unlikely to win out on either continent, but it will prompt China to let the yuan appreciate at a quicker pace.