HONOLULU, EAST-WEST WIRE — Tensions in U.S.-China relations have been rising recently. Trade spats, alleged Chinese hacking attacks, differences over Internet freedom standards, U.S. arms sales to Taiwan and the meeting between President Barack Obama and the Dalai Lama are all souring the world’s most important bilateral relationship.

An old and especially intractable issue is now being added to this long list: the management of China’s currency, the yuan or renminbi.

Although this issue has caused considerable friction in U.S.-China relations in the past, it promises to be even more inflammatory this year. China has emerged from the global financial crisis better than any other major economy, with its exports now growing again. Chinese officials want to sustain this upturn while creating as much stability as possible in China’s external economic environment. A stable yuan-to-dollar exchange rate underpins this policy objective.

The currency issue could become the greatest threat to Beijing’s goal of stabilizing external economic relations. Facing crucial midterm elections this fall, Obama has recently implied that Beijing is keeping the yuan artificially low to give Chinese exports an unfair advantage.

Under increasing pressure to balance U.S.-China trade and to alleviate high unemployment, the administration could gain politically by reopening the battle with China over the yuan, but China is unlikely to budge. Intransigence on both sides could set the United States and China up for an ugly spat, perhaps undermining the broader relationship.

Since 1994, Beijing has viewed “exchange rate stability” as a top priority. The yuan-dollar exchange rate was kept stable with a fixed peg, even during the tumult of the Asian Financial Crisis in 1997-98. After much pressure from its trading partners and a realization that some flexibility was in its own interest, China took the yuan off its peg to the U.S. dollar in July 2005.

After an immediate one-off revaluation, the yuan moved to a managed floating exchange rate based on market forces with a reference to a basket of currencies dominated by the U.S. dollar, the euro, the yen and South Korea’s won. Despite this strategy, the yuan appreciated 21 percent compared to the U.S. dollar between 2005 and 2008, but then was pegged again at a more-or-less fixed rate to the dollar in July 2008.

This re-pegging is causing renewed attention to China’s exchange rate management. Many American economists and politicians hold that the yuan is undervalued by 25 to 40 percent compared to the dollar.

Certainly, an undervalued currency has aided China’s export push. But Chinese exports are now so dominant and moving up the technology ladder so fast that only a sizable and rapid revaluation of the yuan could dent China’s advantages, and Chinese authorities will not contemplate such a radical move.

The biggest problem for China is one of image. As in other areas of Chinese governance, authorities have given short shrift to transparency when managing the yuan’s exchange rate. No details are available on the weighting of individual foreign currencies in determining the exchange rate, and the composition of Chinese foreign exchange reserves, which underpin the yuan’s value, is a closely held state secret. The Chinese want to give themselves maximum leeway, but the way the yuan has been managed also gives rise to allegations of currency manipulation to gain unfair trade advantages.

Given the rising tempers on both sides of the Pacific, it would make more sense for the Chinese to once and for all remove the lack of transparency and aura of manipulation surrounding the yuan’s exchange rate management. Even a one-off revaluation of 5 percent, as rumors would have us expect, will not dispel this fundamental lack of transparency.

To defuse this contentious issue in Beijing’s current economic policy, China should move to its stated goal in 2005: a floating rate based on market forces with a reference to a basket of currencies.

In fact, if the basket is based on major trading currencies, such as the U.S. dollar, euro and yen, with minor shares for the currencies of other Chinese trading partners, such an arrangement could contribute to international exchange rate stability, diminish China’s dependence on the U.S. Treasury market to store its foreign exchange reserves and defuse international tensions over China’s exchange rate policy — a win-win-win proposition.

Political economist Christopher A. McNally is a research fellow at the East-West Center. (mcnallyc@EastWestCenter.org.) The East-West Wire is a news, commentary and analysis service provided by the East-West Center in Honolulu, a U.S.-initiated education and research organization.

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