China and U.S. look to close world's biggest trade gap

China's whopping trade surplus with the United States has narrowed over the past year as the global financial crisis has decimated American demand.

At their Strategic and Economic Dialogue next week, Washington and Beijing will look for ways to balance their $400 billion trade ties on a more permanent basis, steering clear of an open clash about the yuan's peg to the dollar.

The stakes are high for both.

As he tries to reinvigorate the U.S. economy, President Barack Obama has set a goal of doubling exports in five years, which can be met only with a big increase in sales to China.

For Chinese leaders, the task is to show that trade flows are headed in the right direction without fundamental change to the country's exchange rate regime, declawing critics who have called for punitive action if it does nothing.

The United States has said a top concern at the talks will be Chinese industrial policies promoting indigenous innovation that are seen as restrictive and have alarmed foreign companies.

The U.S. Treasury's senior coordinator for China affairs, David Loevinger, said this week that increasing exports meant not only fighting trade barriers but also ensuring that large economies like China with large current account surpluses depend more on their own domestic demand for growth.

Last year, despite the global recession, the U.S. trade deficit with China was $227 billion, the largest for any country. Beijing knows the road to Obama's export target runs through China.

Where are those goods going to go? The Chinese market is huge and it has money in its hands, said Zhou Shijian, with the Center for U.S.-China Relations at Tsinghua University.

That feeds into one of the main messages that Zhou said Chinese officials will not tire of repeating next week. If the United States wants to sell more to China, it should loosen its controls over the exports of high-tech products.

U.S. Treasury Secretary Timothy Geithner and Chinese Vice Premier Wang Qishan will lead the economic talks on Monday and Tuesday, with top trade representatives and hundreds of senior officials from both countries also at the meetings.

LULL IN YUAN STORM

The Chinese government has made clear that encouraging domestic consumption and cutting reliance on exports -- just what the United States wants it do -- are top policy priorities.

But any change will be measured in years, not months. With mid-term elections looming, patience in Washington can quickly wear thin and the yuan remains a flashpoint as the easiest explanation for the trade imbalance.

Geithner postponed a semiannual currency report in April that could have named China a currency manipulator. In the eyes of many, this seemed to be more an ultimatum than an olive branch.

That left the impression that he had sold Congress on a strategy of giving China until the end of June to resume appreciation, said Nicholas Lardy, a China expert at the Peterson Institute for International Economics.

Many investors and analysts thought Beijing was on course to remove the yuan from its de facto 22-month-old dollar peg, but the European debt crisis has cast doubt on this forecast.

They cannot at the moment even pretend to be re-pegging away from the dollar to a genuine basket of global currencies because no one wants to be tied to the euro right now, said Derek Scissors of the Heritage Foundation in Washington.

In muting its criticism of the yuan, the Obama administration is, in part, taking the Chinese government at its word.

External pressure and noise will do nothing but slow the reform process, assistant finance minister Zhu Guangyao said of the yuan exchange rate on Thursday.

In quiet tones, Beijing will also press for reassurance about the safety of the dollar and U.S. government debt. China is the world's largest holder of U.S. Treasuries with $895 billion.

I think the U.S. side has a very weak hand going into these talks, Lardy said.

But it might just be a lull in the storm.

If nothing happens by the end of June on revaluation, then I expect pressure from Congress will resume against Geithner again, he said.

(Editing by Ken Wills & Kazunori Takada)