In what looks to be a central line of attack in the quest to re-balance the global economy, the Treasury Department has ratcheted up the rhetoric against China’s currency peg. The Treasury’s semiannual report to Congress slammed the Chinese for their lack of exchange rate ‘flexibility,’ but stopped well short of accusing the Chinese of currency ‘manipulation’ as Tim Geithner had claimed during his confirmation hearings before Congress.

Bloomberg reports:

“Both the rigidity of the renminbi and the reacceleration of reserve accumulation are serious concerns which should be corrected to help ensure a stronger, more balanced global economy consistent with the G-20 framework,” the report said. “The Treasury remains of the view that the renminbi is undervalued.” China’s foreign-exchange reserves, the world’s biggest, surged in the third quarter as an economic recovery attracted speculative capital and a weak dollar boosted valuations of its yen and euro assets. Record Reserves The holdings climbed about $141 billion to a record $2.273 trillion, the People’s Bank of China said this week. That was less than the unprecedented $178 billion gain in the second quarter. The Obama administration wants China to “pursue policies that permit greater flexibility of the exchange rate and lead to more sustainable and balanced economic growth,” the report said. The U.S. will continue to push China to allow the yuan to appreciate in two-way meetings and through meetings of officials from the Group of 20 nations. People’s Bank of China officials have called this year for an alternative to the dollar as a global reserve currency. At the same time, the issue hasn’t been a central point of debate at recent international summits like a meeting of Group of 20 leaders in Pittsburgh last month.

If Treasury is looking to burnish its populist credentials, making these statements to Congress where protectionist and populist sentiment is running high is certainly the place to do it. The question is: what’s your endgame?

Right now the US dollar is looking weak despite Mr. Geithner’s advocacy for a stronger dollar. If you ask China for more exchange rate flexibility, you clearly are not serious about a strong dollar – and everybody knows it.

Here’s how I see things playing out:

Congress looks at this report and concurs that the key to ending slower global growth is to correct global imbalances via a Chinese currency revaluation. Fair enough.

However, individual Congressmen, looking to reassure jobless constituents ahead of the midterm elections, will escalate by presenting bills to ‘punish’ China if no actions are taken.

China will be aghast at this and, in a further escalation, start making noises about ditching the dollar.

At this point, the question is how does this get resolved. To date, bilateral U.S.-Chinese economic tensions have escalated and led to protectionism. Further escalation will yield unpredictable results and will be destabilizing. Chinese officials cannot be seen by their domestic constituency caving to American pressure. This would undermine their authority and create problems domestically. Therefore, a public frontal assault on the renminbi peg is likely to backfire.

Like Stephen Roach, I see protectionism as the largest threat to global recovery. Let’s hope the Administration is aware of the dangers.