Dec. 15 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke urged China to allow its currency to gain at a faster pace to end ``an effective subsidy'' for exporters.

Bernanke challenged China's policy makers to give greater primacy to markets, improve health care and education, and grant independence to the People's Bank of China. He warned that the distortions caused by an undervalued renminbi, also known as the yuan, could leave China with wasteful investments and costly financial instability later.

``Further appreciation of the renminbi, combined with a wider trading band and with the ultimate goal of a market- determined exchange rate, would allow an effective and independent monetary policy,'' Bernanke said in prepared remarks in Beijing today. This would ``enhance China's future growth and stability.''

U.S. policy makers are seeking to persuade China to spur domestic demand and narrow a record trade gap that is fueling demands for protection among some legislators and companies. Bernanke is accompanying Treasury Secretary Henry Paulson and six members of President George W. Bush's cabinet for the first session of new biannual talks to ease trade tensions.

Bernanke, 53, didn't comment on U.S. interest rates or the economy in his remarks at the Chinese Academy of Social Sciences in Beijing, part of his first trip to China since becoming Fed chief.

Yuan's Gain

China's government has limited the yuan's gains to 5.7 percent since ending its strict peg to the dollar in July 2005. The currency was at 7.8275 per dollar today. China limits movements to a gain or loss of 0.3 percent a day. The currency rose 0.04 percent during the delegation's visit, less than the 0.2 percent advance when Paulson last visited China in September.

While Paulson has limited his comments on the yuan to calls for more ``flexibility,'' Bernanke was specific in his criticism of China's exchange-rate system. Paulson told reporters in Beijing today that China agreed to make its currency more flexible, without giving a timetable -- a similar result to his trip in September.

``Bernanke is trying to say what U.S. Treasury Secretary Henry Paulson can't,'' said Simon Derrick, chief currency strategist at the Bank of New York in London. ``There's a sense of annoyance in China that the U.S. hasn't acknowledged the gains that the yuan has made so far,'' he also said.

Rocky Start

Yesterday's opening session of the talks got off to a rocky start when Vice Premier Wu Yi said ``some American friends are not only having limited knowledge of, but harboring much misunderstanding about, the reality in China.''

In a comprehensive speech that included four pages of footnotes and references, Bernanke said China's progress since opening up its economy in 1978 has largely been based on allowing markets to set prices. He urged the nation to apply that same approach in areas from electricity to interest rates and exchange rates.

``Bernanke's stating the case that yuan gains are in China's own interest,'' said Ben Simpfendorfer, a currency strategist at Royal Bank of Scotland Group Plc in Hong Kong. He is ``perhaps helping reformists argue a case with the leadership for faster yuan gains.''

`Important Distortion'

Bernanke said that ``the effective subsidy that an undervalued currency provides for Chinese firms that focus on exporting'' is an ``important distortion'' in China's economy. When he delivered his speech, the Fed chairman changed the word ``subsidy'' to ``distortion.''

``The situation has likely worsened recently'' because the yuan has dropped 10 percent on a trade-weighted basis after inflation in the past five years, Bernanke said.

The Fed chairman also pointed to risks in China's financial markets. Capital markets, ``despite positive steps, remain distorted and underdeveloped,'' Bernanke said. He encouraged the authorities to allow markets to determine interest rates and suggested ``granting greater autonomy to the central bank.''

In response to a question, he said ``institutional change'' is also important for the functioning of markets, and added that China needed to improve the ``quality'' of its rapid growth.

Exports, accounting for 35 percent of gross domestic product, are propelling China, the fastest growing major economy. GDP increased 10.4 percent last quarter from a year earlier and expanded 11.3 percent in the previous three months, the highest growth rate in a decade. China's trade surplus will reach a record $168 billion this year, the government forecasts.

Domestic Demand

Domestic demand is lagging behind. Consumption last year accounted for the lowest share of GDP since 1978, according to the statistics bureau. Bernanke called the reliance on exports ``the principle imbalance'' in the economy.

``Together with the large trade and current account deficits of the United States, the Chinese external surpluses are contributing to the current pattern of global imbalances,'' Bernanke said.

As China managed its exchange rate, the central bank built up a surplus of foreign exchange that totaled $988 billion in November. To prevent an increase in money supply that would threaten inflation, the central bank issues securities to ``sterilize'' its purchases of foreign exchange.

Bernanke said today this strategy will eventually cause ``problems'' and could interfere with ``the growth and development of private financial markets.''

To contact the reporter on this story: Craig Torres in Washington at ctorres3@bloomberg.net

Last Updated: December 15, 2006 03:03 EST