Dec 20 (Bloomberg) -- U.S. Treasury Secretary Henry Paulson is heading for a confrontation on China with the new Democratic- controlled Congress after his department softened its criticism of the country's currency policy.

Lawmakers condemned the Treasury for failing to label China a currency manipulator in its semi-annual foreign-exchange report yesterday and vowed to call Paulson to Capitol Hill to question him on the decision. Unions and manufacturers also criticized the Treasury report, which conceded China's policy of limiting gains in the yuan is a distortion.

``It's the worst kept secret in the world that they are manipulating,'' said Representative Tim Walz, a Minnesota Democrat and Mandarin speaker. ``A sense of urgency is not there, and it's something we need to move on.''

The chorus of criticism raises the risk that Congress will enact punitive actions designed to pressure China. More than two dozen measures aimed at decreasing the record U.S. trade gap with China were held up by Republican leaders in the past two years.

``They are going to get exactly what they deserve from Congress,'' said Robert Baugh, an executive director of the AFL- CIO in Washington. The nation's largest labor federation contributed $40 million to help Democrats win control of Congress. ``Our argument is that this is an illegal subsidy under U.S. trade law.''

Christopher Dodd of Connecticut, incoming chairman of the Senate Banking Committee, and Richard Shelby, the ranking Republican on the committee, said in a joint statement that they are disappointed with the Treasury report.

Swelling Reserves

China has amassed almost $1 trillion in foreign-exchange reserves through managing its currency. It has allowed the yuan to advance 5.8 percent since ending a peg against the dollar in July 2005, a gain that trails Asian currencies such as South Korea's won, which rose 12 percent in the same period. The yuan climbed 0.08 percent to 7.8152 against the dollar as of 5:30 p.m. in Shanghai, according to the China Foreign Exchange Trade System.

The gains haven't stopped China's trade surplus from continuing to widen. The excess of exports over imports from the U.S. reached a record $24.4 billion in October, the Commerce Department said Dec. 12.

``The Democratic Congress is going to be a lot more fueled to do something dramatic against China,'' said Representative Donald Manzullo, an Illinois Republican. ``The law and the process for designating manipulators needs to be changed because it's not working.''

Diplomatic Approach

Paulson is betting a diplomatic approach will be more fruitful than the threats and sanctions backed by some legislators and companies. The Treasury removed language from the May currency report stating China's delay in freeing up the yuan is ``unjustified'' and in its place said the government's effort is ``considerably less than is needed.''

China and the U.S. last week agreed on the need for the yuan to have more flexibility, while declining to set a timetable. Paulson, who was in Beijing for the first session of a twice-yearly economic dialogue between the countries, said on Dec. 14 that ``tangible results'' are needed from the dialogue to forestall protectionist pressures.

``Rather than come home and state the obvious, I think what they are doing is giving them six months,'' said Tom Coburn, a Republican from Oklahoma who accompanied Senators Charles Schumer and Lindsey Graham on a trip to Beijing in March. ``Nobody knows what private assurances were made behind closed doors.''

Tough to Label

When a country's official policy doesn't show a deliberate intent to stoke exports through the exchange rate, it's tough to label them a currency manipulator, a senior Treasury official said yesterday. Paulson declined to comment.

``What they're saying certainly suggests that they're hearing us and are going to be working toward eliminating those trade distortions,'' Allan Hubbard, director of the White House National Economic Council, told reporters in Washington yesterday. ``It never happens as fast as any of us would like.''

The incoming Congress is likely to be more impatient on China. Six Senate seats held by lawmakers supporting free trade were taken by candidates who are skeptical on trade, according to a study by Simon Evenett and Michael Meier of the University of St. Gallen in Switzerland. In the House of Representatives, 16 seats switched to candidates critical on trade.

``People are frustrated, and they want something,'' said Frank Vargo, a vice president for international affairs at the National Association of Manufacturers in Washington. ``If something isn't done, we will get a legislative approach.''

Democrats such as Sherrod Brown, who unseated Ohio Republican Senator Mike DeWine, and Heath Shuler, elected to the House from North Carolina, made criticism of China and current U.S. trade strategy keys to their campaigns.

Bernanke's Language

Lawmakers may seize on language used by Federal Reserve Chairman Ben S. Bernanke last week to hammer the administration's diplomatic course. Bernanke said in the text of remarks to the Chinese Academy of Social Sciences that China's ``undervalued'' currency was an ``effective subsidy'' for exports.

Bernanke, who accompanied Paulson's delegation to Beijing, substituted the ``subsidy'' term for ``incentive'' and ``distortion'' when he delivered the speech.

His characterization of China's policy ``confirms the fact that China has been controlling their currency to gain a major unfair advantage in its trading relationship,'' Sander Levin, a Michigan Democrat, said in a statement after Bernanke's speech.

To contact the reporters on this story: Matthew Benjamin in Washington at mbenjamin2@bloomberg.net; Julianna Goldman in Washington at Jgoldman6@bloomberg.net

Last Updated: December 20, 2006 05:57 EST