This time the gloves could come off. The Group of 20 developed and developing nations summit in Toronto later this month could be the scene of a tense battle over China's exchange rate.

Escalating rhetoric from U.S. Treasury Secretary Timothy Geithner and senators such as Charles Schumer (D., N.Y.) Thursday was echoed Friday by Lorenzo Bini-Smaghi, a key member of the European Central Bank's policy-setting council, who blamed "the rigidity of the Chinese monetary regime" for slowing down the recovery in the developed world. The U.S. and Europe should jointly pressure China for reform, he urged.

The Asian giant makes a convenient scapegoat at a time when Europeans are worried that their sovereign-debt crisis will curtail economic recovery and Americans are frustrated by anemic jobs growth. Still, the objectives of populists such as Schumer -- f not their methods -- do coincide with sensible macroeconomic reasoning. For the sake of fixing the world's savings-versus-spending imbalances, a yuan revaluation is way overdue.

Various G-20 finance ministers criticized China's policy on the sidelines of a meeting in Washington two months ago. That, and some hints from Chinese authorities, generated expectations for an upward adjustment in the yuan's peg to the dollar by mid-year.

Since then, with the euro zone's financial trauma dominating headlines, nothing has happened.

The status quo in China seems entrenched. In fact, export interests, powerfully represented by the Commerce Ministry, have seized upon this year's 6% increase in the trade-weighted value of the yuan--an outcome of the dollar's gain against the euro--to argue that China has lost enough competitiveness already.

Yet the recent currency trends should bolster the argument for reform, not weaken it.

Deflation risks in the euro zone are driving money into the dollar, exacerbating global imbalances. As demonstrated by Friday's news of a 1.2% decline in May U.S. retail sales, the post-subprime crisis world can no longer regard U.S. households as the consumers of last resort.

Meanwhile, the trade-weighted dollar is up 9% on the year. In other words, the U.S. is paying a higher competitiveness price than China. That's because China depends more on trade with the U.S. than vice versa.

Still, as James Bacchus, the former chairman of the World Trade Organization's appellate tribunal said in congressional testimony Thursday, sanctions against China could backfire. By contrast, showing respect for WTO rules and having China do the same keeps channels of communication open, allowing both sides to coordinate optimal policy.

The best hope is that the Chinese government acts on its on accord out of its own interest. After all, rising wage demands and higher domestic inflation--at 3.1% in May, according to data out Friday--show that China's internal economy is already revaluing on its own, and in a dangerous way.

It's a law of economics: if nominal exchange rates won't adjust to fair value, real exchange rates will adjust via changes in internal prices. The Chinese authorities understand the risks of letting that process play out.

Already, certificates of deposit in China are paying negative real interest rates while 10-year government rates are only marginally positive, according to Naomi Fink, strategist for Bank of Tokyo-Mitsubishi UFJ.

To make future yuan-based bonds appealing, the government must therefore either jack up interest rates, harming the economy, or make yuan assets more valuable via a currency appreciation.

For the sake of the world, let's hope it chooses the latter.

Write to Michael Casey at michael.j.casey@dowjones.com

Sourced from www.online.wsj.com