It seems to me that focus has shifted away from China’s economic and financial doings during the acute financial crisis that began last September.

The story in China for most of this year and last year has been extremely high inflation (particularly in prices for staple foods), and vigorous measures by the country’s banking and monetary authorities to reduce the formation of credit.

Up till late 2007, they also had a wicked bubble in their domestic stock markets (Shanghai and Shenzen, where non-Chinese may not trade), which they popped quite successfully. Be glad you weren’t invested in those markets.

In recent months, they’ve been walking back most of those policies, as economic growth has slowed sharply. Last year’s growth was 12.6%, led largely by exports and capital investment. (Three years ago, China had a true economic boom, led by domestic demand-growth, which had mostly petered out by last year.)

But next year, growth will probably run anywhere from 7.5% to 9%, according to estimates from the World Bank and other sources that are not the Chinese government. The raging inflation of the past year is also mostly gone.

As a result, the government is taking aggressive steps to pump growth back up, notably by pulling back policies intended to reduce bank lending. But it’s not clear to me that they can do this in the most healthy and sustainable way (by stimulating domestic demand).

Instead, they’re reaching for the tried-and-true: export growth.

Foreign trade accounts for about 40% of the Chinese economy, with net value-added to exports probably something like 17 or 18 percent. (Trade is only about 10% of the US economy.)

And even as the global economy has slammed on the brakes, China’s current-account surplus continues to grow, reaching record levels in October. Their share of world export markets continues to grow, as they competitively crowd out other exporters.

On top of this, imports into China are slowing as consumer demand falls with the deepening economic slowdown. This means that China’s economy is becoming even more export-led.

And they just took another big step in that direction: they reversed a year-long trend of currency appreciation.

The People’s Bank of China manipulates the value of renminbi (the country’s money, denominated in yuan) by setting daily limits in which it can trade against other currencies, like the dollar and the euro.

They just set the limits so as to permit a devaluation of about 70 basis points, from 6.83 to the dollar to 6.88.

A year ago, RMB was trading about 7.7 to the dollar. Treasury Secretary Paulson’s most important goal (until the current crisis hit) has been to get the Chinese to let their money appreciate. Stubbornly and very gradually, they’ve been doing it. Until now.

The Chinese have deliberately undervalued their money for years now. And this creates a raft of imbalances, both inside China and in the global economy. If they run a current-account surplus with nearly everyone else, then the rest of us have to run deficits of one kind or another.

Protectionist US Senators and American labor leaders are sure that the objective of Chinese policy-makers is to throw American manufacturers out of business and move their jobs to China.

But America doesn’t manufacture all that much (it’s only about 15% of our economy). The Chinese may instead be trying to make sure that their lower-cost regional competitors (such as Vietnam, Malaysia and Thailand) don’t get any traction.

And the other obvious effect of an undervalued yuan is the astounding accumulation of foreign-exchange reserves in China, which continues unabated and in fact may now be accelerating.

China’s foreign-exchange position isn’t entirely clear because they don’t tell anyone what it is, straight-up. So the people who watch international trade and capital flows have to infer it from such indirect measures as the size of custodial accounts held at the New York Fed.

There are a couple of noteworthy things. First, China appears to have shifted an enormous position in US agency (Fannie Mae/Freddie Mac) securities into straight US Treasury debt. This happened largely over the summer of 2008.

And second, they appear now to be holding about $2 trillion in dollar reserves. At their current, accelerating pace of accumulation, they may be on their way to $3 trillion.

China officially reports the size of their economy at a bit over $3 trillion. Let’s say they’re lying and it’s closer to $6 trillion (which would make it the second largest on earth). If the US were to hold currency reserves in the same proportion, we’d have anywhere from 7 to 14 trillion dollars lying around, and no one would be raising a fuss about Hank Paulson wanting to spend $700 billion to stabilize the financial system.

It’s time to pull these facts out and have a look at them. The most critical economic policy challenge in the US in 2009 will be to prevent a disastrous deflation. When half-measures stop working, the only way to counteract deflation is with inflation.

And the way to create inflation is to print money, which our Federal Reserve has been doing with alacrity. (The remarkable changes they made to policy last week need a separate post to fully explain.)

The problem with this is that China will soon enough be holding $3 trillion in reserve, and they do not want to see us diminish the value of those dollars by printing more.

The ability of the US to pursue a strongly inflationary economic policy next year will be bounded by the willingness of the Chinese to let us do it.

And their calculus will swing between their desire to maintain the value of their reserves, and their need to keep our economy from collapsing (which in turn would collapse their export markets).

They’re not in the driver’s seat of US economic policy. But they’re in a position to do a lot of backseat driving.

And as the only large country in the world with an extremely strong reserve position, they have far more flexibility to act in the global economy than any other player.

-Francis Cianfrocca