Paulson warns trade sanctions could backfire

By Ros Krasny

CHICAGO (Reuters) - Treasury Secretary Henry Paulson on Friday tried to wave off U.S. lawmakers' bid to tighten the screws on China over its currency policy by warning that it could make it harder to settle turbulent markets.

"I don't want to start a trade war," Paulson told an audience at Atlas Material Testing in Chicago, adding it was critical to stay on good terms with China because it was a key market for increased U.S. exports.

Calls are growing in Congress for tougher legislation to force China to let its yuan currency strengthen and to impose tariffs against Chinese imports if Beijing does not do so, a step Paulson opposes.

"Punitive trade legislation could have enormous repercussions, especially when we are working to extend our economic expansion and get through a turbulent time in our capital markets," Paulson said.

He called the U.S. relationship with China "complex" and said that while he, too, was impatient for faster currency appreciation, trade sanctions might make the situation worse.

China is a major buyer of U.S. Treasury securities that are sold to help finance the shortfall between the government's income and its spending, and some commentators have said that Congress should beware of angering Beijing for fear it will cut back its purchases.

In an interview on CNBC television, Paulson said the economy was weathering market turmoil from defaults in U.S. subprime mortgages but repeated it will take time before normal conditions return.

"I feel very confident that this economy is going to continue to grow," Paulson said. "Inflation is contained and that is obviously the key to extending an economic expansion."

The U.S. Treasury secretary was spending a day in Chicago speaking to business people before heading for France and Britain to meet finance ministers on Monday.

He drew a distinction between the current turmoil, which stems from problems in the subprime mortgage sector, and past crises like the Asian currency problems in the late 1990s when much of the global economy was in distress.

"A number of these periods of turbulence in the past were precipitated by problems in the real economy, and that's the differentiating factor here," he said.

"The real economy is very healthy in this country, very strong outside of this country and with that as a backdrop it gives me great confidence we're going to be able to work our way through this," Paulson added.

He told a group that counsels distressed homeowners, Neighborhood Housing Services of Chicago, that it was important not to "over react" to market turmoil by imposing regulations that stifle markets' ability to innovate.

Paulson was speaking just days before the Federal Reserve's policy-setting Federal Open Market Committee meeting. The panel is widely expected to lower rates on Tuesday.

He made no direct comment on the meeting but praised the Fed's actions in taking steps in recent weeks to inject funds into financial markets to ensure they had ample liquidity.