Global Economics

Paulson's China Challenge


Henry M. Paulson is making his first trip to Beijing as U.S. Treasury Secretary, and he's got a lot on his plate. When Paulson arrives on Sept. 19, he'll be facing China's already gargantuan, yet still growing, trade surplus, its controversial currency, and a recent edict banning the acquisition of local brokerages by foreign firms. His two Bush-era predecessors, John Snow and Paul O'Neill, had little luck influencing Beijing. Will a seasoned Wall Street money pro such as Paulson with strong ties to China's top leadership do any better?

Top on Paulson's list: getting China to loosen currency controls. On Sept. 14 the yuan climbed on speculation that Beijing will tolerate some appreciation of the currency ahead of a Group of Seven and International Monetary Fund meeting this weekend in Singapore. Yet the former head of Goldman Sachs (GS) is likely to use every string he can pull in China to argue for broader economic reforms that would have a more meaningful impact on China's trade numbers than just a quick-fix currency adjustment.

Paulson does have plenty of guanxi, or connections, thanks to years of building up street cred with Beijing's power elite. He traveled extensively to China during the 1990s on behalf of Goldman, has served as advisor to the Tsinghua University's School of Economics and Management, and engaged in environmental projects in China's Southwestern Yunnan Province. He's familiar with Chinese President Hu Jintao's top economic team including People's Bank of China Governor Zhou Xiaochuan and Finance Minister Jin Renqing.

"DAUNTING" TASKS. In a recent Washington speech, Paulson signaled his approach won't involve a sledgehammer, but rather a more reasoned appeal to China's economic self-interest. The aim isn't just currency flexibility, but broader financial reform that would modernize China's capital markets, spur local investment, and raise its economic productivity.

To quiet Congressional critics who want China to immediately push through a sizable appreciation of the yuan or face trade sanctions, Paulson counseled that: "The tasks faced by Beijing are so daunting that the biggest risk we face is not that China will overtake the U.S., but that China won't move ahead with reforms necessary to sustain its growth." But Senators Charles E. Schumer (D-N.Y.) and Lindsey O. Graham (R-S.C.) aren't waiting around. On Sept. 14, the duo pushed for a vote by the end of the month on their bill to impose a 27.5% tariff on all Chinese imports as a strong signal to China to revalue its currency.

China is now the world's No. 3 trading nation, exporting and importing about $1.4 trillion worth of goods and services a year. If Beijing doesn't get a lot of things right in its own economic management, a big slowdown in China would hit commodity prices for steel, copper, cement, and oil, and depress growth in Asia. Nor would it do wonders for General Motors (GM), Ford (F), Motorola (MOT), Caterpillar (CAT), and plenty of other U.S. firms with sizable businesses on the mainland.

BIG NUMBERS. That's why Paulson believes so strongly that the U.S. policy approach toward China needs to be far more multifaceted than in the past. Much of the political and media commentary tends to focus on the Chinese currency. There are few who doubt the yuan is undervalued. It hasn't appreciated very much since China abolished its fixed peg to the dollar.

That, many in the U.S., Europe and Japan argue, is driving China's trade surplus skyward. The numbers certainly are startling. On Sept. 11, China reported its fourth straight monthly trade surplus, this time for August and to the tune of $18.8 billion. China's global trade surplus hit $135 billion in 2005, more than double year-before levels, and is on track to finish the year at $174 billion, projects Standard Chartered Bank economist Stephen Green.

China's big 2005 bilateral trade surpluses with both the European Union ($127 billion) and the U.S. ($202 billion) and the likelihood of big numbers this year have drawn international pressure on Beijing to do something to cool off its export machine. But would a big appreciation alone have much impact on China's trade numbers?

EXPORTS SLOWED?. Probably not, argues Standard Chartered's Green and presumably Paulson, judging by his recent speech on China. Green points out that big chunk of China's export sector is domestic and international firms that import parts and commodities, assemble consumer electronics and laptops on the mainland to take advantage of the cheap labor costs, and then ship off finished goods to worldwide markets.

This is the explosive side of China's export growth and wouldn't slow down much if the yuan appreciated. In theory, a more expensive yuan would slow down Chinese export growth because U.S., European, and Japanese consumers would have to pay more for mainland-produced goods.

But in China's assembly-driven export economy the cost of imports would be cheaper because the yuan would have more purchasing power vs. foreign currencies. In the end, yuan "appreciation would have a very marginal impact on the final price of many China goods" and thus a negligible impact on the trade numbers, he pointed out in a research report last month.

BAD DISTRIBUTION. Paulson argued in his speech that what really matters is that China's financial system operate more efficiently and spur more domestic consumption at home. That would ultimately bring down the mainland's reliance on exports and by extension the trade surplus. While the world has marveled at China's dazzling growth rates, the truth is the economy wastes an incredible amount of money getting there. It takes $5 to $7 of investment in China to generate a dollar's worth of gross domestic products, vs. $1 to $2 in the U.S. and Japan.

Chinese banks, often heavily influenced on lending decisions by the government, typically distribute money to the wrong or overcrowded segments of the economy. That hasn't mattered much, as Paulson explained, for "up to now, rapid growth has been achieved by shifting excess labor from agriculture and state-owned enterprises to market-based manufacturing. Today, as the most obvious sources of inefficiency are disappearing, growth will depend on raising productivity."

MULTIPRONGED EFFORT. The other problem: China has a savings glut, and this, too, is tied to both financial reform and the trade surplus. Ordinary Chinese don't have many savings options other than bank deposits and buying a home. The domestic stock markets, though growing, are still small relative to the banks. Chinese are also fearful for their retirements, the state pension system is weak, and other social safety nets are lacking. "The Chinese have an astonishingly high savings rate—50% of GDP—because Chinese households face so many uncertainties," said Paulson.

In the final analysis, winding down China's trade surplus will take a multipronged effort and probably many years of hard work. Paulson will also be hemmed in somewhat by Republican trade hawks back home who want immediate results. Representing U.S. trade policy, rather than just the interest of Goldman, will be a new challenge for Paulson, too. Still, Paulson likely will get a serious hearing in Beijing. And after six years of frustrating financial diplomacy between the U.S. and China, that is progress of a sort.


Steve Ballmer, Power Forward
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