Aug. 27 (Bloomberg) -- Henry Paulson could be excused for wondering what he was thinking.

The former Goldman Sachs Group Inc. chief executive officer accepted the job of U.S. Treasury secretary in mid-2006. Since then, it has been nothing but frustration over China's reluctance to loosen its currency policy, and a U.S. financial system riddled with risks.

Now, Paulson is faced with the specter of these ostensibly unconnected challenges fusing into one.

Last week, two of China's four main state-owned banks, Industrial & Commercial Bank of China Ltd. and Bank of China Ltd., disclosed a combined $11 billion investment in U.S. subprime-mortgage debt. The odds favor other major Chinese banks incurring losses.

It's hardly a disaster. These are huge lenders that China considers commercial arms of government and tools of its rising global influence. If markets blow up again, China Inc. will be even quicker to support its big banks than Japan.

Yet coupled with the country's investment in Blackstone Group LP, China's road toward international finance is proving quite bumpy. The upshot may be a more conservative China.

``Losses in subprime will solidify China's resolve to go slow on financial and other market reforms to the dismay of Secretary Paulson, the U.S. Congress and others in the West that believe China's financial system remains its weakest link and that market forces work best,'' Donald Straszheim, vice chairman of Newport Beach, California-based Roth Capital Partners, wrote in an Aug. 24 report.

Go-Slow Approach

It won't be lost on Chinese officials how insulated their markets have been to the global credit squeeze. It's a reprise of 1997, when China stood firm as Asian markets plunged amid the region's financial crisis. Seeing markets reel anew may encourage China to stick with a go-slow approach toward opening its economy and freeing the yuan.

U.S.-style capitalism, the very carrot that Paulson is using to get China to accelerate things, has become the stick China will use to beat back pressure from Washington. It was an open and complex U.S. financial system that allowed mortgage lenders and credit-rating companies to make a mess of things. Paulson will have a harder time than ever explaining the merits of his free-market philosophies.

Communist Party officials can be excused for having trouble fathoming the American way. What should one think of a system where one day Countrywide Financial Corp. CEO Angelo Mozilo gets saved from ruin by a $2 billion investment from Bank of America Corp., and the next day he says the U.S. is spiraling toward recession? It wouldn't be because of bulls in the proverbial china shop like Countrywide, would it?

Confounded in China

The folks at Bank of America can't be happy now that Mozilo is effectively suggesting they just wasted a couple of billion dollars. MBA textbooks would instruct Countrywide executives to say the credit crisis is over, everything is returning to normal and, hey Americans, go buy a cheap house you can't afford while you still can. Mozilo's recession musings must be confounding policy makers in Beijing and stock gamblers in Shanghai.

Chinese banks have sold stakes to major U.S. banks and brokers to learn about Western finance practices. These days, China may be thinking it's learning more about how not to proceed. That's especially true with Paulson and his boss, U.S. President George W. Bush, appearing to have no interest in keeping today's market turmoil from happening again.

Fed Bailouts

What's more, it smacks of financial socialism that Wall Street is clamoring for another Federal Reserve interest-rate cut. The next time U.S. officials trash China for state support of banks and companies, China can just toss the Fed's bailouts back at them.

Still, China does have huge risks and challenges on its plate. In May, the Asian nation invested $3 billion in the world's largest private-equity fund. Blackstone's shares are down 28 percent since going public in June, provoking an outcry in Internet chat rooms in China. Clearly, China wants to avoid a repeat with huge subprime losses that unnerve the population.

The upshot is that the odds of Paulson getting China to liberalize its economy faster are dwindling. Last week, People's Bank of China Assistant Governor Yi Gang said Asia's No. 2 economy will move at its own pace to open its capital account.

Congress has some interesting China-related choices to make. China's product-safety woes may be a better campaign issue than the yuan. The problem won't go away anytime soon -- not with Chinese officials so far appearing to spend more time blaming the media for covering it than fixing it.

Concerns about China's weak currency may loom larger. Congress can slap tariffs on China in hopes of forcing it to strengthen the yuan -- knowing all the while it won't budge. Or, it can find some middle ground, realizing that China's exchange rate isn't the panacea elected officials claim.

In the meantime, the more China opens up to global markets in the current climate, the more it may frown at what it sees.

To contact the writer of this column: William Pesek in Tokyo at wpesek@bloomberg.net

Last Updated: August 26, 2007 11:26 EDT