Paulson Feeds the Fire on China

In a report, the Treasury Secretary stopped short of accusing Beijing of currency manipulation. But he may have just given more ammo to critics

While trying to thread a political needle through U.S.-China policy, Treasury Secretary Henry Paulson may have ended up pricking himself—and strengthened the hand of China's critics in Congress. Instead of calming China's detractors on Capitol Hill, Paulson's Dec. 19 conclusion that China isn't manipulating its currency is likely to prompt a new round of congressional hearings and a spate of tough legislative initiatives from newly empowered Democrats and anti-China Republicans.

Just a week ago, Paulson led a delegation with big-time political firepower to Beijing. The tough-talking group—which included Cabinet members and Federal Reserve Chairman Ben Bernanke—raised hopes that Washington was finally ready to crack down on the Chinese for the way they manage their currency.

But actions speak louder than the toughest of words. On Dec. 19, Paulson pulled his punches when the semi-annual Treasury Dept. foreign-exchange report stopped short of accusing China of manipulating its currency. While declaring that China's attempts to make the yuan more flexible against the dollar were "considerably less than is needed," the former Goldman Sachs (GS) CEO steered away from charging that Beijing was using an undervalued currency in a premeditated effort to make Chinese goods less expensive across the globe.

Not a Surprise

The Bush Administration can ill-afford a showdown on China trade. The White House faces a growing revolt both from China trade hawks in the Republican Party and from Democrats angered by China's human-rights record. With control of Congress about to shift to the Democrats, the White House may find itself in a losing battle on the issue.

Still, Paulson's conclusion was to be expected. For reasons of both geopolitics and international economics, no American Treasury Secretary in a dozen years has declared China to be a currency manipulator. When the Clinton White House did so in 1994, there was an anti-American backlash from Beijing. And to be fair, China has taken at least a few small steps to allow its currency to float.

Paulson's language was even a bit softer than the report issued by his predecessor. Last spring, former Treasury Secretary John Snow declared that China was "unjustified" in its delay in addressing the situation, which has angered American executives, who feel that China has gained a competitive advantage through its currency valuation. "We are not satisfied with the progress made on China's exchange-rate regime, and we will monitor closely China's progress every step of the way," Snow said on May 10.

A New Process?

From the reactions of key leaders of the soon-to-be Democratic Congress, it appears Paulson and his Administration colleagues may be fending off anti-China legislation in the near future. "I am deeply disappointed that the Treasury Dept. did not reach the conclusion that many of us in the Congress have, that China and other nations are engaged in currency manipulation," said Senator Christopher Dodd (D-Conn.), who is scheduled to become Senate Banking Committee chairman in January. China is "creating an unfair playing field for American companies and hurting millions of American workers," he added.

Dodd's views were echoed by outgoing Banking Committee Chairman Richard Shelby (R-Ala.), who declared that "I have long believed that China manipulates its currency, thereby giving it an unfair trade advantage."

Paulson's action could even prompt a reexamination of the entire process by which the Treasury Dept. reviews global currencies. Senator Max Baucus (D-Mont.), who is in line to head the Senate Finance Committee, called for "a new approach." Paulson's report is evidence that Treasury's semi-annual review "is no longer a relevant tool to deal with currency issues," Baucus said. Other lawmakers are hoping to revive a failed 2005 proposal by Representatives Tim Ryan (D-Ohio) and Duncan Hunter (R-Calif.) that would declare currency undervaluation an illegal export subsidy.

Private Persuasion

China's critics in the U.S. business community had high hopes for the new report after Bernanke, who accompanied Paulson to Beijing, declared on Dec. 15 that China's currency provides an "effective subsidy" for companies that "focus on exporting." David Harquist, counsel to the China Currency Coalition, an alliance between unions and some U.S. manufacturers, says he was "pleased that China's currency undervaluation finally has been identified by a high-ranking U.S. official for what it is: a practice that disregards global trading rules, which are essential to free and fair trade."

Now, incoming chairmen in the House and Senate—including Baucus and House Trade Subcommittee Chairman-select Sander Levin (D-Mich.)—are promising to call hearings asking Paulson to justify his decision.

Paulson, a finance-industry veteran who has been to China dozens of times, believes he can be more effective by avoiding political attacks on China and focusing on convincing the Chinese privately that it's in their best long-term economic and political interests to allow their currency to strengthen against the dollar. It may be harder for Paulson to convince anxious congressional Democrats and China-bashing Republicans that his approach eventually will pay dividends.