Paulson's China Charm Offensive

The Treasury Secretary has skill and connections, but his understated approach to financial diplomacy has yielded mixed results in China

U.S. Treasury Secretary Henry Paulson is no stranger to the glacially slow and sometimes maddening ways of Chinese officialdom. He has the most guanxi, or connections, in China of any post-war Treasury Secretary, given his extensive travels to the country during the 1990s as chief executive and chairman of Goldman Sachs (GS). 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.

He also knows that concessions come slowly, if at all, from Beijing. Paulson prefers reasoned appeal to China's self-interest rather than waving the sledgehammer of potential economic sanctions from the U.S. And his aim isn't just greater flexibility for China's undervalued yuan, but broader financial reform that would modernize China's capital markets, spur local investment, and raise economic productivity. Paulson has said he fears a China that overheats and derails far more than its role as an economic competitor to the U.S.

Paulson is in China this week and will meet with President Hu on Aug. 1 at a time when trade hawks such as Senators Charles Schumer (D-N.Y.) and Lindsey Graham (R-S.C.) continue to push for punitive tariffs on Chinese imports if Beijing doesn't do more to rein in its swelling global trade surplus. And a year after the kickoff of the "strategic economic dialogue" between the U.S. and China, his softer approach hasn't yielded any big gains just yet. Here's a quick rundown of the thorny problems dividing both sides:

Ugly Trade Dynamics

First, the good news: China is now the U.S.'s fourth biggest export market and the fastest-growing one. American exports hit $55 billion in 2006, which is more than U.S. sales to France, Brazil, and India combined.

It is the other side of the ledger that freaks out China critics stateside, however.

The U.S. trade deficit with China totaled $232.5 billion last year, and likely will exceed that record level by the end of 2007. Meanwhile, China's global trade surplus reached $177 billion in 2006 and is on track to finish this year at somewhere near $300 billion.

China's Undervalued Currency

Driving China's supercharged export performance, some economists contend, is a dramatically undervalued currency. Extraordinarily robust export earnings are also feeding into a liquidity boom on the mainland that has electrified the economy and triggered worries that China may overheat and then go bust. The economy grew 11.9% in the second quarter, way above expectations and at the fastest pace in about 12 years.

Hu's government has taken several measures—interest-rate hikes and investment caps—to slow things down and is starting to tolerate more appreciation in the yuan. The Chinese currency yuan has appreciated about 9% since July, 2005, when Beijing replaced its currency peg to the dollar with a semi-fixed system enabling the yuan to move within narrow trading bands against a basket of currencies. Glenn Maguire, chief Asia economist for Société Générale based in Hong Kong, is forecasting a further one-off 3.5% revaluation by yearend. Paulson and others want more, but it can't be denied that things are moving in a better direction.

Chinese Product Safety

China critics in the U.S. have pounced on the recent run of disturbing cases out of the mainland concerning product safety. Shoddy or outright dangerous seafood products, pet food, tires, and other goods exported from China have damaged the country's international reputation in recent months. On top of that, political corruption and lax regulatory oversight have caused health problems and even deaths inside China. On July 10, Zheng Xiaoyu, the former commissioner of the State Food & Drug Administration, was executed for accepting bribes of about $850,000 from eight drug companies seeking quick product approval.

Though China has conceded it has work to do, Beijing regulators have in turn gone after U.S. companies that have alleged problems as well. Imported American poultry and pork products from several major U.S. producers such as Cargill, Tyson Foods (TSN), and Sanderson Farms (SAFM) have been suspended over charges they are unsafe from use of pesticides and drugs, or infected with bacteria.

Fakes and Knockoffs

Counterfeiting and intellectual-property rights abuses in China continue to be a hot-button issue, and have featured prominently in discussions in Washington and Beijing during so-called "strategic economic dialogue" talks between Paulson and Chinese leaders such as Vice-Premier Wu Yi. The local economic interests tied to fake goods and lax regulatory oversight is a long-range problem and is costing U.S. and global businesses billions in lost revenues.

It's true that earlier this month, the FBI and China's Public Security Bureau busted up a pirating syndicate that had been peddling bootleg versions of Microsoft (MSFT) software. However, piracy of music and other U.S. products remains a scourge without any signs of quick resolution.

Good Cop, Bad Cop

While Paulson's charm offensive with Chinese officials continues apace, the Commerce Dept. is playing a far rougher game. Commerce currently has 62 anti-dumping orders on Chinese imports ranging from consumer goods to steel products and chemicals. "These orders represent 27% of the total anti-dumping orders we currently have in effect globally and cover almost $6 billion in imports," David Spooner, Assistant Secretary of Commerce for Import Administration, told a congressional committee on July 25.

Add it all up, and Paulson's early record is somewhat mixed. While the Treasury Secretary gets high marks for his commitment, his inside knowledge of the ways of Beijing, and his sterling contacts, he will ultimately be judged by improvements in trade and piracy. This doubtless will be one of the toughest acts in international financial diplomacy to pull off effectively.

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