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Paulson’s Tango with China

Viewed against the current heat and drama over the exchange rate for Yuan, the looming threat to brand China as a currency ‘manipulator’, the lurking trade wars in its wake, and the sudden, last minute reversal leading to peaceful dialogue in the coming months, it reads like ancient history: the equivalent of Peloponnesian wars. Reference is to the tango which Henry (Hank) Paulson was engaged in with the Chinese leaders from the date he took over as Secretary of U.S. Treasury in July 2006 until his last date in office in January 2009. The camaraderie between the capitalist icon of Wall Street who led Goldman Sachs for over thirty years and the red-hot communist leaders of China was out of the ordinary. In some ways, it was beyond belief. Truly, it is a study in international relations which were played according to the classic rules of diplomacy in which the interests of both the parties were balanced.

When Hank Paulson took over as Treasury Secretary, it was expected that he would bring about a breakthrough in the strained US-China relations. Indeed, he had the credentials. As the Chief of Goldman Sachs, he had undertaken more than 70 visits to China and developed a personal rapport with senior leaders there.

He took charge at a time when there was a shift in White House policies on China. The New China policy of the Nixon era was receding and yielding place to fear and loathing of China as a rival or a threat. The neocon hawks had sidelined doves like Robert Zoëllick. While serving as Deputy Secretary of State, Mr. Zoëllick pursued a policy of looking to China as a “responsible stakeholder.” In some of his articles in journals like Financial Times, he narrated how “given China’s success, its size, its rising influence, it has an interest in working with other major countries to sustain and strengthen the international systems that keep the world more secure, enable it to be more prosperous, and open opportunities to our people.” There was hope that Paulson’s induction into the Treasury would bring this spirit back into U.S. policies.

Truly, Paulson sounded the right note. In his first speech in Washington as Treasury Secretary, he acknowledged that while “many view the growth of China and its increasing importance as the clearest and most tangible threat of globalization,” he argued, “the prosperity of the United States and China is tied together in the global economy.”

As Treasury Secretary, Paulson made his first visit to China in September 2006. By then, he had realized that resolving disputes with China was a game very different from cutting loans and deals with Chinese banks. He had to contend with Congress and Senators along with domestic manufacturing lobbies and reconcile them with China’s demands. He led a delegation which included six Secretaries of State and Prof. Ben Bernanke, the Chief of US Federal Reserve.

During his first visit to China leading a high powered delegation, he could not achieve any breakthrough on any of the outstanding issues such as the Yuan exchange rate, widening of trade deficits and financial opening. However, Paulson secured a commitment to establish a Strategic Economic Dialogue (SED), a high powered bilateral forum, to meet biannually to discuss and resolve disputes.

Such bilateral platforms are standard options for most countries now. Many turn into periodic rituals and photo-ops without much progress. However, the U.S. has been trying to use this device to achieve its economic and trade objectives as ‘big brother’ with some countries and has also failed with others. It was engaged in a similar dialogue mode with Japan in 1980s and 1990s. There is no evidence that Japan yielded to U.S. pressures. As Lawrence Summers cautioned about the SED with China (A Japanese lesson for China, Los Angeles Times, February 22, 2007), “If heavy-handed pressure makes it easier for special interests to invoke nationalism as they resist change, high profile negotiations can be counterproductive.”

It is easy to brand an emerging nation as xenophic as many impatient diplomats from the west are prone to. Nationalism varies from country to country and also from one stage of development of a country to another. Concerns over national interests get transformed into sovereign rights and are non-negotiable. Between advanced countries, it seems more practicable to identify concerns and also arrive at agreements. When there is a chasm dividing the two parties and perceptions over development, employment, etc differ, such agreements seem difficult and need more time. This is more acute when there are global imbalances on the back of financial and capital volatilities. The extreme example of this malaise is the dispute over exchange rate. In fact, the currencies of many other countries are not valued properly (if such valuation is ever possible) and they don’t become warring issues. Unfortunately, Yuan rate becomes the battle cry for U.S. Senators to cure all their ills.

It is to the credit of Hank Paulson that he was aware of the deeper implications of U.S./China relations and did not see it through the prism of Yuan rate. He saw it as one of deepening relations between the two countries, especially in the financial sector. During successive SED meetings, he raised them in a composite manner and gave as much importance to other issues. On exchange rate also he held the firm belief that it was in China’s interest to have a flexible rate as close to the market as practicable. He did not expect this to happen soon. He was pleading with the Chinese to hasten the process with due regard to their own concerns over economic stability.

In recent months, it appears that similar empathy is lacking on the side of Obama administration. Timothy Geithner is young and inexperienced. He is more of a technocrat than a seasoned manager. He started off his career as Treasury Secretary with an attack on Yuan rate and had to retract within weeks. Secretary Hillary had to undertake a special trip to Beijing to assure the Chinese leaders of U.S. bonafides and request them not to offload dollar denominated assets.

A new act of the same drama commenced recently under pressure from the same Senators to declare China as a currency ‘manipulator.’ The U.S. press is agog with warnings to China over possible trade tariffs and ‘trade wars’ in the wake of its branding as a manipulator. The war cry has been given by some academics and, surprisingly, one of them is Dr. Paul Krugman, a respected Nobel economist. Indeed, he has been attacked by many other economists like Stephen Roach of HSBC. The jury is yet out on the value of the Yuan. Even the IMF had to bury the hatchet after two years of effort and explained why it would not designate any currency as ‘misaligned.’

The D day was 15th April. Suddenly, there is a change in attitude and the currency report is postponed. Unscheduled, Timothy Geithner breaks his journey at the Beijing airport and holds discussions with China’s Deputy P.M. The tension over sanctions is over. Here is no assurance that Yuan will be revalued. However, there is hope that it could happen any time. Goldman Sachs holds this hope to readers of Financial Times!

The idea in providing the foregoing rough and ready narration of current events is to suggest that U.S.’ economic diplomacy, especially in the aftermath of the financial currency, is yet to emerge. U.S. needs to show patience in dealing with other countries, especially large emerging economies like China. It may no longer ride a high horse. It has to readjust its style to the changing global economic balance and the southern shift. It needs to honour their sensitivities and not treat them as banana republics.

If Hank Paulson had succeeded in establishing exceedingly good relations with China during his term as Treasury Secretary, he was aware of the mutuality of interests and played for time. Recently, he has brought out a book on the crisis and it is titled: “ON THE BRINK – Inside the race to stop the collapse of the global financial system.” It is a very detailed study and clinically details all the efforts made him and his team to handle the crises even as bank after bank was collapsing. He had to resort unconventional ways to bailout some of them or allow some to sink. It is replete with hundreds of telephone calls he made with other colleagues, bankers in Wall Street, Central Bank governors, Senators, Presidential candidates and the U.S. President Bush himself. Of course, he has not disclosed any new material on individual episodes of bankruptcies or bailouts which is not already in the public domain. He has however provided material which establishes how close he was to the Chinese leadership.

In the introductory Chapter, he narrates his first to China in 1992. Mr. Tung Chee-hwa, who was running a private company and later became chief executive of Hong Kong Special Administrative region, took him to meet President Jiang Zemin. He was astonished over Zemin’s understanding of the U.S. economy. On return to the U.S., Paulson informed Rubin and Friedman of the huge opportunity in China and the scope for aggressive expansion there. From having virtually no presence in 1992, Goldman Sachs had 1500 people when Paulson left the company in 2006. As he writes, “It made Goldman the leading banking adviser in the world’s fastest-growing economy, and it game me a range of close relationships and contacts with the most senior Chinese leaders. These would help us enormously when I was at Treasury, especially during the financial crisis.”

Paulson was closely involved in the privatization deals and rendered strategic and technical advice on many of them. He tried to make the deals acceptable to western investors. “The Chinese, for their part, were eager to adopt the best practices from the west.”

He refers in his book with pride to his achievements in establishing the SED and explains how it brought together the senior leaders of both the countries. He explains how by focusing on bilateral strategic relationship, the SED kept US/China dealings on even keel. “And when the financial crisis erupted, the relationships we had built and strengthened with Chinese officials helped us to maintain confidence in our system. That was crucial, given China’s vast holdings of U.S. debt.”

There is an interesting reference in the book to the third SED in which Paulson elaborates how imbalances could be redressed by aligning currency rates close to market values. Vice Premier Wu Yi responded saying that she could not change equity caps in banks. “However, she quickly followed up by saying that my arguments on the currency were more persuasive.” We refer to this to emphasize the fact that opinion even in China on currency rates has been divided!

When Fanny Mae and Freddie Mac, two of the major mortgage guarantors, were facing financial collapse, Treasury had to consider several options, including that of bankruptcy. The issues were complex and the agency papers (debt) issued by the Twins ran to trillions of dollars and were held by foreign institutions. China alone was known to hold nearly 50 percent of the agency debt. China was indeed worried about the fate of those holdings as they were implicitly guaranteed by the U.S. government. There were rumours around that time that President Jiang Zemin rang up the U.S. President and wanted an assurance about those holdings. Paulson travelled to Beijing to meet Wang Qishan, who had replaced Wu Yi as Vice Premier. He explained to Qishan candidly about U.S.’s difficulties and was mindful that China was one of the top holders of U.S. debt, including GSE debt. He “stressed that we understood our responsibilities.” It was on his return that the Treasury clarified that GSE debt is guaranteed by U.S. government. Treasury also arranged for a loan of $85 billion to improve their operations. During the crisis, Paulson repeatedly assured that Chinese that “everything would be all right.”

Paulson’s book also reveals that during the GSE crisis, Russian officials made an approach at a top level to the Chinese that together they might sell big chunks of their GSE holdings to “force the U.S. to use its emergency authorities to prop up these companies.” It appears that the Chinese did not go along with the suggestion. Heavy selling would have created a sudden loss in confidence and shaken capital markets.

Another interesting episode shows how close Paulson was to the Chinese leaders. In mid September 2008, there were reports that Chinese banks were withdrawing large sums from the money market funds. Reportedly they were pulling back from secured overnight lending and shortening the maturity of their holdings in Fannie and Freddie papers – all signs of their battening the hatches. Paulson had enquired into these reports and they were fund to be baseless. Surprisingly, Zhou Xiaochuan, the PbOC Governor, informed the Treasury official that the moves had not been orchestrated by the Chinese government and could have been undertaken by middle level functionaries. Mr. Zhou informed that Chinese leadership would be giving “some guidance to these professionals not to pull back from the money markets or from secured lending.” Such candour in communication can come about only if there is mutual trust.

As said in his book, Paulson has also been talking to Chinese investing companies or sovereign funds to provide capital to failing banks like Morgan Stanley, Lehman Brothers, Goldman Sachs, etc. It seems even as Secretary of Treasury Paulson had no hesitation in requesting for capital infusion into U.S. banks. Here we see statutory lines being crossed and amoral action taken to save institutions. But we wish to highlight the point that Paulson had the clout and proper relationship with the Chinese counterparts to be able to do it. Perhaps, Mr. Geithner cannot do it!

It is in the concluding part of the book that Paulson deals with the future US/China relations in the context of G-20. Indeed, G-20 gives emerging economies a greater voice. However, as Paulson says, “the strength of the relationship between the U.S. and China will be critical to the functioning of the G-20 and global cooperation.” He is candid in saying that global problems cannot be solved by the U.S. and China alone. “But agreement with China makes it much easier to make real progress on any major issue.”

It is indeed heartening that some of this spirit has dawned on the U.S. in recent days. The statement issued by Timothy Geithner on 3 April, 2010 is even handed and highly balanced. It raises the larger issues of global imbalances and how they have to be negotiated in the context of G-20. Such a dialogue would die in the waters if the U.S. precipitately declares China as ‘manipulator’ and encourages its Senators to clamp down tariffs on China. The collateral damage may be inestimable. We trherefore believe that the U.S. should continue to dance the tango with China.

(The writer, Mr K.Subramanian, is a former Joint Secretary in the Ministry of Finance, Government of India, New Delhi. He is presently associated with the Chennai Centre for China Studies.Email:

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