Paulson in China: The Monster Under the Bed

A few years ago, as the financial storms that would come to define his tenure were gathering off center stage, Treasury Secretary Henry Paulson viewed the economic relationship between the U.S. and China as his biggest challenge — and his biggest opportunity. He would sit down twice a year with his Chinese counterparts and discuss big-picture issues. These weren't negotiations. They were part of a "strategic economic dialogue" — "sort of like the G2," as a former Treasury official puts it. They were a way to flatter China, the world's rising economic power, and to enlist its cooperation on big, global issues like increasing the use of renewable energy and protecting the environment. And if, along the way, Beijing managed to raise the value of its currency, the renminbi, against the dollar as the U.S. desperately wanted, so much the better.

The record will show that over the course of the past two years, China did in fact raise the value of its currency against the dollar more than 15%. But it will also show that during his last visit to Beijing as Treasury Secretary — which ended today — Paulson and his team had to ask the Chinese government not to backtrack on its commitment to "continued currency reform," as a Treasury spokesman put it. The RMB has recently weakened against the dollar, raising global alarm bells that China might try to devalue it as a way to revive its gasping export sector, putting pressure on other exporters to weaken their currencies and stirring up protectionist sentiment in Washington — particularly among U.S. labor unions, which heavily backed President-elect Barack Obama. For its sake, China blandly replied that the recent fluctuations in the RMB market were in line with market forces.

Then, to top off what had to be a miserable two days, Paulson had to listen to lectures from a series of Chinese officials about all the additional steps the U.S. must take to solve its economic mess. The U.S. had to stop consuming and start saving, because "global imbalances" were at the root of the financial crisis, People's Bank of China Governor Zhou Xiaochuan told Paulson. And, added Vice Premier Wang Qishan, Washington needed to "take all necessary measures to stabilize its economy and the financial market to ensure the security of China's assets and investments in the U.S."

In that last comment, some observers saw an implied threat: if the Chinese, who are massive buyers of U.S. Treasury debt, took their money and went home, the repercussions for America would be catastrophic. At a moment when the already large U.S. budget deficit is poised to skyrocket, thanks to the various bailouts and stimulus packages Washington has passed to cope with the economic crisis, a pullout of Chinese assets would send interest rates soaring, and a deepening recession could become something worse.

That, at least, is the nightmare version from the American perspective. But China's ability to make or break the U.S. economy is more of a "monster under our bed," says Michael Pettis, a finance professor at Beijing University, something that people spend too much time worrying about. Economists like Pettis believe — and the data to date suggest — that both consumption and private investment in the U.S. are plunging at a faster rate than government spending is rising. And given that consumers have shut their wallets, the U.S. savings rate is almost certainly headed up as this recession deepens. The result, as former Treasury official Brad Sester points out, is that the overall U.S. demand for capital is diminishing — despite the government's appetite for more money to fund bailouts and a likely forthcoming stimulus package — while its own ability to fund its deficits is increasing via more domestic saving. The bottom line: the U.S. is becoming less dependent on Chinese investment.

At the same time, it's not clear where else China would stash the dollars it earns via its massive trade surplus other than in U.S. Treasuries. Europe's economies are in no better shape than the U.S.'s, and it has again become clear during this crisis that the dollar — not the euro — remains the world's safe-haven currency. Beijing's other option — bringing home the dollars it earns via trade — would complicate China's own monetary policy and possibly drive up the value of the RMB.

That's something the Chinese increasingly want to avoid. Indeed, as Paulson and his team noted at this week's meetings, Beijing has started to make its trading partners nervous with a recent, relatively small reversal of the slow and steady rise in the RMB's value against the dollar. As a senior executive at a state-owned financial institution conceded to TIME two weeks ago, there is undeniable pressure from China's politically powerful export sector to weaken the RMB, which would make Chinese goods more price competitive abroad. If China triggered a wave of devaluations from other East Asian countries that are its export-market competitors, most economists believe the result could be catastrophic, increasing deflationary pressures in the developed world and quite possibly leading to protectionist measures that would add immeasurably to the already grim problems of the global economy.

Thankfully, China is unlikely to go there. For years, its economic policymaking élites have been sober-minded and effective. U.S. officials privately believe that their Chinese counterparts know there is no going back on the currency. Perhaps the more pressing topic of discussion at the meeting this week was the possibility of even more government stimulus coming in China — on top of the 4 trillion RMB ($588 billion) package China announced to great fanfare a month ago. Two weeks later, Beijing upped the ante with an interest-rate cut and tax rebates, and now there are unconfirmed reports that an additional spending plan is being prepared as China's economic data continue to weaken. That would not be surprising. The best way for China to help the world economy at this point is to help itself; not by exporting more, but by spending at home — in whatever way or form possible. After their lectures, and on his way out the door, that's a point that Paulson no doubt also made to his Chinese friends.

See pictures of China on the wild side.