BEIJING -- Expectations are running high in China for the arrival of U.S. Treasury Secretary Henry "Hank" Paulson on Tuesday. Steeped in the vernacular of capital markets, the former chairman and CEO of Goldman Sachs has also cultivated an avid interest in the Middle Kingdom. Paulson famously racked up 70 trips to China while presiding over Goldman's expansion here. For both reasons, Paulson brings an unusual degree of credibility to a thankless task: pressing the Bush administration's case to allow faster appreciation of the yuan. "I think Paulson's biggest job is not convincing China to revalue, it's convincing the White House that their position is wrong," says John Rutledge, a RealMoney.com contributor and chairman of Rutledge Capital, a Greenwich, Conn.-based private equity investment firm. He calls the administration's position "90% politics and 10% economics," adding that a revaluation "could inadvertently destabilize the Chinese economy." Nonetheless, election-minded U.S. lawmakers have been squawking that an undervalued yuan is to blame for a surge of cheap Chinese exports which, they claim, are costing American jobs. Just this August, China posted a record $18.8 billion trade surplus while the U.S. posted a record $68.8 billion trade deficit. Yet Beijing, anxious to nurture China's own economic growth, has lately turned a deaf ear to calls for a yuan revaluation. On July 21, 2005, Beijing allowed a 2% rise in the value of the Chinese currency relative to the dollar. But since then China has repeatedly ignored foreign hectoring for further revaluations. The currency has ticked up by only another 2% in the ensuing year.
Although that's too little to satisfy outside critics, most analysts are convinced Chinese authorities will stick with their incrementalist policy -- and Paulson's visit isn't likely to change that. This weekend's Group of Seven meeting in Singapore ended with a communique stating: "greater exchange rate flexibility is desirable in emerging economies large current-account surpluses, especially China." In reaction, China central bank governor Zhou Xiaochuan reiterated plans to keep the exchange rate "relatively stable." Changes in the yuan's value will be driven by the market, not by pressure from the U.S. or other countries, analysts agree. Some expect that by the end of the year China will widen the daily trading band with which the yuan is allowed to fluctuate against the dollar -- now 0.3% on an intraday basis. But change will nonetheless be gradual, they say. At Royal Bank of Scotland, currency strategist Ben Simpfendorfer predicts the yuan will strengthen to 7.8 to the dollar by year-end, up from a close of 7.9460 Monday in Hong Kong. "I think Beijing will allow greater volatility," Simpfendorfer says, but adds that it won't be very significant until the market sees more sustained dollar depreciation. Market sentiment aside, some China watchers defend the economic logic of Beijing's position. A stronger yuan, which would make Chinese-made goods more expensive throughout the world, could reduce demand for exports and thus wipe out a critical part of China's growth machine. Manufacturers might have to lay off workers, which could in turn cause labor unrest and threaten political stability -- something the one-party Communist state seeks to avoid at all costs.
"The internal economy plus financial market instruments in China are very fragile," says He Yin, an economist who teaches at Peking University. "If exports suddenly decreased on a large scale, that would hurt domestic firms and then the financial markets. There might be a chain effect." He and other economists also say the government wants to ensure that state-owned banks are on a more sound footing before allowing a significant rise in the yuan. China's big banks have extensive property loans on the books that might go bad in the event of a sudden currency shock. The banks also hold foreign deposits from currency speculators who might repatriate their money following a sudden, sharp revaluation, unsettling the entire banking system. In short, given the extent China's economy relies on a stable yuan, no one expects the new Treasury secretary to win over hearts and minds on the revaluation front. But unlike his predecessors (notably former Treasury Secretary Snow, who as a former railroad executive had little China experience), Paulson is at least likely to fail with aplomb. The Chinese respect him for his business prowess (an editorial in one government paper commended his involvement in Goldman's expansion in China) and seem to consider him more credible than the usual colorless array of U.S. government suits. Helpfully, Paulson has come out against protectionism in all forms, making clear he would be opposed to legislation that would slap punitive tariffs on Chinese goods sold in the U.S.
Paulson has taken pains to acknowledge Chinese interests, even as he advances a U.S. agenda. In a closely watched speech delivered last week, Paulson said he plans to tell Chinese leaders, "Our economic fortunes are interconnected. I will say: 'We want you to succeed.'" "If you push too hard
on the currency issue , the Chinese government won't do anything. It will actually have a negative effect. Mr. Paulson knows this, and I think he won't push too much," says Peking University's He. That said, Paulson also has spoken bluntly about the risks of China remaining on its present export-driven course. The secretary warned in his speech last week that over the last couple of years, he had seen antitrade sentiment around the world begin turning into an anti-China backlash. Increasingly, he said, China is viewed with fear, as a "symbol embodying both the real and imagined downsides of global competition." Unfortunately, at least on the China trade front, things are likely to get worse for the U.S. before they get better. Beijing's efforts to rein in China's overheated economic growth, which have included two interest rate hikes since this spring, are bearing fruit as August data showed the growth of money supply and lending slowed. But weaker domestic demand suggests China's appetite for imports will decrease, while exports out of China won't be affected. The upshot: China's trade surplus is likely to get even bigger in coming months, making Hank Paulson's job that much more complicated.