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Fall 2007

Chinese Reserves Make the World Go ’Round

Henry Paulson is the United States secretary of the Treasury. He spoke with NPQ editor Nathan Gardels in September.

NPQ | Liquidity makes the world go ‘round. Six months ago the commentary was all about how the world was awash with a global savings glut—not least because of China’s $1 trillion in reserves along with petrodollars—and this was driving global growth, including keeping down US long-term interest rates through massive purchase of T-bills and mortgage-backed securities.

Now all the talk is about “liquidity crunch” as risk is re-priced and credit has turned tight. Yet, in the larger, longer term, all that liquidity in foreign reserves is still out there. Doesn’t that suggest that once the mortgage market is sorted out here in the US, we’ll be back on the path to global growth?

Henry Paulson | I agree with the fundamental thrust of your comment, but let me put it in a broader perspective.

Unlike other times of turmoil in the market, the current stress wasn’t precipitated by problems in the real economy. The current problems were precipitated by excesses in the form of undisciplined lending practices which came about, in part, because of great liquidity and a strong economy.

In a number of markets, lenders reached for yield at a time when risk premiums and interest rates were at historic lows.

It will take a while to work through this now. But we have the advantage, which differentiates this from other periods of stress, of having the background of an exceptionally strong global and US economy.

It will take longer in some markets than in others. We’re already seeing improvement in a number of credit markets. One of the markets, obviously, where it will take longer is the sub-prime mortgage market, where we will see recess over the next 18 months to two years.

Now, the reason it will take a while to work through this—more than weeks—is because we are more integrated into the global economy than before and because of the complexity of the securitized mortgage products.

The key to liquidity coming back to certain markets, to making the credit market function as normal, is investors regaining confidence that they understand the security, the risks associated with that product and pricing that risk properly.

You are essentially right in your question: Because the US has a big, resilient economy, we always work through these issues and, as you say, the big liquidity pools are still there and the global economy as a whole is strong.

This gives me great confidence that we are going to work our way through this. Of course, you can’t have the kind of housing decline and turmoil in the sub-prime mortgage market we’ve had in the US without there being some penalty to growth. But as we work this through, this economy is going to continue to grow, the standard of living will increase and real wages will go up.

Clearly, there are the pools of capital looking for investment and strong underlying fundamentals. Our major corporations are well capitalized. Our financial institutions are well capitalized, with record earnings. Pension funds and insurance companies are in good shape.

NPQ | The other side of the great liquidity pool of Chinese reserves is the $800 billion US current account deficit. US Federal Reserve Board Chairman Ben Bernanke told the Bundesbank recently that “this imbalance can help reduce tendencies toward recession” because these reserves keep long-term rates down by investing in US T-bills and debt. And he said this condition could last “a few decades.”

It sounds like this is just what you are saying.

Paulson | I have great confidence in him, but I’ll let him speak for himself. I will also say that if you look at the economic data that just came out, the US had a small surplus in July. More importantly, if you look at the data over the last year, from July 2006 to July 2007, US exports grew at 15 percent while imports were up a little over 5 percent. What we are seeing is the strength outside the US economy is benefiting us, driving jobs and growth through exports.

NPQ | If the US depends on China’s reserves, China depends on the US consumer. China’s Achilles’ heel is lack of effective regulation of what it produces because of ineffective rule of law. Do you think the American consumer backlash against China’s tainted toys and pet food will compel it down the path to greater rule of law? Might US purchasing power force some reform on its part?

Paulson | Those people who worry about whether China’s continuing growth will hurt the US are worried about the wrong thing. The US and the rest of the world benefits from China being a very important contributor to global growth. US exports to China are growing at a fast rate now. And, of course, we benefit from Chinese imports.

What should concern us would be instability in China that would break this growth path. I have always emphasized to the Chinese that moving too quickly is a much lower risk than moving too slowly.

The Chinese economy is growing so quickly and becoming so integrated into the global economy that the Chinese need to speed up the pace of change in economic reform, moving beyond the World Trade Organization in terms of opening up to competition.

When they get to the point where they are able to have a market-determined currency—and in the meantime a currency that reflects economic fundamentals—it will be easier to manage their increasingly complex economy with macroeconomic tools rather than administrative tools.

They also need to speed up the pace in regulation and the law. As you mentioned, they need to move faster in regulation and rule of law when it comes to product safety and food safety.

But this touches a wide variety of areas, including respecting intellectual property, which is important not just to us but to them if they want to move up the value-added chain, producing more sophisticated products.

Environmental issues are very important to the Chinese people, and the leadership takes this seriously. Having competitive capital markets is absolutely critical for them to become a well-developed economy where the benefits are spread throughout the society.

This is very important to us in terms of reducing the trade imbalances. Are they going to be a country saving at a 50 percent level or where development is more balanced and there is greater domestic consumption?

NPQ | Will the consumer backlash in the US accelerate their move toward the rule of law?

Paulson | Product and food safety are as important to the Chinese as they are to us. I can say they are really focused on it now.

We are dealing with this and the other issues in the Strategic Economic Dialogue I have set up with the Chinese leaders. In that forum we have a clear understanding that we are not going to be able to inspect our way out on this one. There needs to be effective regulation and rule of law. And quality has got to be built into the production process. There are responsibilities on both sides.

NPQ | Needless to say, in your view any protectionist moves by the US Congress in response to the issues of product safety and job loss during this election season would hurt China’s progress?

Paulson | The best way to deal with China is through a vehicle like the Strategic Economic Dialogue, not through legislation where there are unilateral, punitive sanctions. These would be destructive measures at this moment where US growth depends more and more on exports and the continuing strength of the global economy.

The relationship between the US and China is so important we need to keep it on an even keel with a view to the long term. The Dialogue allows us to focus on the key structural economic issues and reforms beyond WTO while providing the forum to deal at any point in time with sensitive issues that might arise, like the current one over product and food safety.