Why US speaks softly with China on trade

America's economic point man is taking the tack of cooperation rather than confrontation on a visit to China this week, despite a widening trade deficit and disputes over everything from pirated movies to barriers that hinder US exports of auto parts.

It's a softer tone driven by China's rising economic power, by the interdependence of the two nations, and by a pragmatic approach to financial diplomacy.

But for Henry Paulson, America's new Treasury secretary, it also reflects an assessment of risk that may come as a surprise to many Americans.

For all its rapid strides, China is in some ways a fragile economy. That, trade experts say, is a danger not just to leaders in Beijing but to the world economy.

"If reform stalls, the Chinese economy will stall, and that is in nobody's interest," says Daniel Griswold, an economist at the Cato Institute, a libertarian think tank in Washington. Paulson "understands that our interest is in a thriving, liberalizing China."

China has committed itself down the road to an increasingly market-based economy. Its surging output of electronics and other goods has been stunning – and unsettling to rival manufacturers in other nations.

But this doesn't mean China's path of progress will necessarily remain smooth. Among the challenges: an outdated financial system heavy on bad loans, state-owned businesses in distress, a volatile social rift between prosperous urbanites and the rural poor, and the looming burden of a rising elderly population.

Secretary Paulson pointed to many of these challenges in a major speech before heading overseas.

"The biggest risk we face is not that China will overtake the US," he said, "but that China won't move ahead with the reforms necessary to sustain its growth and to address the very serious problems facing the nation."

Paulson's stated goals for the US-China economic relationship have much in common with those of his predecessor, John Snow. Both put the issue of a more flexible Chinese currency high on their list – a move that could bolster the exports of struggling US manufacturers.

But Paulson's tone appears at once softer and more ambitious. He is not simply calling for change from Beijing officials. He expects to work with them regularly, building on the ties he established there in his career as a globe-trotting investment banker.

Wednesday, Paulson and a Chinese official announced the creation of a new high-level dialogue designed to deal with long-term issues between the two nations. At the same time, he has dampened expectations for any quick victories on issues such as the yuan-dollar exchange rate.

All this reflects a tempered approach to China at a time when critics continue to press the Bush administration for punitive measures if China is not responsive.

"Time is running out. I hope that Hank returns with tangible results," Sen. Charles Schumer (D) of New York said in a statement last week. He and Republican Sen. Lindsey Graham of South Carolina say they may have "no choice" but to call for a vote on their proposal that China face a 27.5 percent tariff in the US if Beijing fails to act on the currency issue.

His sentiment is backed up by many small- and medium-size manufacturing companies. Kevin Kearns, president of the US Business and Industry Council, said this week that America needs a get-tough approach. Use China's reliance on exports to the US and the threat that those sales could be lost, he suggested, to leverage concessions from Beijing.

Many economists, however, caution that a trade war could harm both nations and the world economy. Their arguments include:

•The US and China, currently the twin engines of global growth, have become increasingly interdependent. Supporting gradual reforms, and a healthy Chinese economy, is more important than winning concessions.

•China's increasing clout makes it likely that its leaders will continue to make decisions based on perceptions of their own interests, not outside pressure.

•Even if the yuan were to rise sharply against the dollar, it is unclear how much impact that would have on the mammoth US trade deficit. America might simply import more from other nations, or pay more for imports from China.

Moreover, a large revaluation of the yuan might destabilize China.

"If they did it suddenly, their financial system might not be able to withstand the adversity," says Michael Cosgrove, an economist in Dallas who publishes the Econoclast newsletter.

A recent study, prepared for Congress's Joint Economic Committee, outlines a collection of challenges China confronts. It calls the banking system "dysfunctional," dominated by four state-owned banks and wrestling with a tide of nonperforming loans. One estimate, by the US accounting firm Ernst & Young, reckoned that the bad loans totaled $911 billion, or 41 percent of China's gross domestic product, at the end of last year.

China also has a jobless or underemployed "floating population" of some 140 million. By 2015, a decline in the working-age population promises to shore up the labor market.

But the flip side of that trend is an aging population without a social safety net. Already, this has distorted the economy by pushing China's domestic savings rate sky high. That's hindering the nation's hoped-for shift from an export-driven economy to one fueled more by domestic consumption.

"They themselves have come to the view that their current growth path is not sustainable," says Nicholas Lardy, an expert on China at the Institute for International Economics in Washington.

He says China is making headway with financial and other reforms.

Now it needs to find a way to boost domestic consumption while reducing runaway investment in industrial production – and to achieve this in lock step so that the economy doesn't slump. "The whole strategy is fraught with risk," Dr. Lardy says.

A more flexible exchange rate could help, he says. That would allow the central bank to focus more on domestic conditions and less on maintaining the yuan.

Paulson echoed that view in his recent speech on the global economy.

He spoke of "freeing up an inflexible currency regime" that hinders the development of a balanced economy. A more nimble monetary policy and financial system in China, he said, could "keep its economy from veering out of control."

Member nations of the International Monetary Fund are also nudging China and the US to do more to address imbalances in the world economy. To many, that means exchange-rate shifts in the dollar and yuan. It also means more saving (and less borrowing) in the US, and more consumption within China.

Lardy and others say China isn't fragile to the point of breaking. But it faces some tough transitions.

The reforms "will be when they feel it is in their interest to do so," Lardy says. "Paulson, at the margin, could help them see their way to the decision."