Why Henry Paulson Says The U.S. Should Engage More Deeply With China by [email protected]

Few have had as much business interaction with China as Henry M. Paulson, Jr., former U.S. Treasury Secretary and head of Goldman Sachs. In Dealing with China, Paulson draws on his experience to provide his insights on how business works in China and how businesses can engage with China in the future. On the occasion of the publication of the new paperback edition, [email protected] reviews the book.

Henry M. Paulson, Jr., is best known for his short but eventful tenure as Secretary of the Treasury in the second administration of George W. Bush — in particular, for his much-scrutinized handling of the financial crisis triggered by the collapse of the subprime mortgage market in 2007. The previous year, however, Paulson requested — and was granted — great latitude in establishing a series of strategic talks with China that has continued through the Obama administration.

Moreover, these diplomatic initiatives and his work on the financial crisis were not unconnected: China quietly played a key supportive role in stabilizing capital markets, and the crisis had significant repercussions for relations between the two countries.

Yet Paulson’s interest in China dates well before his time at Treasury. At Goldman Sachs, he inherited the firm’s Asia office almost by default (based in Chicago, he was “closer” than the New York staff). Paulson quickly became convinced of the importance of engaging with the unwieldy and often inscrutable nation. That engagement, in turn, would become his focus after leaving the Treasury.

Along with his interest in environmental protection, China has in many ways become his life’s work: a quarter-century (and counting) journey he recounts in great detail in his book Dealing with China: An Insider Unmasks the New Economic Superpower.

“Why Are You Helping China?”

Early in 2014, Paulson– his years at Treasury and at Goldman Sachs behind him, and three years into running his eponymous nonprofit institute devoted to forging closer economic and environmental cooperation between the U.S. and China — was fielding questions from a group of American financial executives. “Hank,” one of them said. “You’re a real patriot. Why are you helping China?”

Dealing with China is, in a sense, a long and layered answer to the question of why Paulson — a Republican deeply committed to his country, to capitalism and the free market, and to the environment—feels so strongly about meaningful engagement with a socialist nation that has, in his words, “emerged as our biggest, most formidable economic competitor since the end of World War II.” Moreover, China has, he acknowledges, “started flexing its newfound military muscle in unsettling ways,” has shown an inconsistent commitment to free-market principles, and is guilty of a spotty record on human rights and the environment.

Dealing with China is, in a sense, a long and layered answer to the question of why Paulson … feels so strongly about meaningful engagement with a socialist nation that has, in his words, ‘emerged as our biggest, most formidable economic competitor since the end of World War II.’”

Paulson didn’t travel to mainland China until 1991, just over the midway point of his 32-year career with Goldman Sachs. Over the next 15 years he would make some 70 trips there: helping his firm catch up with (and surpass) rivals like Morgan Stanley; forming partnerships and friendships with a number of Chinese public officials and business leaders; and coming to the conclusion that, notwithstanding vast differences in culture and ideology, the national self-interests of the U.S. and China were intimately bound up with one another. To get there, he had to learn to navigate an often opaque decision-making process and to understand the limits of reform in a system committed to a “socialist market economy.”

An Early Foothold in Hong Kong

In late 1990, Paulson was named one of three co-heads of the investment banking division at Goldman Sachs and given the lead role in Asia — not then a priority for the firm. There was considerable internal debate about whether to bet on China or on the so-called “Asian Tigers” (Hong Kong, Singapore, South Korea, and Taiwan). Early on, Paulson felt that China — despite its volatility and murky politics — was worth the risk: “I simply did the math in my head — as successful as all those countries were, together they had about one-third the population of China.”

In those first years, the firm decided to focus its efforts on Hong Kong. And in the years leading up to the handover in 1997, that made sense: China was courting the colony’s business leaders, who were in turn cultivating ties and investing in the mainland. Goldman’s first splash was helping to broker Rupert Murdoch’s 1993 purchase of Star TV from an influential Hong Kong businessman, solidifying a relationship that the firm would parlay into a number of other deals.

In retrospect, one of the most important deals from Paulson’s early years was one that never materialized. China was struggling to meet the energy demands of its rapidly growing economy, and Goldman’s solution — developed in concert with reform-minded officials — was to sell a partial stake in one power plant to a group of foreign investors and use the proceeds to construct new power plants. The deal fell through, but it taught Paulson and his colleagues valuable lessons about the nature of doing business in China. It would also be the template for a series of deals that would establish Goldman Sachs as the pre-eminent Western financial firm there, and would allow reformists in China to use foreign investment as leverage for economic liberalization.

Reforming SOEs Through IPOs

In the first half of the book, Paulson highlights three major deals he and Goldman Sachs worked on in China. Two involved putting together public offerings for two of the country’s critical state-owned enterprises (or SOEs) — sprawling companies that were both driving the Chinese economy forward, and at the same time, holding it back. These companies might contain profitable and innovative units but they were also expected to serve as a vehicle for pet state projects, and to provide China’s version of a social safety net: the so-called “iron rice bowl,” a de-facto cradle-to-grave government guarantee of necessities like housing, food and medical services. As a result of trying to maintain this untenable dual role, SOEs had — almost of necessity — avoided adopting modern management practices and transparent accounting.

The failed power plant deal demonstrated to Paulson that reformers within China intended to use the accountability and standards built into public offerings as a way to force needed reform. They “wanted to overhaul the way SOEs were managed, eliminate their special privileges and subsidies, and encourage the development of professional managers to invigorate the state sector.”

In a word, they were seeking to undertake a kind of modified privatization on their own terms (only they preferred to call it “corporatization” or “capital restructuring”). Doing so would not only improve China’s competitiveness, but would also pave the way for eventual entry into the World Trade Organization.

An initial test of this strategy involved reform of the telecommunications industry, in dire need of capital investment (as of the late 1980s, there was still just one telephone line

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