Dealing with China: An Insider Unmasks the New Economic Superpower

by Henry M. Paulson Jr.

Chinese meetings have a definite choreography and ceremony to them, and it is within this context that you look for the signals being sent and the messages being given. In general, everyone sits in chairs set out in a horseshoe or U-shaped arrangement, with the most senior Chinese official at the closed end of the U and the most important visitor to his right; other Chinese officials and members of the visiting delegation are arrayed in descending rank on the flanks of the horseshoe, facing one another.

The key to breaking into new markets is to brand yourself by building strong relationships with the most important clients.

“Chinese learning as a base, Western learning for practical applications.”

We discovered quickly the need to be very selective about the business we pursued and never to take anything for granted. That’s a wise approach the world over but nowhere more so than it was in China during that early period of rapid economic change.

We came away with a crucial lesson: many officials could approve a deal, but it took only one well-placed official in a consensus-ruled system to kill it.

That was living on the edge, China style, but that was how you had to operate. In China you frequently had to work in a gray area. Deals often had to be completed before the country, reinventing an entire economy on the fly, had put in place laws and regulations that had not been necessary in the days of centrally controlled planning. You had to take it on faith that the Chinese would live up to their word and deliver, even if they could not, for one reason or another, put something in writing as precisely as you had hoped.

Trust and face were uppermost: you had to trust that if the Chinese committed to doing something, they would deliver, even if they danced around the point. In dealing with China’s most senior government and business leaders for two decades now, it has been my experience that they have come through, without fail, when it was in their best interest to do so.

Borrowing freely while hemorrhaging money, the SOEs had run up enormous debts, crippling the banks and threatening to derail economic growth and undermine China’s standing in world markets. By 1997 the government calculated that a staggering 25 percent of the Big Four’s bank loans were nonperforming.

Jiang and I were sitting side by side at the big round banquet table, and when the interpreter had translated my remarks, Jiang shifted in his seat to face me more directly. “Hank,” he said. “Would Goldman Sachs be interested in becoming one of our strategic investors before we do our IPO?” His proposition caught me off guard. I’d expected to pitch for the underwriting and had not focused on this option.

ICBC was a perfect example of the problem. Beginning in 1999 it had transferred roughly $50 billion in bad loans to Huarong Asset Management Company, the entity created to work out and recover bad debts. But five years later ICBC still had $85 billion to $95 billion in bad loans on its books, or about one-fifth of its total loans.

I had been focused on asset quality, and all those sour loans. But the other side of the balance sheet was a revelation. ICBC had more than $600 billion in deposits, and new deposits were flooding in at a rate that worked out to nearly $225 million every business day. In one year that would bring in enough money to rank among the top 15 of all U.S. banks.

The Communist Party had essentially made a deal with the people to provide prosperity in return for continued political power. The Chinese leaders’ credibility with their citizens was rooted in economic opportunity, job creation, and an ever-improving standard of living.

The president had assured me I would be in charge of all economic issues for his administration, and we decided to define “economic” broadly, as the Chinese did. Why shouldn’t it include such vital matters as energy and the environment—or food and product safety? The way I saw it, the SED should embrace everything except national security and foreign policy. This would require me to take on a leadership role with my fellow Cabinet members on U.S.-China relations. I understood the inherent problems with that. Some would surely see it as a power grab. That wasn’t the intention: if the SED was going to be successful, someone on the U.S. side had to prioritize our objectives and then negotiate at China’s highest levels across a range of subjects and controversies. President Bush couldn’t do this twice a year, but I could.

“My staff told me you picked up beer cans on the shore of Qinghai Lake,” Wen noted. “It is clear that you care about China. The situation we are facing is very grim.” As he spoke his face glowed with appreciation, and his eyes moistened. I knew that Wen cared deeply about his country’s troubled environment.

The next night, after a celebratory banquet, the Chinese thought it would be amusing if I played Wu Yi at Ping-Pong. I’m not good at the game, and I would have had no problem letting the vice premier beat me—no shame in that. Wendy beat me all the time. I thought the game would be good for U.S.-China relations. I started to feel the adrenaline pumping, and I was looking forward to playing her, but my staff disagreed and wouldn’t let me. “It wouldn’t look good for you to be beaten by Wu Yi,”

Out of this several-month process came the Paulson Institute, a nonprofit that was to be funded initially only by me. It was officially established in June 2011 with a mission of promoting sustainable economic growth and a cleaner environment by facilitating greater cooperation between the U.S. and China. We laid down several clear goals: to encourage energy efficiency and better environmental practices, to increase cross-border investment leading to the creation of jobs, and to promote responsible executive leadership and best business practices on issues of international concern.

The gap between urban and rural areas is stark. City dwellers are four times as productive as their rural counterparts; they earn three times as much and consume three to four times as much. “The discrepancies are large, but it also means the potential is large,” Li told me that afternoon. “We’ve come to a consensus: urbanization has the greatest potential for boosting China’s future domestic demand.”

China would also do well to address property rights: unlike in the U.S., the state owns all the land. Since the late 1990s, city dwellers have been permitted to own their apartments (the land beneath buildings is leased from the state), but farmers are allowed only so-called land-use rights to work and live on land that is owned by local agricultural collectives and held in the state’s name. Many city residents have made a killing as property values soared in recent years. Not so farmers, who can’t sell or mortgage their land rights. Financially strapped cities, which can’t afford to pay pension and health care benefits to armies of migrants, would be more welcoming if the farmers could turn the land they live on into capital to provide them with financial security.

Advocates of sustainable development today emphasize the importance of building mixed-use neighborhoods that bring together in close proximity housing, work, education, recreation, and shopping. They press for zoning that promotes dense grids of streets and small blocks, rather than huge boulevards and superblocks, and that creates green spaces to improve air quality and give residents spots to gather. The architects of ancient Beijing might as well have inked the site plans of these so-called New Urbanists: the blocks of courtyard houses that they laid out along hutong alleys did not just house people, they provided places to shop and go to school; they were near where people worked; and their courtyards served as oases in which families could relax.

It was such a typically Chinese phenomenon. An issue will lie dormant, or be put on simmer, for weeks, months, even years, as the Chinese study, debate, test, and build consensus around it behind the scenes. Then, suddenly, they will embrace it wholeheartedly and drive home their message with great clarity and urgency.

Shortly after he took power, Xi Jinping unveiled his “Chinese Dream,” a vision of national rejuvenation that calls upon the Chinese people to strive to restore their country to its rightful, historical place in the front ranks of the world’s civilizations.

The total amount of debt in China’s economy climbed from 130 percent of GDP at the end of 2008 to 206 percent of GDP at the end of June 2014, a dangerously high level for an emerging economy. (The U.S. total debt to GDP ratio at the end of the second quarter in 2014 was roughly 102 percent.) Equally concerning: China’s debt has been growing much faster than its GDP, a clear recipe for trouble.

Frankly, it’s not a question of if, but when, China’s financial system, particularly the trust companies, will face a reckoning and have to contend with a wave of credit losses and debt restructurings. The commercial banks will also have to deal with a higher level of bad debts.

I don’t know what Xi’s long-term agenda may be, but I can tell you that it doesn’t involve Western-style multiparty electoral democracy. His chief political concern is to maintain the primacy and power of the Communist Party by cleansing, strengthening, and revitalizing it. Those hoping for signs of Western-style democratic initiatives are certain to be disappointed. “The very essence of ‘socialism with Chinese characteristics’ is the leadership of the Chinese Communist Party. And this makes China quite different from the United States and other countries that believe that we should have a multiparty system,” Xi told me in July 2014. “Because we have one-party rule, we need to be a good party. So we have three tasks: self-improvement, self-purification, and self-regulation.”

To be sure, Xi has proposed some welcome changes in China’s social policies. The Third Plenum in November 2013 promised, for example, greater freedom of movement through a relaxation of restrictions on residency permits, the effective end of the one-child policy, and the elimination of forced labor camps for reeducation. China’s citizens are also likely to benefit from broad efforts to improve governance, increase efficiency of government institutions, and professionalize the legal system, providing greater consistency in the application of law—all of which are essential to a smoothly functioning market economy. But the leadership’s overwhelming priority is tackling the daunting set of economic and social challenges it inherited.

I sense, too, that many people are searching for something more meaningful than getting rich or blindly obeying Party dictates. NGOs are increasing in numbers, and a new breed of Chinese philanthropist is setting up charitable organizations. Religion is practiced more widely and openly than before. There has been a strong revival of interest in Buddhism, Taoism, and Confucianism, and many are embracing traditional Chinese values.

Later that month Charles Xue, an outspoken Chinese-American venture capitalist with 16 million fans on Sina Weibo, was arrested on charges of soliciting a prostitute. Many China-watchers saw the arrest as aimed at suppressing online dissent. Xue subsequently appeared on television in handcuffs admitting to the charge of solicitation and saying that he had been too casual with some of the information he had posted online. New rules were issued specifying that rumor mongering—defined as rumors viewed more than 5,000 times or forwarded to more than 500 people—could lead to up to three years in jail.

Wanxiang Group, China’s largest auto parts maker, is one Chinese company that has made welcome inroads in the U.S. Founded in 1969 as a bicycle and tractor repair shop in Zhejiang Province by a budding entrepreneur named Lu Guanqiu and some friends, Wanxiang now has $23.5 billion in annual revenues and some 12,500 employees, just under half of whom are in the U.S., where the company owns 28 manufacturing plants in 14 states. My friend Lu was among the private sector business leaders with whom I shared dinner my first day in China as Treasury secretary in 2006.

Wanxiang’s Illinois-headquartered U.S. operations are run by Lu’s son-in-law, Ni Pin, a neighbor of mine, whose youngest child will start in the fall of 2015 at my alma mater, Barrington High School. Ni’s two oldest children have already graduated from there; one is at the University of Chicago, the other at Northwestern University. “America is our new home,” Ni told me. “And we’re going to build an important business here.”

We need to figure out how to deal with this new force. To begin with, the U.S. must continue to invest in a state-of-the-art military capable of projecting power and bolstering deterrence.

Concerning China, two key issues stand out for the U.S. One is a national security concern about cyber-war-making capabilities. It is only logical to expect China and other nations to develop offensive and defensive capabilities, just as we are doing. At a minimum, the U.S., China, and other major nations need to reach an agreement that imposes some restraints—perhaps through an updating of the Geneva Conventions—to protect civilian populations from the devastation that could accompany the use of cyber weapons on essential services and infrastructure. And we have a compelling interest to work with China to prevent cyberattacks from terrorist groups or rogue regimes. The second issue is the pilfering of American companies’ secrets. Just about every U.S. CEO of a global company that I know has told me of a Chinese-originated attempt—often successful—to breach his or her company’s computer system. In one comically inept hack that I know of, data from a U.S. military contractor wound up in the files of a U.S. entertainment company.

This is easier said than done. Despite all of America’s efforts to assist China’s progress and to welcome it into the global economic system, many Chinese suspect that we now want to contain or thwart their rise. There is also a growing suspicion on the part of Americans that someday China might become our enemy.