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, Knowledge@Wharton 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 for every 200 citizens). In early 1997, Paulson and Goldman Sachs were charged with shepherding an IPO for a new company called China Telecom created by bundling the mobile assets of two provincial units of the Ministry of Posts and Telecommunications. The lure to investors was that the proceeds would be used to purchase other provincial telcom units. Coming mere months after the Hong Kong handover, the IPO was, in Paulson’s words, “transformational:” branding the new China in global markets and making possible similar offerings from other SOEs.
“One of the most important deals from Paulson’s early years was one that never materialized.… It would … be the template for a series of deals that would establish Goldman Sachs as the pre-eminent Western financial firm [in China].”
Overhauling the country’s stagnant oil industry would be a stiffer challenge. In the 1970s, a concerted national push for energy independence saw China emerge as the world’s ninth-largest producer and a net exporter. But domestic operations couldn’t keep up with the explosive growth of the 1980s, and by 1994, the Chinese were once more a net importer.
Restructuring the huge China National Petroleum Corporation was imperative. Goldman’s approach was to separate its core, lucrative assets and package those into an IPO under the new name PetroChina. The scope of the problem was enormous, Paulson writes: “CNPC, like so many other state-owned enterprises, was less a company in the Western sense than a self-contained city-state.”
As if the internal obstacles weren’t enough, the deal faced international resistance from environmental and union activists who objected not just to the deal itself, but to the prospect of China’s admission to the World Trade Organization all of which came to a head at the WTO’s meeting in Seattle that December. The IPO went through in early 2000 and raised nearly $2.9 billion. Yet the restructuring resulted in the loss of hundreds of thousands of jobs, and in the absence of a social safety net the parent company was left to keep the peace though years of support for the laid-off workers and their families.
The Dark Side of the Chinese Miracle
Although difficult and contentious, the PetroChina deal at least offered the satisfaction of crafting a new company and bringing it to international market. The third major deal Goldman oversaw — the restructuring of a holding company in Guangdong province — was brutal and decidedly unglamorous. Yet Paulson would characterize it as “among the most important pieces of work we would ever do in China.”
Even during its boom years, China’s economy has consistently been hobbled by a dearth of modern capital markets and commercial banking options. As early as the late 1970s, Chinese leaders reluctantly recognized the need for foreign investment. Their solution was the creation of International Trust and Investment Corporations (or ITICs), a vehicle for joint ventures with foreign companies. The much-needed capital helped fuel what Paulson calls a “vast economic improvisation.” Yet the ITICs also became “honey pots” for local officials, leading to “waste, mismanagement, fraud and corruption on an epic scale.”
An implicit guarantee by the central government only further encouraged misspending and risky investment. When the Guangdong company faced a credit squeeze resulting from the Asian financial crisis, Chinese reformers decided to make an example of it and send the message that they were serious about market reform: the company (and its debt) would be restructured, or liquidated.
“[Paulson] credits China — the second largest foreign investor in the U.S. — with resisting the urge to pull out of key capital funds and thus helping to stabilize financial markets.”
As Paulson and his team dug into the company’s books, they found a morass of debt and subsidiaries and insolvent businesses. Once again, they culled the company’s core and best-performing assets, hoping to appease creditors (who were sure to take a hit on the company’s many liabilities) with the prospect of eventually getting their money back with a profitable if slimmed-down profile. It was a milestone. While China had had bankruptcy laws in place since 1986, the Guangdong firm was the first major company to go through the process. It sent a signal that, in the future, inevitable corporate failures would be dealt with through bankruptcy and restructuring, not government bailouts.
Two of Paulson’s most important initiatives in China during these years were undertaken as a private citizen. In 1999 premier Zhu Rongji asked him to evaluate the School of Economics and Management at Tsinghua University (known as the MIT of China) and make recommendations. Zhu understood that the Chinese economy was hampered by a shortage of well-trained executives. In large part, this was the legacy of Mao’s Cultural Revolution — universities were shut down in 1966 and not fully re-opened until 1977. (The long shadow cast by the Cultural Revolution is a quiet but constant theme in the book. Paulson sketches short bios of many of the officials and executives he worked closely with, and for most, these years were formative ones for them — holding back their education and professional development, but also instilling, in his words, tremendous “grit and ingenuity.”)
The other venture was in his capacity as co-chair of The Nature Conservancy’s Asia-Pacific Council. Paulson grew up on a farm in Illinois and as a boy had dreamed of becoming a forest ranger. Environmental protection has been a life-long passion for him and his wife, Wendy. With the help of reform-minded officials (among them the man who had helped lead the financial reforms in Guangdong), The Nature Conservancy partnered with the provincial government in Yunnan to create the Great Rivers Project — an unprecedented level of cooperation with a foreign NGO.
Both initiatives were made possible by the deep personal connections Paulson had cultivated over the years. Both reinforced his conviction in the inevitability of reform in China, however uneven and frustrating the path could be at times. And the very real change he felt he had effected during these years later prompted him to accept a cabinet post he initially decided to turn down.
Return to Public Service
When Paulson took over the Treasury in July of 2006, he had a number of domestic issues he wanted to tackle, entitlement reform among them, but developing a new approach to U.S.-China relations was an early priority as well. The new Secretary felt that, since the Nixon overture in 1972, the relationship had been driven mainly by security concerns, and that more common ground could be found on the economic front. The President gave Paulson the go-ahead to spearhead what would be a series of Strategic Economic Dialogues (SED), the first of which was held in Beijing that December. The session produced modest progress, including an announcement that the Chinese would allow both the New York Stock Exchange and Nasdaq to open offices in China.
“In the closing pages of the book, [Paulson] insists that engaging with China is ‘more than ever in America’s own self-interest….’”
Even before the first SED, Paulson had to contend with growing anti-Chinese sentiment in Congress that only intensified with the midterm elections of November 2006. Concern centered on China’s suppression of its currency, which benefited Chinese exports, and in turn contributed to a widening trade deficit between the two countries and the loss of American manufacturing jobs.
Paulson agreed that the Chinese eventually needed to allow the renminbi to fluctuate with the market, but argued that the problem was more fundamental. “Structural reforms and greater market access for U.S. companies and products would benefit U.S. workers more thoroughly than adjusting the currency alone.” During his tenure, Paulson successfully fended off a number of bills that would have penalized China for currency manipulation.
The following year saw Paulson increasingly preoccupied with a snowballing financial crisis that began in the subprime mortgage market and eventually threatened financial giants like Bear Stearns, Merrill Lynch and Lehman Brothers, and required a federal takeover of Fannie Mae and Freddie Mac. Yet Paulson insisted on keeping the SED process on track, holding two summits in 2007 and two more in 2008. Moreover, he credits China — the second largest foreign investor in the U.S. — with resisting the urge to pull out of key capital funds and thus helping to stabilize financial markets.
A “Think and Do” Tank
The financial crisis continued to haunt Paulson even after leaving office. “I spent months huddled with my lawyers: complying with subpoenas, being deposed, testifying before Congress.” He decided to write a memoir about the experience, but found the book, On the Brink, offered little in the way of therapy. At the end of 2009, unclear about his next move, he received a call from the outgoing Chinese ambassador, inviting him to participate in an economic forum in China the following spring. Paulson became the first U.S. trustee for the Boao Forum (a sort of Asian counterpart of the World Economic Forum), and on the trip — his first to China since leaving the Treasury—renewed old connections and rediscovered his conviction that economic cooperation between the U.S. and China was a key, not just to the health of the global economy, but to the health of the environment as well.
After months of consultations, in June 2011 he announced the formation of the Paulson Institute, a nonprofit housed at the University of Chicago, with the mission of “promoting sustainable economic growth and a cleaner environment by facilitating greater cooperation between the U.S. and China.” Initially funded solely by Paulson, the Institute now has a staff of 30 and overseas collaborative programs in urbanization, global leadership, climate change and air quality, conservation and cross-border investment.
The challenges China faces are daunting. While it has the second-largest economy in the world, its GDP per capita ranks 80th (war-torn Iraq is 81). Economic growth has leveled off. Wealthy mainland Chinese are investing abroad as never before, and many are looking to leave the country or have already done so. Protests and civil disturbances — over jobs, benefits, and, increasingly, environmental issues — have soared during the past decade. Urban air quality is frequently abysmal, a problem that will only get worse as the country’s massive urbanization proceeds — while the U.S. has 9 cities with a population of over a million, China has 174.
Yet Paulson remains optimistic, and in the closing pages of the book insists that engaging with China is “more than ever in America’s own self-interest… [J]ust about every major global challenge we face—from economic and environmental issues to food and energy security to nuclear proliferation and terrorism—will be easier to solve if the world’s two most important economic powers can act in complementary ways. But these challenges will be almost impossible to address if the U.S. and China work at cross-purposes.”
The ripple effects of China’s devaluing of the yuan in August of 2015 are a bracing reminder of just how important China is to world markets.