Given all the challenges in front of the U.S. economy, the newly-appointed Treasury Secretary may soon see the end of his honeymoon. Ironically, though, his relationship with China looks promising. President Bush and China’s President Hu established a “high-level economic dialogue” this summer, and Secretary Paulson heads the U.S. team. A part of the good news is that this dialogue, in addition to managing bilateral issues, could help him address other U.S. economic problems.

U.S. economic challenges include global trade and financial imbalances, collapse of the Doha Round, pension reform, health care costs, and stopping those who finance terrorism. An equally serious challenge is the influence of U.S. special interests in thwarting good policy. Secretary Paulson must accomplish policy breakthroughs while accommodating well-financed political pressures.

The new China dialogue follows years of U.S. frustration over an organizational mismatch between the U.S. and Chinese sides. China’s cabinet has an extra layer of eight vice premiers and state councilors, who supervise departmental ministers. The U.S. Treasury Secretary— America’s highest economic official—should hold summits with a vice premier. But until now China has paired him with its Minister of Finance, who reports to a vice premier and heads what is really a government funding ministry, not the economic powerhouse a finance ministry is in many countries. The new dialogue corrects this anomaly by pairing Secretary Paulson with Vice Premier Wu Yi.

We cannot expect any quick public shifts from Treasury’s traditional positions on China.But how Secretary Paulson privately reappraises key topics in the first U.S.-China strategic economic dialogue, scheduled for early December, will help determine whether this dialogue realizes its potential.

Take the financial sector. At his APEC and G7 meetings in Asia earlier this fall, Secretary Paulson reiterated Treasury positions about China’s need for expanded foreign investment and competition in its domestic financial markets. One frequently hears that China’s banks, capital markets and investment systems are inefficient, technically insolvent, and in desperate need of foreign invigoration.

But Chinese senior leaders, supported by China’s successful record, don’t accept this assessment. Decades-old claims that China’s financial system is broken have grown stale, despite their repetition by international agencies, Wall Street and some academics. Data show that China’s financial sector—reforming rapidly on multiple tracks—successfully channels funds to essential infrastructure, profit-oriented firms, home mortgages and consumer credit. Meanwhile, world-class financial market reforms need at least a decade to mature.

Interestingly, China’s sustained financial efficiency for powering GDP growth has been better than India’s. Revised data from both countries confirm this over five, ten and even fifteen years. What is more, China’s investment levels have been higher and focused more on capital-intensive manufacturing than India’s. China’s financial sector is thus doing its most important job quite well.Wall Street understandably wants better access to Chinese brokerage and investment banking clients. But on China’s financial system, Treasury must avoid being seen in Beijing as a special-interest mouthpiece.

Secretary Paulson commented on his recent return from Beijing that his only financial-sector policy differences with Chinese leadership were over “timing.” But timing is important, and from the Chinese perspective, “later” may mean not years but decades.The greatest risk to China’s sustained economic growth and modernization could be premature financial liberalization. China’s senior leaders see this, and Secretary Paulson must, too. His dialogue with Wu Yi should concentrate on less ambitious longer-term arrangements for appropriately pacing financial reforms with maximum exposure to U.S. methods and standards.

Trade and the Doha Round of WTO negotiations may be Secretary Paulson’s greatest opportunity, because they span both domestic and international challenges. Protectionist pressures, from the common misperception that China is the principal cause of America’s trade deficit, clearly need effective management. The new dialogue will help Secretary Paulson bring USTR’s documented WTO complaints to the attention of China’s most senior leadership.

On China’s exchange rate, however, he must continue to tread carefully. The long preferred language encourages “flexibility” without a timetable, because without freer capital flows, there is no way of knowing where unfettered market forces would take China’s currency.

Secretary Paulson must also appreciate that China’s more than adequate management of short-term capital flows means it doesn’t need exchange-rate flexibility to ensure domestic interest-rate policy independence. A better emphasis is pushing for full and timely implementation of China’s WTO accession agreement.

Bilateral trade disputes aside, Secretary Paulson can use the challenge of China’s legitimate commercial success to stimulate U.S. reforms enhancing American competitiveness. Reforms in healthcare, pensions, education and labor mobility are all vital for strengthening America’s export performance. Given the moral authority inherent in his China dialogue leadership role, Secretary Paulson could promote a wide range of needed reforms, despite the influence of U.S. industry interests that have blocked reforms in the past.

These domestic reform efforts will not be easy and indeed may be impossible without China’s cooperation on many subtle aspects of building U.S. policy coalitions. To gain such cooperation, Secretary Paulson needs to strengthen American credibility with Beijing across the board. On the Doha round, which has stalled over agricultural issues, Secretary Paulson’s credibility with China – and the rest of the world – would gain enormously if he used his new dialogue influence to support reforms in the 2007 U.S. Farm Bill eliminating crop specific subsidies that not only violate WTO rules but also strike Doha negotiators as hypocritical. Only good-faith steps in this direction can revive the Doha Round.

In a more traditional vein, Secretary Paulson should soften his predecessors’ theme that “free trade, free capital flows and market-based exchange rates” are prerequisites for successful economic modernization. China’s experience says these are issues of degree and timing. Treasury would do well to use the new dialogue to study China for lessons from its development success suitable for even non-authoritarian governments and incorporate them into Treasury’s advice to the World Bank, the IMF and other international bodies.

In sum, both China and the United States have much to gain, and Secretary Paulson’s new dialogue with China opens opportunities extending even beyond China. But to seize them he needs to adjust inherited positions that no longer work in America’s best interests.

The author wishes to thank Pieter Bottelier, Sherman Katz, Oriana Mastro, Sandra Polaski, and Viji Rangaswami for their comments on earlier drafts of this essay.

This article was originally published in the CSIS Freeman Report, October 2006.