Henry Paulson’s predictions for China

April 11, 2013, 10:41 AM UTC

Hank Paulson is uniquely qualified to comment on the state of affairs in China, since he has visited and negotiated with Chinese officials scores of times over the decades in his capacity as Treasury Secretary, CEO of Goldman Sachs (GS), and board chairman of The Nature Conservancy. Paulson was recently interviewed by Fortune’s editor, Andy Serwer, in a public forum at George Washington University. Here are excerpts:

You’ve said the good news is that President Xi Jinping is a strong leader. The bad news is that he has to be one. What do you mean?

This leadership team is going to be tested by challenges domestically and internationally over the next 10 years. Given the scale of the economy and the pace of change, the current economic model is running out of steam. He really needs to make some big changes in governance to institute the rule of law, which is very necessary for continued business, economic, and political success.

What will it take for China to address environmental problems?

The Chinese have done some extraordinary things in terms of the investments they’ve made in alternative sources of energy. But I think people are beginning to really understand that the growth model isn’t sustainable. I think that all of us need to really rethink some things. Economic growth and environmental protection are not at odds. They’re opposite sides of the same coin if you’re looking at longer-term prosperity.

Is the Chinese government behind hacking of institutions in the U.S.?

I think all governments engage in intelligence gathering vis-à-vis other governments. The big point of friction and tension comes when a government or a company, through hacking, gathers intelligence, trade secrets, from U.S. companies. I think it’s really important for all companies to do everything they can to protect themselves against cyber-theft of all kinds, and it’s also the responsibility of their government to help ensure economic security. Let’s move to China: This is a major area of tension with China, and rightfully so. We desperately need some international protocols and ways of enforcing them, and we need to find common ground with China. It’s in everyone’s interest to make sure that economic security is maintained.

What should be China’s top priority in terms of reforming the financial sector?

China’s private sector is not getting the capital it needs out of the current system; having efficient capital markets will lead to a more efficient capital allocation. And right now you have oversaving in China because people don’t have adequate safety nets, [such as] Social Security and welfare, and because they don’t get really good returns on their investment. I’d say interest rate liberalization would be one thing to really look at, and then opening up to competition so you can have world-class institutions.

This story is from the April 29, 2013 issue of Fortune.

Update: An earlier version of this story incorrectly stated that Paulson was board chairman of Conservation International. He was board chairman of the Nature Conservancy.