But, he added: "We must not heed the siren song of protectionism, trying to reduce the losses of the present by sacrificing the opportunities of the future."
He called on China to move more quickly to open its economy to US products and services.
"We're dissatisfied with the speed with which China is appreciating its currency, the value of which is not market determined, and with China's intellectual property protections"
"In my judgment, the greatest risk to the economic well-being of our two nations is not that China will move too quickly, but that they will move too slowly in reforming their economy," he said.
The Bush administration in coming under increasing domestic pressure to address the trade deficit with China, which hit a new record of $232.5 bn in 2006.
Democrats took control of the House and Senate in November's elections in part with campaigns accusing the Bush administration of doing too little to protect US workers from unfair foreign trade practices.
Cost of protectionism
But Paulson said erecting protectionist barriers would harm American consumers and make the US less competitive.
"Raising protectionist barriers and isolating ourselves from the gains of trade would hurt our economy," he said. "The long-term cost of protectionism - for us and for the rest of the world - is lost jobs and lost opportunity."
US manufacturers say China's currency is undervalued by as much as 40 per cent, making Chinese goods cheaper in the US and American goods dearer in China.
Paulson is to meet Wu Yi, the vice-premier in Beijing and finance leaders in Shanghai next week.
Separately, the US State Department said on Thursday that China's failure to adequately tackle corruption was hampering its fight against drugs.
The report said Chinese-made chemicals were being increasingly diverted to make illegal narcotics from Belgium to Mexico, and China faced a serious problem from drugs flowing over the border from Myanmar and Central Asia.
"Chinese authorities view drug trafficking and abuse as a major threat to its national security, its economy, and its national and regional stability," the department said in a report released in Washington on Thursday.
"But corruption in far-flung drug-producing and drug-transit regions of China limits what dedicated enforcement officials can accomplish," the report said.
The department conceded, however, that there was no evidence of high-level official corruption and praised China's counter-narcotics efforts.