At the Export-Import Bank’s annual conference last Thursday, President Barack Obama took the latest swipe at China’s currency policy. In his speech, President Obama argued that liberalizing China’s exchange rate would help increase consumption in countries like China that have external surpluses, and boost savings and exports in countries like the U.S. that have external deficits. “As I’ve said before, China moving to a more market-oriented exchange rate would make an essential contribution to that global rebalancing effort,” he said.

The reaction from China was immediate. When asked about President Obama’s remarks on the sidelines of the National People’s Congress on Friday, People’s Bank of China Vice Governor Su Ning said, “We don’t agree with politicizing the…exchange rate issue. We also don’t agree with a country taking its own problems and having another country solve them.”

Vice Governor Su Ning’s comments suggest two things to me.

First, they demonstrate how exasperated China must be with the United States for continuing to politicize the exchange rate issue. As we pointed out in our most recent post on the subject, “Three Misconceptions Regarding China’s Currency Policy“, many experts believe that China will begin allowing its currency to adjust by mid-year. It makes sense. China is as concerned about economic conditions in the European Economic Union as it is with the health of the United States economy, and arguably, a currency adjustment by China at this time could help the European Union the most as it struggles with economic woes in Greece, Portugal and Spain.

During the first two months of 2010, The European Union and the United States remained China’s two largest trade partners. In January and February, trade with the European Union grew by 34.5 per cent to $65.53 billion, while trade with the United States rose by 25.1 per cent to $49.32 billion. At least with respect to the dollar, the exchange rate to the yuan has remained stable over the past two years. Since the first quarter of 2009, the yuan has depreciated by almost 10 percent against the Euro.

As a result of economic problems in Europe, the dollar –and the yuan since it has been pegged to the dollar since July 2008–has been strengthening against the Euro since the end of 2009. As much as China might like to begin adjusting its currency policy to take account of these recent events, it cannot be seen as giving in to political pressure from the United States. Therefore, every time that President Obama, Secretary of the Treasury Timothy Geithner, or some other senior government official opens their mouth on the subject, it further delays the decision. If the United States brands China a “currency manipulator,” all bets are off.

Secondly, Vice Governor Su Ning’s comments demonstrate how little regard China’s leaders must have for the Obama Administration. The United States is the land of free speech, but it’s hard to imagine a high ranking U.S. government official making similar comments about statements made by China’s President Hu Jintao or Premier Wen Jiabao. The Dow Jones reporters on the scene took the Vice Governor’s comments as suggesting that the president was trying to divert attention from the U.S.’s own economic mismanagement. If that’s what he was really saying, those are pretty strong words.

While many may dismiss it as pure propaganda, the Vice Governor also made the point that I made in my last post, that liberalizing exchange rates doesn’t necessarily resolve trade imbalances. “We believe the yuan exchange-rate issue will not help shrink or increase our trade surpluses and deficits [in the U.S. or China],” he said.

Could the Vice Governor be reading Managing the Dragon?

Zhou Xiaochuan, governor of the People’s Bank of China, used an appearance at the National People’s Congress to give the clearest indication in months that Beijing is preparing to abandon the peg to the US dollar that it informally introduced in mid-2008. He told a press conference that the currency peg was a “special measure” to help China weather the financial crisis. “These kinds of policies sooner or later will be withdrawn,” he said.

The National People’s Congress, which began on Friday, March 5 and runs through March 14, brings together around 3,000 delegates from provincial parliaments, the ranks of the armed forces and Hong Kong, Taiwan and Macau.

Predictably, the PBOC Governor’s comment touched off a flurry of written and verbal commentary on the subject of China’s currency policy. In reading the articles and listening to the interviews, it seems to me that there are three general misconceptions on the subject.

Misconception #1: China Keeps the Value of the Yuan Low to Maintain Its Export Competitiveness

As compelling as this explanation may be to some, I believe it’s far too simplistic, and that in fact, China’s policymakers take into account several factors when determining the country’s currency policy. The impact of any change in currency policy on export competitiveness is certainly one, but China must also be mindful of the effect its currency policy may have on the large amount of dollar-denominated assets which the country now holds. In this regard, I believe that China looks very closely at the relationship between the dollar and the Euro, the two currencies that account for a significant portion of its international trade, and tries to maintain a balance between the two. I don’t think it is mere coincidence that China re-instituted the peg to the dollar in July, 2008, providing important support when the dollar was at a five-year low against the Euro.

Misconception #2: Revaluing the Yuan Will Reduce China’s Trade Surplus With the United States

The empirical evidence does not support the notion that a revaluation of the yuan against the dollar will reduce China’s exports to the United States. In 1985, the exchange rate between the Japanese yen and the US dollar was 250 to 1. Yielding to political pressure from the United States, the yen was allowed to double in value over the next three years, to the point where by 1988, one U.S. dollar could only purchase 121 yen. What did exports from Japan to the United States do during this period? They increased from $69 billion to $90 billion.

Similarly, when China released the yuan from its dollar peg in July 2005, the yuan increased in value by 21 percent against the dollar over the next three years. What did China’s exports to the United States do during this period? They increased by 40 percent from $163 billion to $233 billion.

In both cases, a more highly-valued currency meant that Americans paid more for the goods which they did import, and my guess is that the composition of exports from Japan and China to the United States also changed. Exporting goods with more raw material content, for example, might more than offset higher relative labor costs because raw materials can be purchased more cheaply with a more valuable currency. In the case of China, a more highly-valued yuan has caused exporters to move to higher value-added products where labor content is much less a factor.

Misconception #3: China Will Yield to Political Pressure to Change Its Currency Policy

As the November elections near, and concerns about unemployment in the United States increase, calls for President Obama to “get tough” with China on its currency policy and to label the country a “currency manipulator” will become deafening. Anyone with any experience in China, however, knows that this will only delay any decisions the Chinese government might make to alter currency policy. Simply put, no Chinese leader wants to be seen as yielding to outside pressures on this issue.

Many analysts predict that China will once again allow the yuan to begin a gradual revaluation against the dollar by mid-year. If the dollar continues to gain ground against the Euro, I believe that China will release the dollar peg sooner rather than later.

U.S. politicians would be wise to stay quiet and let events play out.

If you don’t think that we now have a trade war between the United States and China, log on to the FT.com Web site to see the record of trade disputes between the two countries.

Since the end of 2001 when China joined the World Trade Organization (“WTO”), there have been 20 formal complaints filed with the body: eight by China against the United States, and 12 by the United States against China. Of these disputes, none were filed in 2003 and 2005, one was filed in each of 2002, 2004, 2006 and 2008, four were filed in 2007, nine were filed in 2009, and three have been filed so far in January. Another way to look at it is that eight trade complaints were filed during the eight years that George W. Bush was in office, while 12 have been filed in the one year that Barack Obama has been President.

And the pace has been accelerating. Of the 12 complaints that have been filed during the Obama Administration, six have been filed since December. In December, China imposed duties on imports of certain specialty steel products from the United States and Russia, while the United States slapped anti-dumping duties on Chinese steel grating imports and imposed duties of from 10 to 16 percent on Chinese steel piping imports.

In January, 2010, the United States put additional duties of from 43 to 289 percent on imports of Chinese made wire-decking, following tariffs ranging from 2 to 438 percent announced in November 2009 on the same products. In February, China announced anti-dumping duties of from 43 to 105 percent on imports of United States chicken products, and then hours after China filed its complaint, the United States put anti-dumping taxes of up to 231 percent on Chinese ribbons used for gift wrapping.

In case you’re scratching your head and wondering, the gift wrapping ribbon industry is not a major one in either China or the United States. According to the report filed by the International Trade Administration of the United Sates Department of Commerce, imports of narrow woven ribbons from China increased by 53 percent during the first quarter of 2009, as compared to the first quarter of 2008. And here’s the clincher, the imports of narrow woven ribbons from China during the first quarter of 2009 totaled all of $2.2 million!

What in the world is going on? How can bureaucrats in Washington justify spending so much time on such tiny issues when the country has such big problems? Isn’t the relationship with China more important to the United States government than a couple million dollars of imports?

Actions like the import tax on ribbons tells me that the relationship between China and the United States is in complete disarray. If you think that a petty action like the imposition of an import duty on an inconsequential product category goes unnoticed in Beijing, think again. If you are an American businessman or businesswoman in China, and your application for approval of some project has slowed, you now know the reason — the action taken by the Department of Commerce to protect the gift wrapping ribbon industry in the United States.

It’s now official: the Hummer deal has been scuttled. The conventional wisdom from the very beginning has been that the Chinese government would never approve the sale of Hummer by General Motors to Sichuan Tengzhong Heavy Industrial Machinery Co. because it runs counter to current Chinese auto policy which is promoting smaller, more fuel efficient vehicles. Against this backdrop, approving the purchase of Hummer by a Chinese company would be against everything that Beijing wishes to promote as far as its automotive industry.

I never really bought the conventional wisdom. In fact, I was so confident that the deal would be completed that I borrowed the line, “Book ‘em Danno!” from the Hawaii Five 0 television series to end my post on the subject in October. Despite the fact that Hummers are gas guzzlers, I believed that the off the road technology that came with a purchase of the company would be interesting to China’s military and other organizations in need of rugged vehicles. Moreover, China Daily had three articles in one edition in October touting the deal, which seemed to be a good sign. After all, China Daily is a state-owned newspaper that tends to promote government policy, isn’t it?

How could I have been so wrong? Perhaps the Hummer message is so antithetical to what Beijing is preaching these days that there is no way that the deal was ever going to get approved, and I just didn’t give that line of reasoning enough weight.

That may be the case. But there is one other explanation that is at least worthy of consideration, and that has to do with the fact that the relationship between the United States and China has deteriorated significantly over the past six months. It all began with the famous tariff on tires. In the name of jobs, and as a tip of the hat to the United Steelworker’s Union, the Obama Administration slapped a 33 percent tariff on tires made in China last year. That decision did not sit well with Beijing, and we may now be witnessing one of its repercussions.

General Motors has exhausted the list of potential buyers for Hummer. As a result of its broken deal with Tengzhong, the company has announced that Hummer will be wound down, and many of the 3000 Hummer jobs in the United States will be at risk. Who owns General Motors now? As we all know, it’s the United States Government. What better way to send a subtle message to President Obama?

I’m not a believer in conspiracy theories, and I never look too far beneath the surface for ulterior motives. However, the state of the relationship between the United States and China is now such that American businessmen in China would be wise to keep this in mind as they go about their daily business. Maybe the tariff on tires has absolutely nothing to do with Hummer, but the fact that we are able to even draw a possible connection is telling.

Figures released by the U.S. Treasury Department on Tuesday showed that China reduced its holdings of U.S. Treasury securities by $34 billion in December. This marked the second straight month that China has been a seller, making Japan now the largest owner of U.S. Treasuries. According to U.S. government data, Japan’s stockpile of Treasury securities stood at $769 billion in December, while China’s came to $755 billion, down from $790 billion held in November.

Needless to say, these capital market actions have sparked numerous stories purporting to explain why China is dumping U.S. Treasuries.

One report blamed the securities sales on the recent announcement by the United States that it would sell $6.4 billion of arms to Taiwan. This argument was given some credence when Majors General Zhu Chenghu and Luo Yuan and Colonel Ke Chungqio of China’s People’s Liberation Army were quoted in an official Chinese publication calling for the Chinese government to retaliate against the United States economically, beyond the sanctions already announced, for this decision.

General Luo, a researcher at the Chinese Academy of Military Sciences, told China’s Outlook Weekly:

We should go in for a strategic mix of retaliation across politics, military matters, diplomacy and economics… For example, we could sanction them using economic means, such as by dumping some U.S. government bonds.

The Wall Street Journal had a somewhat different take, arguing in Heard on the Street that it wasn’t at all clear that China had, in fact, reduced its holdings.

How so? The key is to look at U.S. Treasury holdings in the U.K. and Hong Kong. Both have at least doubled in the past year. At the end of December, the U.K.’s holdings totaled $302.5 billion, and Hong Kong’s were $152.9 billion. In the Treasury International Capital data, analysts suspect a large portion of the holdings from those places—perhaps as much as half—in fact originate in China. The problem arises because Treasuries are often held on behalf of clients in financial centers like Hong Kong or London. For the data compilers, it’s hard to unearth the ultimate owners of the debt.?

The Wall Street Journal goes on to argue that indirect Treasury purchases suit China politically.

Headline data showing mainland China’s purchases of Treasuries leveling off help allay domestic criticism that China, a “developing” country, is keeping the profligate U.S. government afloat. ?It also injects a grain of doubt into the minds of free-spending U.S. policy makers when it comes to assuming that China will always be there to snap up the country’s debt.

There is no question that the relationship between the United States and China is deteriorating by the day. It began in 2009 with the U.S. tariff on tires; manifested itself in the complete lack of dialogue between the Obama Administration and China over the issue of climate change in Copenhagen; and has been exacerbated this year by the Google Internet war, arms sales to Taiwan and President Obama’s meeting with the Dalai Lama.

However, China always acts in its own best interests, and I don’t believe that China would shoot itself in the foot to protest any of these measures, its PLA generals notwithstanding. As many economic analysts point out, China’s stockpile of foreign currency reserves is so large that it has to own dollar-denominated assets, and any wholesale dumping of these assets would only drive down the value of the remaining securities in its portfolio. That is why I believe the explanation by the Wall Street Journal may be more accurate. International money flows are always difficult to decipher, and China has both political and economic reasons to obfuscate its capital market actions.

Sometimes, though, the simplest explanation is always the best. Perhaps China is just playing the currency markets, seeking to maximize its overall investment return? After all, $34 billion of sales is still less than a 5 percent move on a $755 billion portfolio.

I’m not a foreign exchange specialist, but in implementing its currency policy, it seems to me that China pays particular attention to the relationship between the U.S. dollar and the Euro, the two major currencies in the world. Over the past five years, there have been two notable events in China’s currency history—July, 2005 when China released the yuan’s peg to the U.S. dollar, allowing the Chinese currency to appreciate by 21 percent within two years; and July, 2008 when China once again pegged the yuan to the greenback, this time at approximately 6.8 to 1. It may be mere coincidence, but both events occurred when the dollar and the Euro were at high and low points relative to each other.

In the latter half of 2005, the U.S. dollar was at a high point against the Euro, which I would argue gave China room to release its dollar peg. By July, 2008, when China reinstituted the peg, the dollar’s value in relation to the Euro had fallen by 38 percent from its 2005 high. (At its high point in 2005, one U.S. dollar purchased 0.85 euro. By July, 2008, one dollar purchased only 0.62 euro, much to the chagrin of American travelers to the continent.)

It’s natural then for China’s currency traders to look at the relative values of the dollar and the Euro in determining their trading strategies. What have the dollar and the Euro been up to over the past year? After peaking at about 1 USD to 0.80 Euro in early 2009, the dollar fell throughout the year to a low of 1 USD to 0.66 Euro in early December. Throughout December and into this year, however, the dollar has regained strength, appreciating by approximately 12 percent against the Euro. Currently, one dollar buys 0.74 Euro.

My guess is that China’s currency traders have been selling into this rally, taking advantage of recent dollar strength. If the dollar continues to gain ground, look for China to continue to sell U.S. Treasuries. If dollar strength appears sustainable, look for China to once again reconsider the peg and allow the yuan to appreciate against the dollar. In this way, China’s currency traders may be tipping us off to future changes in the country’s currency policy.

I don’t mean to diminish the milestone that China’s auto industry reached last year by surpassing the United States in vehicle sales, but it was a bit like winning a tennis match by default—the American auto industry never showed up.

After chalking up vehicle sales of between 15 million and 17 million annually for much of the past 20 years, the industry in the United States was crippled by the global economic crisis, eeking out sales of just 10.4 million vehicles in 2009, the fewest since 1982. While China’s sales of 13.6 million vehicles in 2009, a 46 percent increase over 2008, were impressive, it took an economic crisis of global proportions to end a century of American dominance of the auto industry that began with Ford’s Model T.

In 2010, however, China’s auto industry is entering brand new territory. Vehicle sales in January surged to a monthly record of 1.7 million, double the number sold in January, 2009. Analysts are now projecting vehicle sales this year to be 15 million or more, and for sales to reach an incredible 25 million in 2015. To put that into perspective, there were only 66 million vehicles sold throughout the world in 2009. China could soon account for 33 percent of the entire world market.

Is there really that much new buying power being created each year in China such that so many more individuals can now afford cars? Not really. While incomes are indeed rising, and wealth creation in China is unprecedented, what we are in fact seeing is the conversion of “unconventional” means of transportation to more conventional cars, trucks and buses. In other words, China’s impressive gains in vehicle sales do not merely reflect new demand for mechanized transportation. They also reflect existing demand that is just being satisfied in a different way. Let me explain.

Every year, approximately 50 million gasoline and diesel engines are made in China for transportation. 13.6 million of those engines in 2009 went into cars, trucks and buses, but the other 36.4 million went into motorcycles, agricultural vehicles and “inkfish,” the contraptions that Chinese innovators create when they combine a chassis with a one-cylinder diesel engine. (They’re called inkfish because they spew off so much black smoke.)

This is the transportation version of what I mean when I talk about China’s two markets, and I use the auto industry as an example all the time when I talk about this phenomenon. The portion of the market that is represented by the 13.6 million cars, trucks and buses sold in 2009 is what I call the “foreign/local” market. This market is characterized by higher price and higher technology and is the battleground where Volkswagen, General Motors and the other global players are fighting for market share with the best of the local players. The vehicles that used the other 36.4 million engines produced in 2009 represent the purely “local” market for transportation, which is characterized by lower price and lower technology. In this purely local, price-driven market, only local companies compete. Despite their different outward appearances, however, vehicles in both market segments serve the same purpose — they move people and goods around the country.

As part of the stimulus package enacted in 2009, China cut the consumption taxes on cars with engines smaller than 1.4 liters, and began granting rebates to residents of China’s rural population who traded in their agricultural vehicles and inkfish for more conventional cars, vans and trucks. That is why compact cars, mini-busses and mini-trucks have been the fastest-growing segments of the market. In 2009, compact cars outperformed in the passenger car market, with “upper small” and “lower middle” cars growing by 73 percent and 56 percent, respectively, and the “upper middle” and “luxury” segments growing by only 25 percent and 21 percent. In commercial vehicles, mini-trucks grew by 43 percent, while mini-busses increased by 83 percent.

There are three conclusions to be drawn from this analysis:

1. The fast growth in China’s auto industry is not necessarily as bad for the environment as one might think. To the extent that heavily polluting inkfish and agricultural vehicles are being replaced by more conventional vehicles, China is actually better off.

2. China’s auto industry will continue to show rapid rates of growth for many years because China’s total demand for transportation is already much bigger than most people think. I would argue that China’s transportation industry is actually 50 million vehicles per year, not the 13.6 million vehicles sold in 2009, or even the 15 million vehicles that might be sold this year. They represent only one part of the market.

3. As smaller vehicles gain market share, so too will local Chinese vehicle makers. Foreign brands now account for 70 percent of the passenger car market today in China, with local brands accounting for the remaining 30 percent. Look for this ratio to be reversed in 10 years.

Yesterday morning, news reports were filled with headlines that President Barack Obama had “vowed to get tough” with China on its currency. By the end of the day, the headlines told how China was “hitting back” over Obama’s criticism of its currency policy. And so it goes. A currency dispute between the two superpowers now joins tariffs, climate change, Google and the Internet, arms sales to Taiwan, Iran, and the Dalai Lama on the list of issues where the two countries don’t see eye to eye.

But, will a revaluation of the yuan against the dollar really lower China’s exports to the United States and have the impact on the U.S. negative trade balance with China that President Obama thinks? Some experts aren’t so sure. Before President Obama issued his statements and created this latest row with China, he should have read “The China Export Edge”, an excellent editorial by Alexandra Harney that appeared in Wednesday’s Wall Street Journal.

Alexandra knows a good deal about this subject. In 2008, she authored the bestselling book, The China Price, and is currently a visiting scholar at the Center of Asian Studies at the University of Hong Kong. I have had the pleasure of appearing on several panels with Alexandra and trading ideas on a variety of topics over the last several years, and there’s no question that she knows her stuff. Unlike many who write on these subjects, her opinions are based on real, on-the-ground research, not just theory.

In her article, Alexandra gets right to the point:

Anyone pinning their hopes on a rapid revival in American manufacturing as a result of a revaluation of China’s currency needs to meet Ben, the owner of a coastal Chinese shoe factory.

But last year was Ben’s best ever. As his competitors teetered, Ben invested $2 million in new equipment to shift away from making cheap, no-brand shoes and into steel-toe work boots, hiking shoes and branded athletic footwear. He now produces these under contract for well-known Western companies. Ben’s average selling price has almost tripled. Sales are up more than 50% year-on-year.

In other words, China’s manufacturing is now moving up the value-added chain, and is becoming even more globally competitive as a result. In doing so, to quote Alexandra:

China has turned the Great Recession into the Great Opportunity, growing its share of imports in the United States to 19.1% from 15.9% between November 2008 and November 2009. That share is only going to increase, regardless of what Beijing does with the yuan. After years of accumulating market share and building the infrastructure to supply the global market with the help of an undervalued currency, China’s advantage is so entrenched in certain industries that a yuan revaluation is unlikely to divert substantial volumes of orders to other countries.

While the years of profligate American consumer spending were boom times for Chinese exporters, the slowdown was like a one-year MBA program: It forced surviving exporters to focus on the bottom line, invest more in research, development and product design, and find new markets for their products. “We need to reduce labor intensity and improve productivity, or else we’ll lose orders to our competitors,” says Ben, who counts some 6,000 rivals in his city alone.

I’m with Alexandra on this one. Her analysis and real-life example help explain two statistics that I like to quote when speaking on this subject.

In the 1980s, Japan was in exactly the same place as China. The country was exporting more and more to the United States, and its currency policy was under attack. Giving in to pressure from the United States, Japan’s currency was revalued. In 1985, one U.S. dollar bought 250 yen. By 1988, one buck could only purchase 121 yen. What did Japan’s exports to the United States do during this period? They increased from $69 billion to $90 billion.

The same thing happened with China. From mid-2005 to mid-2008, the yuan appreciated by approximately 20 percent. What did China’s exports to the United States do during this period? They increased by 40 percent from $163 billion to $233 billion.

In the case of both Japan and China, exports to the United States did not decline when their currencies appreciated against the greenback. Instead, manufacturers in both countries started getting paid more for what they sold, and they began producing higher value-added products.

Instead of listening to the theories expounded by his well-educated staff of economic advisers, or the union officials and other interest groups that want to blame China for all of America’s ills when he wants advice on currency policy, President Obama should take Alexandra’s parting advice. He should “Just ask Ben.”

In case you haven’t noticed, the deteriorating relationship between the United States and China is turning out to be the major story of 2010. Quite apart from tensions on trade and the currency, new issues are popping up every day, and old issues like Taiwan that have not been in the news for some time are resurfacing.

It all started with the decision by the Obama Administration last year to slap tariffs on tires made in China. That was followed by a similar decision with respect to steel tubes at the end of the year.

In Copenhagen, the dialogue between the two leading economies of the world degenerated to the point where Premier Wen Jiabao avoided meeting with President Obama on two occasions.

Two weeks ago, a new issue arose regarding the Internet as Secretary of State Hillary Clinton called for China to investigate cyber attacks on search giant Google after the company said email accounts of human rights activists had been hacked. In addition, President Barack Obama is expected to meet soon with the Tibetan spiritual leader, the Dalai Lama, who is deemed a separatist by Beijing. And to top it off, the Pentagon notified Congress this past Friday that it intends to sell $6.4 billion of arms to Taiwan. Needless to say, the Chinese are furious about all of these statements and actions by the United States.

The United States, of course, is the world’s leading economy and superpower, and as such, can say anything it wants; meet with anyone it wants; and sell anything it wants to any buyer it chooses. That’s not the point. The point is that the failure of the Obama Administration to constructively engage China now threatens to hurt the efforts of the United States to deal with very difficult issues like Iran.

Even without the friction that has surfaced between the United States and China over the past few months, Iran was going to be a thorny issue. Premier Wen Jiabao made this very clear in October 2009 when he said in a meeting with visiting Iranian Vice President Reza Rahimi that, “The Sino-Iran relationship has witnessed rapid development, as the two countries’ leaders have had frequent exchanges, and cooperation in trade and energy has widened and deepened.” In exchange for guaranteed supplies of oil and natural gas, China has pledged billions of dollars in energy-infrastructure investment in Iran.

Most observers concluded from Wen’s statement that China would not support efforts to impose sanctions on Iran over its nuclear program, and that such positive statements undermine any expectations that China would support U.S. sanctions against Iran within the United Nations Security Council. In this context, Secretary of State Hillary Clinton’s warning in Paris last week that China risks diplomatic isolation and economic uncertainty if it doesn’t join the push to further sanction Iran for its nuclear program, is likely to fall on deaf ears in Beijing.

Secretary Clinton said:

As we move away from the engagement track that has not produced the result that some had hoped for, and move forward the pressure and sanctions track, China will be under a lot of pressure to recognize the destabilizing impact that a nuclear-armed Iran would have in the Gulf [region] from which they receive a significant percent of its oil supplies.

That may be true, but someone in the Obama Administration had better figure out pretty soon how to deal with China if it wants the country’s cooperation on key global issues. It’s not about who’s right. It’s about getting something done.

When I sat down on January 12 and made the following two predictions for 2010, I believed that a trade war was looming and that the relationship between the United States and China would deteriorate as a result.

Prediction #4: The relationship between China and the United States will deteriorate in 2010.

Prediction #5: China will begin to act unilaterally on global issues like Iran.

I could not have predicted that a cyber war would prove to be an even greater threat to the stability of Sino-American relations. Nor could I have predicted that a dispute over the internet could jeopardize cooperation between the two countries on an issue as important as Iran. But that is exactly what has happened over the past two weeks, in a surprising beginning to the new year that no one could have predicted.

At the same time that I was making my predictions for 2010, David Drummond, SVP, Corporate Development and Chief Legal Officer of Google, was writing on the company’s official blog that Google had come to the conclusion that it “should review the feasibility of our business operations in China.” The reason Drummond cited for Google’s possible decision to pull out of China was that the company had detected in mid-December a “highly sophisticated and targeted attack on our corporate infrastructure originating from China that resulted in the theft of intellectual property from Google.” Moreover, Drummond stated that Google had “evidence to suggest that a primary goal of the attackers was accessing the Gmail accounts of Chinese human rights activists.”

As an American, it’s impossible to be against freedom of speech, the free flow of information and protection of privacy. After all, those are all core values that have lead to America’s greatness. Nonetheless, Drummond’s comments were provocative to say the least. One only hopes they were made as a last resort, only after Google had aired its grievances with the relevant Chinese officials behind closed doors. If Google’s objective was to make a political statement, then the company succeeded. If it was to try and influence behavior, it had the opposite effect. While U.S. companies have a tendency to litigate publicly through the media to achieve some desired goal, that’s never a good approach to doing business in China.

American companies also like to enlist the support of the U.S. government when they run into trouble in China. And that appears to be what Google did. In a speech on January 21, Secretary of State Hillary Clinton called for a global Internet free of censorship, and demanded that China investigate claims by Google that e-mail accounts belonging to human rights activists had been targeted by hackers. “We look to Chinese authorities to conduct a thorough investigation of the cyber intrusions that led Google to make this announcement,” she said. “We also look for that investigation and its results to be transparent.”

Needless to say, China’s government reacted sharply to Google’s statements and Secretary Clinton’s remarks. As reported by the Associated Press, “China sharply rebuked the United States, denying involvement in any Internet attacks and defending its online restrictions as lawful after Washington urged Beijing to investigate an attack against Google.” The Foreign Ministry said Secretary Clinton’s remarks “damaged bilateral relations,” while a Chinese state newspaper said Washington was imposing “information imperialism” on China. The Ministry of Industry and Information Technology went on the offensive, saying the country’s anti-hacking policy is “transparent and consistent.”

The dispute took a more ominous turn, however, when a commentator in the People’s Daily, the Communist Party’s main newspaper, said that America is seeking to control the Internet and alleged that the U.S. used the Web to incite election protests in Iran last year. As reported by Jason Dean in The Wall Street Journal:

The brief People’s Daily article, which carried the byline Wang Xiaoyang, charged that the U.S. developed the concept of cyber warfare and that it had used the Internet to foment unrest in Iran. “It was America that initiated Internet warfare, using YouTube videos and Twitter micro-blog misinformation to split, incite, and sow discord between the conservative and reform factions…to bring about large-scale bloodshed in Iran,” the article said.”

So much for cooperation between the two countries on Iran.

The Xinhua News Agency also cited the State Council, China’s Cabinet, as criticizing what it called interference in the country’s domestic affairs. Internet control is considered a critical matter of state security in China. Beijing promotes Internet use for commerce, but heavily censors content it deems pornographic, anti-social or politically subversive and blocks many foreign news and social media sites, including Twitter and Facebook, and the popular video-sharing site YouTube.

After all of that, Fox News reported on January 26 that:

Google is in talks with the Chinese government to keep its research center in China. It also seeks to maintain an advertising sales team that generates most of the company’s revenue in the country and a fledgling mobile phone business. The talks are said to be delicate, because of Google’s recent move to stand up to the Chinese government’s demands for censored search results. But Google still wants to have access to the country’s engineering talent and steadily growing online advertising and mobile phone markets.

It sounds to me like Google wants to have its cake and eat it too, which is fine. I just wish Google had had those “delicate talks” before causing an international incident.

Carleen and I just returned to China last Thursday after spending the holidays at our farm in New Jersey. A month seemed like such a long time when we first arrived in the States in mid-December, but it went by very quickly. And with our three-year-old grandson asking repeatedly why we have to go back to China, it was particularly difficult leaving this time around. Spring festival is fast approaching, though, and it’s kind of nice to go from one holiday to another. Besides, there is so much to do here.

Before we left the U.S., James S. Chanos, the famous hedge fund investor who built a fortune on Wall Street shorting companies such as Enron, Tyco International and Boston Market whose stories seemed too good to be true, caused quite a stir when he predicted that China is headed for a crash.

As most of the world bets on China to help lift the global economy out of recession, Mr. Chanos is warning that China’s hyperstimulated economy is headed for a crash, rather than the sustained boom that most economists predict. Its surging real estate sector, buoyed by a flood of speculative capital, looks like “Dubai times 1,000 — or worse,” he frets. He even suspects that Beijing is cooking its books, faking, among other things, its eye-popping growth rates of more than 8 percent.

In an interview in November with Politico.com, Chanos warned that “The Chinese are in danger of producing huge quantities of goods and products that they will be unable to sell.” In December, he appeared on CNBC to discuss how he had already begun taking short positions, hoping to profit from a China collapse.

In meetings I had in the U.S. with other knowledgeable American investors and market observers, I found that many shared the views held by Chanos. Like those companies whose stocks Chanos made so much money shorting, China’s economic performance just seems too good to be true.

In that context, it was somewhat refreshing to read Tom Friedman’s recent editorial, “Is China the Next Enron?” Referring to the dire predictions being made by Chanos, Friedman offered two notes of caution. First, never short a country with $2 trillion in foreign currency reserves. Second, although China has enormous problems, it also has a political class focused on addressing its real problems, as well as a mountain of savings with which to do so.

To further his point, Friedman went back to basics and cited some of the fundamentals that are driving China’s growth. These include:

• The massive investments that have been made, and that China continues to make, in infrastructure projects. For example, crash programs building subways in major cities and high-speed trains to interconnect them will benefit China well into the 21st century.
• China’s 400 million Internet users, 200 million of whom have broadband. (By comparison, America has about 80 million broadband users.)
• China’s 27 million students in technical colleges and universities — the most in the world—which brings a great deal of brainpower to the market.
• The large number of well-educated Chinese returning to China to fill management positions.
• The fact that factories don’t have to move out of China as labor and other costs rise. Low-end manufacturing can move from coastal China to the less developed, Western part of the country and become an engine for development there.

On this one, I’m in Friedman’s camp. Over my 15 years in China, I’ve heard just about every argument that has been made as to why China’s economy would collapse. Civil disturbances would plunge the country into anarchy; regionalism would cause China to break up into a number of different countries; the country’s banks would collapse under a mountain of bad debt; China’s export growth is unsustainable — and the list goes on.

To me, China’s success in overcoming its major obstacles is due to two fundamental factors. First, China has an enormous amount of human capital that is now being educated and mobilized as Friedman points out. Second, the country’s leaders developed a game plan for economic development 30 years ago and have stuck to it ever since.