The China Checklist (Part II)

U.S. Treasury Secretary Tim Geithner concluded his maiden journey to China this week.

With Geithner reassuring China that its dollar assets are safe, back in the U.S. Congress, legislators have again proposed to take China to task for alleged currency violation.

With this as a backdrop, the list of issues that define today’s economic ties between the United States and China are continued below.

6. Capital: China’s top export to the United States

While the mainland’s exports to the United States run the gamut, from Barbie dolls to footwear to computers, China’s most important export to the United States may be capital. Or, to be more exact, U.S. dollars.

Lost on many legislators in Washington who want to punish China for running such a large U.S. trade surplus is this simple yet critical fact: China not only provides U.S. consumers with cheap, high-quality goods, it also provides the capital to purchase such goods by recycling greenbacks earned from trade back into U.S. Treasuries and other dollar-denominated assets.

In 2008, U.S. net portfolio inflows from China totaled $130.4 billion, an 18% increase from the prior year. The financial crisis and the flight to safe assets cut inflows to a paltry $9.5 billion in the first three months of this year, down 75% from the same period last year.

China overtook Japan as the top holder of U.S. Treasuries in September 2008. Should the United States opt to curtail or sanction China for its exchange-rate policy, it may be cutting off a key source of foreign capital — something the world’s largest debtor nation can hardly afford.

7. The mainland: An unlikely source of U.S. profits

The lopsided nature of U.S.-China trade gives the impression that all the benefits go to the Chinese. That is simply not true. One of the best-kept secrets on Wall Street is that U.S. firms are making tidy sums of money in the Middle Kingdom.

Data on foreign affiliate income from the Bureau of Economic Analysis corroborate these findings. U.S. foreign affiliate income in China rose from $1.2 billion in 2000 to $6.2 billion in 2008. Affiliate income jumped 4% from the year before.

China is among the most profitable emerging markets in the world for U.S. companies. Add U.S. affiliate income earned in Hong Kong, and the total is greater than earnings by U.S. affiliates in Germany or France.

The bottom line: At a time when Washington is threatening to impose greater trade sanctions against Beijing, U.S. firms with operations in China are posting record profits.

8. Floating the yuan: Be careful of what you wish for

As China’s trade surplus with the United States has increased during the past year, so has American pressure for China to further revalue its currency.

A stronger renminbi, according to prevailing logic, would help redress America’s outsized trade deficit with China, bringing some competitive relief to U.S. workers threatened by low-cost Chinese labor.

While we question this logic, we are even more concerned that Washington may be putting the cart before the horse when it comes to China adjusting its exchange rate. More to the point, the United States may be setting up a currency debacle.

Before China adopts a freely floating currency, the mainland first needs a sound and strong financial sector, in addition to a more liberal capital account. Washington should be advocating financial sector reform in China rather than narrowly pushing for an adjustment of the currency.

Floating the currency without financial sector reform could be a recipe for economic trouble.

9. The Chinese Consumer: Not all fast cars and fancy malls

While China has emerged as one of the fastest-growing markets in the world for just about everything, times are tough for the average Chinese household.

The average Chinese household can no longer count on the guarantee of lifetime employment once provided by the Iron Rice Bowl’s cradle-to-grave social welfare programs.

Many of these social benefits have been scaled back or eliminated during the past decade, saddling the average Chinese consumer with the burden of paying for healthcare, pensions, education and housing.

The share of total healthcare expenditures paid out-of-pocket by individuals has climbed from 20% in 1978 to roughly 54% today. Meanwhile, only 16% to 17% of the population is covered under any basic government pension scheme — and just 14% of China’s workforce was covered by unemployment insurance in 2005.

The cost of education — a national obsession — continues to soar, with many parents finding themselves financially strapped after paying for private tutors, extra classes and other items related to producing the best and brightest.

Additionally, housing costs have skyrocketed as government subsidies for housing have declined. Also, many households are confronting the further financial burden of caring for their elderly.

The bottom line: There is a great deal more economic angst coursing through the average Chinese household than the average U.S. household.

10. Pollution: A chance for investors to clean up

There are multiple ways to invest in the Middle Kingdom. We believe one of the best plays on China could lie with large-cap U.S., European and Japanese firms that have the capabilities and core competencies to assist China in cleaning its environment.

China is choking on its own success — literally and figuratively — as it confronts one of the most daunting environmental challenges the world has ever known.

Against this backdrop, the government has set ambitious environmental goals, planning to spend billions of dollars during the next decade on environment-related projects.

These projects mean more business and earnings growth for western multinationals with the cutting-edge technologies capable of cleaning China’s air and water. That’s just for starters.

As China goes green — a gradual process, to be sure — the main beneficiaries, besides the Chinese, will be western multinationals with the appropriate technologies to make it all happen.