ITS NO LONGER NEWS THAT CHINA IS BECOMING A MAJOR player on the world economic scene. Yet, as weve noted in past editions, investing in China is fraught with uncertainty, due to a still un-free political situation, and insecure property rights. Despite our current lack of interest in Chinese stocks, Chinas renaissance clearly has implications for investor decisions worldwide, simply due to its markets enormous size.

Recently, Chinas newfound economic strength has become fodder for political electioneering, and talk of protectionism is once again rearing its ugly head. Candidates are falling over each other to see who can blame the Chinese more effectively than their opponents. Of course, our readers recognize such ranting as nothing more than political gamesmanship. Nonetheless, all efforts to save jobs at the expense of free trade can only be dangerous to the US economy. Looking back in history, identical rhetoric led to trade barriers, and the Great Depression.

For the moment, the greater issue may be what the future holds for China, and what impact that may have globally. The key to the future centers on Chinas currency and their banking system. Trade with the US, while important, is truly a secondary issue. So far, every story in the press involving Chinas economy seems to focus on trade issues, business growth, and cheap labor. Those are interesting. But an issue that is getting little or no press dwarfs them.

China has two overwhelmingly significant flaws in its economic structure that must converge in the relatively near future to cause a devastating collapse. When that happens, politicians and reporters who have focused on trade issues will look silly at best. Only recently have we begun to see unfocused stories about Chinas economic bubble. They cite skyrocketing real estate prices, and over-investment in specific industries such as automotive or aluminum, but they miss the bigger picture. Blame is cast upon Chinese peoples penchant for gambling, as though it is the citizens who have brought this upon themselves.

As usual, we know to look to the government for most of the fault. Chinas financial system is a relic from the past: a dinosaur from the days before competition entered the economy. The nations financial system primarily comprises four government-owned banks, which may be privatized in the near future. Thus far, these institutions have been shielded from competition and guaranteed by the government. Those who remember the savings & loan fiasco here know that thrusting such incompetent institutions into a competitive world is disastrous. Long overdue for reform and utterly unprepared for the pressures of competition, the problem with Chinas financial system doesnt end there. Chinas economy has grown impressively over the past decade but much of that growth has resulted from tricks played by the government related to its currency and exchange rates. Over the past decade, the Chinese government has carefully managed exchange rates in such a way to devalue its own currency. This has made Chinese goods unnaturally cheaper for foreign currency holders, simultaneously impoverishing segments of the Chinese population.

To accomplish this valuation, China has had to hold vast sums of dollars, yen, and other currencies, instead of exchanging them for yuan. This leaves other countries holding their yuan, and causes their value to fall. The falling yuan makes Chinese trade goods more attractive to the rest of the world, but the citizens suffer in the short-term, due to their weak currency. We hear that the new administration in China (which is directly related to the old administration) has an interest in seeking a more responsible balance of payments and reducing inflation, but we find this unimpressive. Until actions follow the talk, there is little evidence that any real change will develop.

The combination of currency disruption and a weak banking system is a recipe for near-sure collapse. This leads us to recommend against the rush to Chinese stocks. However, the bigger question is what impact this collapse will have on the world economy. It is difficult to determine how devastating the repercussions would be, but suffice to say, it wont be good. Wed imagine that stable economies will hold up best, but the very size of Chinas economy would likely affect everyone. On the other hand, due to the nations relative isolation, it is possible that problems will be somewhat muted. The greatest threat would normally be a trade disruption. We might see some price increases in Chinese-produced goods, but the impact on the U.S. economy or those of other developed economies would not seem to be incredibly susceptible.

The greater fear may be that when China runs into trouble, it will start spending all those dollars theyve been holding. The result may be further pushes toward inflation in the US, an outcome weve already predicted. In these days of rabid spending, and increasing debt, an inflation rate that pushes interest rates higher cannot be good. These concerns are not immediate, but a long-term investment plan requires some foresight.

Despite our concerns about the longer term, we are still quite confident that the economy, and hence the market, will perform relatively well through the elections in November. As a result, we strongly recommend making the best of it, as the longer-term outlook is uncertain. Perhaps when November comes, we will have a clearer view of the future, but for now, investing for the present is all that can be done.