China and the u.s. are tied together in an uneasy relationship, each needing the other but unhappy about the interdependency.

China desperately needs the U.S. to keep growing; exports to the U.S. are the key driver of the Chinese economy. The U.S. desperately needs China to continue to buy U.S. treasuries; China is financing the huge U.S. trade and fiscal deficits and is keeping the U.S. dollar from plummeting. The U.S. also needs Chinese imports to keep inflation under control, thereby allowing the Federal Reserve Board to keep interest rates low and the economy growing.

Americans who complain that China is taking jobs away from them do not understand this link between Chinese imports and U.S. inflation and interest rates. It is only because of inexpensive Chinese goods that inflation has not accelerated in the face of the high oil and metal prices. Take those imports away, and the U.S. would face spiralling inflation, high interest rates to contain it and an inevitable recession.

Nor do these Americans understand the tinderbox of potential widespread social unrest upon which China is sitting. Every month, several million Chinese — equivalent to the population of Toronto — move from rural areas to the cities, and they will need jobs if social unrest is to be kept at bay. In addition, China is losing 10 million to 12 million jobs a year in the industrial sector because the country has to convert or shut down the old state-owned enterprises, says Leo de Bever, executive vice president of global investment management at Manulife Financial Corp. in Toronto.

Employment, therefore, is the priority of the Chinese government. Everything is focused on top-line revenue growth and increasing global market share to generate more jobs. Profitability is not a focus — which makes it hard to find good investment opportunities in the country. But that doesn’t bother the Chinese government.

Some Americans want to see a big appreciation in the Chinese currency. The Chinese know the renminbi is undervalued but they cannot afford a large increase in its value. Their government has started to push it up slowly, pegging it to a basket of currencies rather than the US$. This has resulted in an appreciation of 2.1% in July and 0.6% since. That is small potatoes but in the right direction.

Strategists and money managers expect more currency appreciation this year but at a very gradual pace. National Bank Financial Ltd. is predicting what is probably the biggest increase of 5%-8%. John Arnold, portfolio manager at AGF International Investors Inc. in Dublin, also thinks China might push its currency up 5% this year.

That will not satisfy the U.S., but there is little Americans can do about it. China is now a member of the World Trade Organization. The U.S. could probably get away with protectionist measures against Chinese imports in some small categories but it cannot introduce broad-based measures, Arnold says: “China is a respectable country with well-established treaties.”

Nevertheless, there is a risk that the U.S., spurred by the political right, may do something “silly” on the international trade front, says de Bever.

Despite the Bank of China’s inexperience, China has done a tremendous job of generating the needed employment while keeping inflation at bay. Growth is expected to slow a little this year to 7%-8%, vs more than 9% in 2005, reflecting the expected slowdown in the U.S.

One risk to Chinese growth is high oil prices. Domestic prices have been subsidized, which could become very expensive if oil prices remain significantly more than the US$50 a barrel that most forecasters are assuming. The country does, however, get much of its energy from coal-generated electricity, where capacity is increasing.

China is attempting to stimulate domestic demand to lower its dependence on exports. But that is not easy to do. As Peter O’Reilly, global money manager for I.G. International Management Ltd. in Dublin, says: “[There is] healthy growth in consumer spending.”

Yet, says Clement Gignac, chief economist and strategist at NBF in Montreal, retail sales account for just 13% of economic activity. That compares with 38% for exports and 30% for capital investment.

Stephen Way, portfolio manager at AGF Funds Inc. in Toronto, says the Chinese authorities are beginning to direct investment away from large infrastructure projects and toward areas in the economy in which bottlenecks are forming.

@page_break@But Ross Healy, president of Toronto-based Strategic Analysis Corp. , isn’t impressed, saying that most of the capital investment is going into export industries: “They haven’t been using resources to focus on expanding and building infrastructure, such as roads and schools, or widening and deepening the basic strength of the economy through strengthening consumer banking and encouraging local entrepreneurs.”

With so much investment going into export industries, China is increasingly vulnerable to a global slowdown. “China has overinvested substantially in steel, auto, electronics, cement, chemicals and many other industries,” says Franki Chung, head of the Asia-Pacific equity investment team in Hong Kong for CIBC Asset Management Inc. “The excess capacity sometimes exceeds 100% of current sales. China needs to export to digest its excess capacity.”

That overcapacity also spells bad news for other countries, even without a serious slowdown. That is one of the dangers of China’s development. Foreign companies initially benefit, but China, with all its cash, can afford to build anything it wants and is doing so. Only producers of basic resources, such as oil, gas, other minerals and metal ores can count on continuing demand. China can build steel and aluminum capacity, but it will always need to buy the basic inputs of iron ore and bauxite.

China’s big cash position is unusual for a developing economy. Normally, industrializing countries rely on foreign direct investment to fund their growth. In China’s case, it is able not only to finance itself but also to buy up companies elsewhere. Because of concerns about corporate governance in China, there is a debate about whether such sales should be allowed, says de Bever.

However, making money in China remains difficult. “Every western company that goes in loses money,” says Nandu Narayanan, chief investment officer at Trident Investment Management LLC in New York and manager of several CI Investments Inc. funds.

De Bever can’t see how to make money there, either.

Many money managers — O’Reilly, for one — prefer to take advantage of China’s growth indirectly by investing in companies supplying the resources that China needs so badly.

De Bever adds that shipping is another way to play China’s growth.

However, there are opportunities. One is property. “Over the next 20 years, China hopes to move 200 million people from the countryside to urban areas, and the resulting demand in terms of urbanization — building of new roads, infrastructure — will be tremendous,” says Timothy Leung, head of Asian equities in Hong Kong for I.G. Investment Management Ltd.

AGF’s Way owns Hong Kong-listed China Overseas Land Ltd., a condominium builder with property positions in many of China’s major cities, and Shangri-La, a high-end hotel operator with a big presence in China and throughout Southeast Asia.

Chuk Wong, investment counsel in Toronto at Goodman & Co. , advisor to Dynamic funds, likes SinoCom Software Group Ltd., the second-largest infotech services company in China, which is benefiting from a Japanese trend to outsource its IT services not to India but to China.

Way also owns China Mobile Communications Corp., the world’s largest mobile phone company, as a play on the emerging consumer.

Resources companies are also drawing investment, particularly CNOOC Ltd., the Chinese national offshore oil company. Most money managers are bullish on energy prices and the region’s thirst for fuel. “CNOOC has a pretty good production and growth profile. And from a global perspective, its valuations are attractive,” says Way.

On a recent trip to China, O’Reilly was impressed by how some of the conglomerates are refining their holdings and becoming more focused. He is not yet ready to invest, but he is keeping an eye on China. IE



— with files from Rudy Mezzetta