by Clif Droke The news spotlight recently was stolen by Google (GOOG), the Internet search engine giant. A statement issued by Google a couple of weeks ago was greeted by dismay on Wall Street as shares retreated in response to the company's announcement that it no longer supports China's censoring of searches that take place on the Google platform. China has defended its extensive censorship after Google threatened to withdraw from the country. Adding fuel to the controversy, the Obama Administration announced that it backs Google's decision to protest China's censorship efforts. In a Reuters report, Obama responded to a question as to whether the issue would cloud U.S.-China relations by saying that the human rights would not be "carved out" for certain countries. This marks at least the second time this year that the White House has taken a stand against China (the first conflict occurring over tire imports). Without wishing to dramatize an already volatile situation even further, let's take some time to examine a critically important issue for U.S. and global investment markets. We'll take pains to avoid the potential political and military ramifications surrounding the U.S.-China issue, focusing instead on the financial implications. Let me first say by way of disclaimer that any time the topic of discussion turns to China there will always be a certain level of nebulousness and confusion surrounding the issues being discussed. China is very much like Sigmund Freud's "Dark Continent" in that the lack of transparency in that great country, coupled with Communist Party propaganda, makes it difficult to discern the true state of affairs. I've followed the China musings of several analysts in recent years and have always been perplexed at how there can be so much disparity among what these analysts are proclaiming on any given issue concerning China. Sometimes their statements are diametrically opposed on the issues under discussion, leading one to ask, "How can so many China observers be so completely at odds with each other in their observations and conclusions?" In light of the recent Google-China conflict, however, I've come to the realization that one of the sources I've been reading is probably more correct than some of the others. I'm referring to the FRC Money Forecast Letter and its sister publication, The U.S.A./China Letter. For some time now FRC has been forecasting a turnaround in U.S.-based manufacturers here at home, based on the contention that U.S. firms in China have already begun a slow exodus from the country. Apparently these firms are discovering that the pot of gold promised to U.S. firms doing business in China hasn't been forthcoming. It also turns out, according to FRC, that China's government courted U.S. firms to set up shop in China, only for these U.S. firms to have their technology and intellectual property stolen from them. Now that China has complete access to Western technology and production methods, they no longer have need for these firms. And so the exodus continues with Google representing the latest in a growing number of U.S. corporations that have exited China in recent times. But the Google issue isn't the only one troubling the great Red country. Its free ride at the expense of America's long-term thirst for foreign imports has apparently ended. One factor that has helped create a reversal of China's longstanding dominance in the U.S. as a net exporter is the continued weakness of the dollar. The weak dollar has helped to bolster America's trade balance at the expense of China. In an article by the Grameen Foundation it was observed, "The sliding dollar has already begun swelling the total new manufacturing orders." Grameen asks rhetorically, "Will manufacturing jobs shipped overseas due to cheap labor come back to the United States due to the current financial crisis?" Grameen goes on to point out that a large number of Chinese factories are closed there due to the scaled back spending by American consumers. Grameen asks further, "Now what effect does this have in bringing manufacturing back to the United States?" Grameen continues: "The primary reason manufacturers move overseas is purely cost savings. Companies do not move to China for any reasons other than cheap labor. So cheap labor drove manufacturing companies overseas. But America's cost structure was not rising—it was falling. Meanwhile, China's costs were rising fast. All of this could bring a massive readjustment in currency values. What would that mean? First, a reduction in the value of the U.S. Dollar. What would a weak dollar really do? A low value dollar, along with a rising yuan (China's currency) could make any manufacturing overseas commercially unfeasible. That is, the American companies would see no reason to set up factories in China to export to the U.S." This analysis confirms what has been seen in recent times, most notably underscored by the Google controversy. All of this leads us to ask, if in fact U.S. firms begin a mass exodus out of China and back to the home land, and if current U.S. export and consumption trends continue, what impact will all of this have on U.S.-China relations? Or more to the point of this analysis, how will China's economy withstand the shock this would almost certainly create? Already, according to FRC and other sources, there are telltale signs that China is heading down the same primrose path that was trod by America not many years ago—the path that leads to economic perdition. FRC explains: "The latest data from Red China [shows] State-owned banks have been throwing cash at any communist party member who wants cash to buy. It is all part of a plan to replace consumer sales to Americans. The trouble is that this fast spread of easy money has already begun producing a giant expansion of bad debts in China." Is China's economy setting up for its first major debacle since its aggressive growth spurt began? If so, it will almost certainly be preceded by a pronounced decline in China share prices. To that end, we'll be focusing our attention closely on the Shanghai Composite stock index as well as our favorite proxy for U.S. listed China shares, the China 25 Index Fund (FXI).

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