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The Big Showdown: U.S. Sovereign Debt vs. Chinese Inflation

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As 2010 draws to a close, tensions continue to mount between the U.S. and China. As the U.S. continues to pump up its own economy with quantitative easing rounds and tax cuts, China is crying no fair.

Meanwhile, China refuses to tackle its own outsized inflation, preferring to keep the yuan cheap -- the result is an increasing trade deficit favoring the Chinese. But according to economist Andy Xie, sooner or later, something's going to have to give. The former Morgan Stanley chief Asia-Pacific economist opines that "the most likely candidates to trigger the next global crisis are the U.S.' sovereign debt or China's inflation." If one goes down, "the other can prolong its economic cycle."

So who's slated to come out on top in 2011's clash of the economic titans? In Xie's opinion, that will largely depend on how China deals with inflation, a problem it can't keep putting off forever. If the Red Giant can get a handle on it without bringing economic growth to a halt, it could be the U.S. sovereign debt that sets off the next global crisis.

But if China fails to find a solution to its inflation predicament, it will be the U.S. that emerges victorious. Lower import prices would cut down the U.S. trade deficit, boost the dollar and help taking down the Treasury yield.

So which superpower has the edge? Xie thinks it may be China. While the U.S. can't turn the faucet off on its liquidity measures, China has the means to rein in inflation. In Xie's opinion, the country's inflation stems largely from excess expenditure by its local governments. Limiting expenses, by cutting their funding sources, could be an extremely effective and manageable solution.

Whether you're Team China or Team USA, there are plenty of ways to play the trend. Here's a list of exchange-traded funds to keep an eye on. (Click here to access free, interactive tools to analyze these ideas.)

  • PowerShares Golden Dragon Halter USX China Portfolio (NYSE: PGJ  ) : This fund tracks the Halter USX China Index, a benchmark that is comprised of the U.S.-listed securities of companies that derive a majority of their revenue from the People's Republic of China. As such, PGJ offers a unique option for China exposure.
  • SPDR S&P China ETF (NYSE: GXC  ) : State Street's GXC invests in a broad range of market sectors, allowing investors to have their hands in all corners of the China equity market. GXC tracks the S&P China BMI Index, a benchmark that measures the investable universe of publicly traded companies domiciled in China that are legally available to foreign investors.
  • iShares FTSE/Xinhua China 25 Index Fund (NYSE: FXI  ) : FXI is the biggest China ETF, but it certainly isn't the most diverse. This ETF has about 25 holdings, and big weightings in the financials and energy sectors. FXI is light on consumer exposure, a potential drawback for investors looking to tap into China's growing middle class.
  • Claymore/AlphaShares China Small Cap Index ETF (NYSE: HAO  ) : HAO tracks the AlphaShares China Small Cap Index, a benchmark that includes companies with a float-adjusted market cap between $200 million and $1.5 billion. This fund gives investors more diverse exposure to the Chinese economy.
  • Claymore/AlphaShares China All-Cap ETF (NYSE: YAO  ) : For investors looking to cover the whole spectrum of Chinese stocks, YAO is an interesting option. This fund gives a big weighting to energy and financials, but maintains a relatively balanced allocation overall.
  • PowerShares DB US Dollar Index Bullish (NYSE: UUP  ) : The investment seeks to track the price and yield performance, before fees and expenses, of the Deutsche Bank Long U.S. Dollar Futures index (i.e., bullish bets on the U.S. dollar). If China fails to find a solution to its inflation predicament, it could be the U.S. that emerges victorious. Lower import prices would cut down the U.S. trade deficit, and boost the dollar.

Interactive Chart: Click on the time line to compare the performance of the iShares FTSE/Xinhua China 25 Index Fund (FXI) against the S&P 500 index.


Kapitall's Eben Esterhuizen and Alicia Sellitti do not own shares of any funds mentioned.

The Motley Fool has a disclosure policy.

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