The United States and China are locked in battle over China's manipulation of its currency. The yuan's undervaluation has become so considerable that economists now blame it for stifling the economic recovery and pushing us into a liquidity trap. Nobel laureate Paul Krugman has even urged the Treasury Department to formally label China a currency manipulator so the U.S. could then institute tariffs and other trade barriers without running afoul of the World Trade Organization.

Because China isn't likely to abandon this policy anytime soon, the tensions between our countries are bound to escalate. A recent book titled Currency Wars even reported that the Defense Department has collaborated with financial experts to simulate a full-blown currency war. Whether this will come to fruition is anybody's guess, though it isn't outside the range of possibilities.

Why China manipulates its currency
While Americans associate 2001 with the al-Qaeda attacks on the East Coast, most Chinese are likely to recall it for a very different reason. That was the year China gained admission to the WTO after a decade and a half of negotiations.

The WTO was established to supervise and liberalize international trade. On one hand, it prohibits a country from directly subsidizing its export industry to the detriment of the industry's foreign competitors. And on the other, it protects countries that play by the rules from unilateral trade sanctions imposed by a fellow member.

What's notable about the WTO from China's perspective is that, unlike the International Monetary Fund, the WTO doesn't prohibit a country from indirectly subsidizing its exports through currency manipulation. If a member was so inclined, it could accordingly have its so-called cake and eat it too. In other words, it could subsidize exports by keeping its currency artificially cheap, while at the same time seek shelter from retaliation under the WTO's proscription against trade sanctions.

And this is exactly what China has done. As you can see in Chart 1, it has systematically devalued the price of the yuan over the last 30 years. In 1980, $1 bought 1.71 yuan. By 1995, $1 bought 8.37 yuan. (Note: The exchange rate in the chart is inverted to achieve a negative slope.) An 80% decrease in value! This has bolstered its export industries by making Chinese manufactured goods artificially competitive in the global marketplace. And by doing so, it has markedly contributed to the phenomenal growth in the country's gross domestic product.

Sources: Federal Reserve Bank of St. Louis, World Bank, and author's calculations.

How China manipulates its currency
The foreign exchange market and currency values can appear imposing and abstract. Yet currency is simply a commodity. Its value is set by supply and demand. The higher the supply of a currency relative to demand, the lower the value. And vice versa.

So if China wanted to decrease the value of the yuan relative to the dollar, it would simply increase both the supply of yuan and the demand for dollars by selling the former and buying the latter. A country that does this over time thus accumulates large reserves of foreign currencies. And according to data from the IMF, this is the case with China, as you can see in Chart 2.

Source: Federal Reserve Bank of St. Louis.

China's accumulation of foreign currency reserves is unprecedented. It's gone from just under $4 billion in 1980 to $3.18 trillion today, most of which consists of dollars. This represents an increase of nearly 80,000%! And what does China do with all of its excess dollars? It lends many of them back to our federal government to finance its massive deficits -- $1.1 trillion, to be precise.

The impact of China's currency manipulation
With the preceding discussion in mind, the negative aspects of China's currency manipulation may not seem obvious. We print money, give it to them for their artificially cheap goods, they give it back to us with interest, we print more money to pay the interest, and on, and on. While this has contributed to a significant trade imbalance with China, the cost of our borrowing to finance the deficit has been limited effectively to the cost of printing dollars -- which nowadays we do by pressing a button on a computer.

For many years, a number of economists even believed this cycle was beneficial to the American economy. As late as 2007, a paper was published by the Federal Reserve Bank of Philadelphia, titled "Trade Deficits Aren't as Bad as You Think" (PDF file, Adobe Acrobat required). It argued that trade deficits were good because they "shift worldwide production to its most productive locations, and allow individuals to smooth out their consumption over the business cycle."

Unfortunately, this line of thinking didn't account for the volume of dollars that flooded back into the American economy. These dollars made their way into the housing sector and fueled the then-burgeoning real estate bubble. Federal Reserve Chairman Ben Bernanke calls this his "savings glut" hypothesis. The implication is that we are where we are because of these capital flows. And these capital flows are the natural consequence of China's currency manipulation. In the greatest irony of all, in fact, it's for this reason that China strictly limits capital flows into its economy.

I'm nevertheless bullish on China
While I believe it's likely that China's manipulation of the yuan has contributed to both the depth and duration of the Great Recession, I don't think now is the time for investors to be xenophobic. And particularly with respect to China, as its economic potential is unprecedented and will handily compensate investors for otherwise tepid growth in the Western world.

Given the rampant fraud underlying Chinese stocks, however, I would urge investors against speculating in questionable companies. Two such examples are Internet search giant Qihoo 360 (NYSE: QIHU) and China Green Agriculture (NYSE: CGA). Qihoo 360 came under fire last November when Citron Research accused it of overstating its popularity as the third most popular Internet company by user base. And China Green Agriculture has recently come to the attention of short-sellers.

 A much better bet is to go with known entities like Chinese fertilizer maker Yongye (Nasdaq: YONG); Baidu (NYSE: BIDU), aka "the Google of China"; or Dangdang (NYSE: DANG), aka "the of China." Our own Tim Hanson recommended Yongye after visiting its management and manufacturing plants on multiple occasions. Fellow Fool Brian Stoffel calls Baidu one of his favorite pure plays in China. And Dangdang is one of 2012's best performers thus far.

Our top stock recommendation for 2012
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