Western investors have always had two major problems when it comes to China. First, they just can’t seem to believe what they’re seeing – even after they’ve been there.

Second, even if they end up believing what they saw, they still can’t seem to make sense of it all. By that, I mean they can’t seem to put it into a usable perspective.

That lack of understanding has morphed into a full-blown misunderstanding. That’s why, for some, China represents a colossal economic train wreck that’s just waiting to happen, while to others the Red Dragon represents nothing but hope, progress and profits.

The truth, of course, is somewhere in the middle of those two divergent viewpoints – which is why every investor needs a China strategy.

Here’s the bottom line: What’s happening in China is simply too big to ignore. But it’s important to understand the risks and rewards before taking the plunge.

Let’s consider both.
The Benefits and Challenges of the Red Dragon

Short-term, there are a few risks to consider. For instance, inflation is running at a 10-year high, but the central bank has been tightening monetary policy in an effort to curb it.

There also are valid concerns that a slowing U.S. economy will derail China’s ability to withstand a U.S.-led global recession. And there are spiraling production costs that are seemingly set to squeeze the life out of China’s production lines which owe much of their competitive advantage to costs that are super low on a worldwide basis.

Longer-term, however, the proverbial “genie is out of the bottle,” which is why we believe that every one of these risks is surmountable.

For instance, even though monetary policy has tightened significantly over the past 12 months, don’t forget the economy is still growing at a double-digit rate – and will continue to operate at that pace for decades to come.

At the same time, remove fast-escalating food prices from this equation, and China’s non-food Consumer Price Index (CPI) has nudged up less than 1%, which is hardly a blip on the radar.

As for the notion of a U.S.-led recession causing China’s economy to crater, well, we just can’t see that happening. Not only has China successfully diversified its own export markets so that it is less dependent on the United States, it also has taken steps to create domestic demand for China-made products so that it’s not solely dependent on Western buyers to be prosperous.

China’s not quite there yet judging from the fact that most Chinese consumers still go for Western “bling” – Money Morning Executive Editor Bill Patalon coined the phrase “The Baywatch Effect” to describe that desire – but understand that the time is coming when the Chinese will demonstrate a “Made-in-China” nationalism that’s not entirely different from the “Made In USA” mantra that until recently has been prevalent throughout the United States.

There’s also a worry that rising prices will overcome the benefit of cheap labor in the China market. That’s another argument we don’t buy – at least not in the long run. Beijing is playing it smart here: It’s begun moving factories and production deep into the country’s interior, where production costs and labor are still dirt cheap. China’s central government also is focusing on the necessary infrastructure – such as highways – the country will need to keep investing in to keep costs low and long-term profitability high.

In fact, when China gets into that “long run,” we don’t see anything but bullish potential, especially when a few macroeconomic observations are thrown into the mix.

Let’s look at a few.
The Lowdown on the Long Haul

Beginning with liquidity. China’s literally swimming in capital reserves at a time when we here in the United States are struggling to find any. China just last month announced that its foreign reserves had reached a record $1.68 trillion. Domestic savings, according to the long-time China experts at ICS Trust (Asia) Ltd., exceeded $5 trillion in 2007 and represents a savings rate as high as 40%. That stands in stark contrast to a negative U.S. savings rate, and the paltry savings we’ve got on tap.

Not only does this give China unparalleled flexibility in dealing with any potential slowdown – regardless of its cause – but it also provides that country with the financial firepower to spend its way out of a slowdown, which is a luxury that we don’t have, even with the U.S. Federal Reserve’s printing presses running overtime.

Plus, China’s also got what is essentially the Beijing equivalent of Franklin D. Roosevelt’s New Deal program. There are public works projects everywhere you look and, not including the projects dedicated to the Beijing Summer Olympic Games (which open in early August), these construction endeavors represent trillions of dollars in spending all over China and employ millions of people.

China’s central government also is making economic reforms at light speed. Ironically, both experts who spoke to our China investing tour group here in Hong Kong pointed this out – independently of one another. Kishore K. Sakhrani, who is a director at Hong Kong-based ICS Trust (Asia) Ltd., noted that Beijing is lowering corporate tax rates from 33% to 25%. And Professor BaoKun Gui observed that new futures contracts will help develop financial markets providing Chinese exchanges with much needed stability and flexibility.

And that’s really the key when it comes to China.

China has been far more resilient than Western leaders expected or businessmen forecast, thanks in large part to its leaders who are increasingly pragmatic and open to new ideas even as they tighten their communist party holdings.

Western investors who understand and accept that are ready for the next step – reaping profits from the greatest growth market on earth.