China Stole the Show in 2010. Next Year May Be Tougher

Optimism about the American economy is mounting on Wall Street, and some pundits have gone as far as declaring 2011 as "the year of the USA." But when it comes to the year just about passed, it's hard to think of another country that saw its star rise as fast as China.

While the U.S. struggled with near-10% unemployment, China grew at that same pace over the year as it overtook Japan to become the world's second-largest economy by some measures. That has left much of the American public in awe. Nearly half of the respondents in a recent U.S. poll saw China as the world's strongest economic power, for example.

But investors would be wise to take a measured look at China's role in the global economy. Even as its influence on the world stage grows, the country faces massive internal problems. And that leaves Beijing's leadership in a far more difficult situation than the praise constantly heaped on the country implies.

Chinese Self-Interest Rules

Commentators are often enamored by the clout China's vast coffers of foreign reserves give it. But China needs to use those funds to keep the world economy stable as much as any other country. Last week, China's campaign of checkbook diplomacy picked up more steam after the country pledged to buy European bonds in order to stabilize the euro.

Much like Chinese efforts to stabilize Greece over the summer, Beijing would like to cast the move as another demonstration of the benevolent and responsible role China is playing. But the strategy is at least as much about Chinese self-interest as it is generosity. China counts the EU is its largest trade partner and its second-biggest export market.

The same goes for China's approach to U.S. government bonds. While plenty of commentators love to howl about an inevitable dumping of American debt, China nevertheless continues to stockpile U.S. Treasurys. After all, it can't afford to upset the applecart when it comes to its major trading partners because a meltdown in foreign markets would send shockwaves across the heavily export-dependent Chinese economy.

A Lack of Innovation and Creativity

Some prominent domestic commentators are pointing to the flaws of the Chinese economy even as the rest of the world grows increasingly impressed. "China's rapid growth has been achieved at an extremely high cost," Yu Yongding, a former member of the People's Bank of China's monetary policy committee recently wrote. "Only future generations will know the true price."

Some of Yu's criticisms have been frequently made before. For example, high-profile American short-seller Jim Chanos has railed about the country's massive make-work investments that may ultimately result in vast amounts of poorly allocated capital. But Yu says a more fundamental lack of innovation and creativity are the "Achilles heel" of the Chinese economy.

On the diplomatic front, too, China faces staggering limitations even as its overall influence grows. By investing in politically sensitive and labor-intensive sectors abroad like the Greek shipping industry, for example, China is again using its funds to buy influence.

Why So Easy on North Korea?

And yet China has shown far less ability to influence events in its own backyard than might have been expected. Beijing has stood by largely quietly even as a reckless North Korean regime reliant on its patronage embarked on a series of provocations that analysts say have led to considerable embarrassment.

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But in this case, a fear of instability seems to be binding Beijing's hands. China seems to be unable to risk a refugee crisis or publicly chastise a fellow authoritarian regime. Instead, it took a newfound toughness on the part of South Korea along with the U.S. to stabilize the region (so far, at least).

Markets tend to get carried away. Sentiment in the U.S. is getting much more optimistic, even though the most-heard alarm not long ago was that the domestic economy would be stuck in the mud for years.

China, on the other hand, can do little wrong for the time being. But investors should be aware of the vast economic and political limitations the country faces despite its red-hot growth.