China and the U.S. will hold a third round of Strategic and Economic Dialogue May 9-10 in Washington DC.  From Associated Press:

What began in 2006 as a purely economic forum with treasury and central bank leaders has expanded during the Obama administration to cover strategic and security issues that loom increasingly large as China’s global reach and military power grows, challenging American dominance.

Treasury Secretary Timothy Geithner will be joined by Secretary of State Hillary Rodham Clinton at the head of a U.S. delegation that will also include Federal Reserve Chairman Ben Bernanke and officials representing 16 U.S. government agencies.

The visiting Chinese team will be led by Vice Premier Wang Qishan, a top economic policymaker, and State Counselor Dai Bingguo, a veteran diplomat, along with officials from 20 Chinese government agencies.

For the first time, senior Chinese military representatives will also attend.

American and Chinese delegates will have a lot on their plate to discuss. The U.S. is first and foremost concerned with trade and economic issues. U.S. Secretary of Treasury Timothy Geithner has indicated he will ask  China to hasten the yuan’s rate of appreciation and give American businesses more access to Chinese markets. From Brookings:

In a speech earlier this week, U.S. Treasury Secretary Geithner reiterated a clear quid pro quo that defines the overall parameters of the bilateral economic relationship. The speech makes the U.S. position clear that in order to attain China’s objectives in the bilateral relationship, China must adequately satisfy U.S. interests. China’s objectives are seen as including access to high technology products, investment opportunities in the U.S. and market economy status.

For its part, U.S. interests lie in greater market access for its companies, including in government procurement; stronger protection of intellectual property rights; and other reforms that would ensure a level playing field within China for domestic and foreign producers. Secretary Geithner’s speech acknowledges the commitments made on some of these issues during President Hu’s visit to Washington in January but, with good reason, reserves judgment on China’s implementation of these commitments.

Secretary Geithner also urges faster implementation of China’s own reform agenda—financial market reforms, a more flexible exchange rate regime, and growth rebalancing to stoke private consumption and make the economy less dependent on exports or investment. While there are differences in opinion about the desired pace of these reforms, there is agreement on both sides that such reforms would promote the sustainability and durability of China’s growth and also contribute to the global rebalancing effort.

American businesses have voiced concerns that the Chinese government is instituting barriers to American investment and their access to Chinese markets. From Wall Street Journal:

“The big thing is a focus on implementing the high-level pledges that have recently been made,” said John Frisbie, president of the U.S.-China Business Council. In January, China’s President Hu Jintao agreed to beef up Beijing’s protection of intellectual property and allow U.S. companies greater access to Chinese markets.

U.S. Commerce Secretary Gary Locke, tapped to become ambassador to China, last week ticked down a list of company complaints that China gives its companies advantages in investment opportunities and hasn’t done enough to protect intellectual property, such as software copyrights.

“All of these recent moves by China result in its economy becoming less competitive and less welcoming to foreign direct investment,” Mr. Locke said.

China has indicated a willingness to amend some rules that are acting as a barrier to foreign investments, “but even if they are amended and they change the letter, you don’t necessarily change the spirit in which people actually act,” said Yukon Huang, a senior associate in the Carnegie Endowment for World Peace and a former World Bank country director for China. One major problem has been getting provincial authorities to implement central-government mandates.

“We want to see these commitments…translate into action,” Mr. Geithner said.

For its part, Beijing has logged concerns about the Federal Reserve’s easy-money policies, about Chinese companies’ lack of access to some U.S. industries, such as energy and technology, and about Washington’s slow restructuring of export controls.

Besides economic issues, cyber security is also expected to be on the Strategic and Economic Dialogue agenda. From the Heritage Foundation:

Much cyber-related attention has been focused on the PRC. China is reportedly the source of many of the hacking efforts directed at U.S. military and security computer networks. Chinese computer infiltration has reputedly obtained access to such sensitive programs as F-35 design information. Such efforts as Titan Rain, Ghostnet, and others have reportedly attacked U.S. and other nations’ information systems systematically and have infiltrated email servers and networks around the world. One example is the “Shadow network,” which affected “social networking websites, webmail providers, free hosting providers and services from some of the largest companies.” Many have been traced back to the PRC—but attribution to any specific Chinese entity is extremely difficult.

A growing concern is that China can exploit its position as one of the world’s largest producers of computer chips, motherboards, and other physical parts of the Internet to affect American and allied infrastructure. China has apparently already demonstrated an ability to tamper with Domain Name System (DNS) servers based in China, “effectively poisoning all DNS servers on the route.”

The fear is that they could now affect foreign-based routers. In this regard, the issue of Chinese counterfeit parts is compounded by uncertainty about whether fake parts are being introduced as part of a concerted intelligence campaign or simply the result of profiteering by local contractors.

Pundits are cautiously optimistic about the talks. Most agree that it will not lead to any dramatic breakthroughs between the U.S. and China since both countries are ultimately looking for stability as leadership transitions in 2012 . From Reuters:

Chu Shulong, a professor at Tsinghua University in Beijing, cautions that as China’s focus shifts to a successor to Hu, who retires as Communist Party chief in late 2012 and leaves the presidency in 2013, it will be less flexible in policymaking.

“For example on exchange rates, China will be focused on stability and economic security, and that could mean the government is less willing to move faster on the (yuan),” Chu suggested.

The United States has pressed China for years to allow the yuan to rise in value. China has allowed a faster appreciation of late, but U.S. officials argue more must be done for Beijing to combat sharply rising domestic prices.

Analysts say Monday and Tuesday’s once-a-year Strategic and Economic Dialogue is unlikely to break new ground on the range of prickly issues — from U.S. impatience with the pace of the yuan’s rise to Beijing’s unhappiness at U.S. arms sales to Taiwan — that complicate bilateral ties.

The political context for both countries will likely prevent any from undertaking substantial shifts in their policies. From Brookings:

With the unemployment rate now below 9 percent and job growth modestly positive, next week’s meetings will take place against a more benign economic backdrop in the U.S. Moreover, Republicans in Congress have made it clear that currency legislation against China is not a priority. This gives the administration a little more leeway (and perhaps a little less bargaining power) in its dealings with the Chinese.

The political calendars of the two countries will drive the debate on economic issues. The Chinese leadership transition that begins in early 2012 and the U.S. presidential elections in the fall of 2012 could lead to a hardening of positions on both sides and also to some degree of policy paralysis, especially on bilateral issues.

China is keen to ensure a smooth transition to its new leadership in early 2012, making it unlikely that there will be significant policy shifts or initiatives in the latter half of 2011. The reformist credentials of the presumed heirs to President Hu Jintao and Premier Wen Jiabao are unclear and untested. In any event, the jockeying for senior positions and the work the new leadership needs to do to consolidate its power all point to the low probability of any major policy shifts during the first half of 2012.

The waters will appear calm and friendly at next week’s discussions but there remain deep and difficult tensions hidden beneath the surface.