7 Reasons Why Investors Should be Afraid of China

October 19, 2012

Because the Chinese economy has expanded by leaps and bounds during the past few decades and is widely expected to keep posting solid growth for years, it may seem safe to assume China’s a great place to invest. But the world’s second-largest economy has some major disadvantages, both in terms of risks to you as an individual investor and to the global economy.

Here are seven reasons why investors should think twice before investing in Chinese stocks.

1. Government interference

With a domineering government like China’s, the risk of harmful meddling in the economy is much greater. This may take many forms in China, from economic data manipulation to inappropriately close ties between business and government. For instance, there have been reports of government officials falsely inflating a variety of economic data — corporate profits, corporate tax receipts and overall economic output — by as much as 2%. Thus, China’s current slowdown could be much worse than it appears.

Because the Chinese government is autocratic, shareholder-unfriendly regulations can also be quickly imposed. For instance, China’s coal industry was far more robust until a few years ago, when the government established production minimums and other rules favoring oligopoly. Many analysts now see the country’s coal industry much less competitive than before.

2. Lack of transparency

Incomplete, inaccurate or nonexistent financial data that make it difficult or impossible to value individual companies is a common scourge of emerging-market investors. It’s all too common among U.S.-listed Chinese firms, which have been known to report different revenue numbers and other data to the Securities and Exchange Commission and Chinese officials.

There have also been reports of company suppliers being owned or controlled by management as a way to milk companies from the outside. In a highly-publicized scandal a couple years ago, the Chinese wastewater treatment company RINO International Corp. (OTC: RINO) lent its CEO and chairwoman, the CEO’s wife, $3.5 million without a signed loan agreement. Trading in the stock was suspended Nov. 19, 2010, and has not resumed.

3. Unfair advantages for state-owned companies

There are more than 100,000 state-owned businesses in China. Of these, about 100 are centrally-controlled “national champions” that dominate in their industries, in particular because they’re heavily backed by the government and enjoy a range of unfair advantages, such as low-cost loans from official banks that in turn receive guaranteed profits for providing such loans. (Loan costs for private companies are typically three times what state-owned firm pays, if the a private company can get a loan at all.) Some of China’s better-known national champions include the integrated oil giant China Petroleum & Chemical Corp. (NYSE: SNP) and telecommunications behemoth China Mobile Ltd. (NYSE: CHL).

4. Currency manipulation

Most economists agree the yuan is undervalued by 25-40%, and China achieves this by pegging the yuan to the dollar. The goal, say critics of this policy, is to give China an unfair trade advantage by keeping exchange rates artificially low so Chinese goods can be cheaper than U.S.-made products. Besides hindering the U.S. economy, this policy produces huge trade surpluses for China, which in turn must put hundreds of billions of dollars back into the United States every year to maintain the yuan’s link to the dollar. Because China does this mainly by purchasing U.S. government bonds, the United States is now in debt to China to the tune of nearly $3 trillion. Some economists also say currency manipulation aided the bursting of the real estate bubble in 2008, because China also plowed billions of surplus dollars into U.S. real estate.

5. Trade and labor violations

A major gripe against China is its widespread use of government subsidies to bankroll the rapid growth of its industries. One of the most publicized examples is solar and wind power, where U.S. companies find it virtually impossible to keep up with subsidized Chinese competitors. A couple weeks ago, the Obama administration reported nearly 200 Chinese subsidies to the World Trade Organization, arguing that many violate free trade rules. Critics of China also point to horrendous labor violations, like the failure to enforce a government mandate limiting the workday to 11 hours and factory employees commonly working for days or even weeks straight without a break.

6. Government-created bubbles

Many investors fear extremely fast government-aided growth has created bubbles in the Chinese economy that could burst, damaging the global economy in the process. For example, virtually no one would dispute the existence of a bubble in Chinese commercial real estate. The sector is now so overbuilt, there are dozens of “ghost cities” like Henan province’s Zhengzhou New District, which is replete with business centers, modern high rises and shops — but almost no inhabitants.

A similar situation likely exists in residential real estate. The Chinese capital of Beijing alone has more vacant homes than the entire United States (3.8 million vs. 2.5 million). There may be a dangerous commodities bubble in China, too, based on reports of massive unused stockpiles — like the nearly 10 million tons of coal sitting idle at Qinhuangdao port, one of the largest coal storage areas in China. The prior record was 9.3 million tons in November 2008, when the global economy was presumably far worse.

7. A possibility of armed conflict with Japan

Nothing destabilizes markets and upsets economies like armed conflict, and there does appear to be some risk of this between China and Japan over several disputed islands in the East China Sea. The nasty feud erupted in mid-September, when Japan purchased the islands from a private owner — an event that triggered violent protests in China, produced heated rhetoric between the two governments and put a strain on business relations between the two countries. Most political experts consider the risk of military confrontation very slim at this point, though armed conflict could materialize if any incidents occurred between Chinese and Japanese patrol vessels in the area.

Action to Take –> I don’t think Chinese stocks are worth the risk. I certainly wouldn’t buy individual Chinese stocks — nor would I invest in a fund or exchange-traded fund (ETF) devoted to China. I strongly suspect government officials are painting a much rosier picture of the Chinese economy than actually exists, and I also suspect their economy could be a lot closer than anyone would like to admit to a crisis like the U.S. suffered in 2008.