Is the World's Hottest Market Starting to Wobble? Investors in China have recently earned one eye-popping return after another. But making money there won't be quite so simple in the years ahead.
By Carla A. Fried

(Business 2.0) – How's this for a can't-miss investment opportunity: Enormous but struggling nation with a potent workforce turns capitalist and embraces its destiny as a future economic powerhouse. Foreign capital pours in, early investors pocket near triple-digit returns, and the sky seems to be the limit.

Sounds like hundreds of headlines you've recently read about China, doesn't it? But it also perfectly describes Russia in the mid-1990s--and we all know how that ended. Turned out that Russia's young economy was too shaky, its financial institutions too immature, and its communist legacy still too powerful for investors' rosy expectations to be realized without a hitch. When the country defaulted on its debt in 1998, investors lost their shirts.

That experience should sound alarms for investors dazzled by recent results from China. The Middle Kingdom may have produced more than 10 percent of all U.S. imports last year, but it's still just another emerging market. Like other young economies, China suffers from backward infrastructure, flimsy financial institutions, and an unhealthy dependence on foreign capital. No other emerging economy--not the Asian "tigers" of the 1990s, not even the youthful United States in the 1850s--has reached prominence without painful setbacks en route. Mark Headley, co-manager of the Matthews China Fund and a long-term China bull, agrees that the road ahead will have rough patches. "The higher the valuation for Chinese stocks 10 years from now, the harder the hiccups we will probably have to live through to get there," he says.

Such talk doesn't mean you should avoid China. But there's a strong case to be made for limiting your investment, and even for waiting awhile to get in. Here's why.

THE PICTURE LOOKS ROSIER THAN IT REALLY IS.

Right now it's easy to believe that the Chinese economy is firing on all cylinders. Last year China sold a robust $438 billion in exports. Some $54 billion worth of capital poured in from abroad, making China the world's largest recipient of foreign direct investment. And a growing share of its 1.3 billion consumers have money to spend. "The long-term fundamental story is promising," says Raymond Lin, portfolio manager with Tricera Capital, a San Francisco-based investment firm specializing in Asia.

But get past the sexy numbers and you'll find some rather unlovely characteristics. China's export market thrives in no small part because its currency, the yuan, is fixed at an artificially low exchange rate. That helps keep its export goods amazingly cheap. However, competing U.S. manufacturers, already at a distinct disadvantage because of China's lower labor costs, are lobbying for tariffs on Chinese wares. Then there are the rumors that China's central bank will increase the yuan's value by 10 percent in the next two years, or at least give it room to float. Changes like that could hinder demand for exports, which is the locomotive of the Chinese economy. And a slowdown could squeeze the flow of foreign capital, which is the coal for China's locomotive.

Foreign investors wouldn't be so crucial if China had reliable internal sources of capital. But it doesn't. Reinvesting domestic savings is the job of a nation's banking system, and China's banks are an accident waiting to happen. They lend too much to cronies and too little to viable private businesses. As a result, as many as half of the banks' loans aren't being repaid. Put bluntly, Chinese banks are in worse financial shape than American savings and loans were during the early 1990s.

Economic expansion eventually allowed the S&Ls to grow out of their crisis. But they first had to stop making bad loans, and it's not clear that Chinese banks have done so. "The big question is, what are they doing with new loans? How much of the new debt is soon to be bad debt?" says Headley, who's been investing in Asia for more than a decade. "The answer is, we don't know."

EVENTUALLY, THE HONEYMOON WILL END.

After a nation reforms its economic policies and encourages foreign investment, there's a period when it can do little wrong. China is now in the middle of its free ride. Recent, enormous growth in its industry and service sectors has coincided with a huge increase in the worldwide demand for commodity goods and an explosion in manufacturing technology. Since it's now possible to assemble even fairly sophisticated gear in low-wage Chinese factories, is it any wonder that the nation's export market exploded by 225 percent in the last five years?

Investors buying into China at today's prices are betting that the honeymoon will continue uninterrupted. History suggests that's a pretty risky wager. For instance, back in 1993 the Morgan Stanley Capital International Emerging Markets Index, the S&P 500 of the developing world, gained 65 percent. Then in 1997 and 1998, the index dropped a total of 35 percent. What happened? Latin America ran into credit problems, Thailand's baht plummeted--and the list goes on. A revalued yuan, a banking crisis, or something unforeseen (say, a SARS outbreak) could trigger the same kind of free fall in China. Emerging markets simply don't have any margin for error.

WHERE THE SMART MONEY GOES.

Since you can't predict which forces of economics or nature might sidetrack China's march to prosperity, you should limit the effects such a setback could have on your portfolio. So invest only what you'd bring to a poker game directly in a Chinese stock: Even a compelling bet like China Mobile (2003 return: 32 percent) requires you to keep up with news happening a world away. It's safer to choose from the fairly wide selection of U.S. mutual funds that invest either in China alone or in a variety of emerging markets (see "The Many Ways to Play China," opposite). The Matthews fund, for instance, has performed well by putting companies dedicated to building up Chinese infrastructure in its portfolio. But don't commit more than 5 percent or so of your investments to such funds, advises Rosanne Pane, a mutual fund strategist for Standard & Poor's. That way, if something does go wrong, you're not in over your head.

An even less threatening way to play China is to invest in well-established, Western companies that have lots of exposure there. Many do. Motorola, Cisco, and Intel, for example, recently were players in a $2.3 billion sale of goods to Chinese telecom firms. HSBC, the U.K. banking giant, recently became the first foreign firm to underwrite Chinese government bonds. There's also Federal Express, which already carries more packages around China than any of its peers. Such companies get a boost from China's growth, but their worldwide operations prevent any stumbles in China from profoundly affecting the bottom line. Besides, what could be a more American way for you to take a stake in China than to help introduce that country's newly bustling society to the miracle of overnight delivery?

Carla A. Fried also writes about investing and the stock market for the New York Times.