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(AP Photo/Chien-min Chung) (CHIEN-MIN CHUNG/AP)
(AP Photo/Chien-min Chung) (CHIEN-MIN CHUNG/AP)

The Buy Side

Why not to invest in China: Let's count the reasons Add to ...

Investors are fleeing from Sino-Forest and other companies with operations in China. Some people see this as a buying opportunity; I disagree.

In my opinion, China is slowly unravelling, and the imploding share prices of many Chinese companies are a symptom of deeper problems. This is a view I've held for some time and I believe the evidence is mounting that China's economy is on the verge of a slowdown. Let me list some reasons:

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Banking problems. As I've noted before in this space, China has been selling products at artificially low prices to keep its population employed and prevent social disorder.

Like Japan in the 1990's, China has kept its cost of capital depressed to help exporters generate jobs. That has fuelled a wave of bad lending, notably to local governments and the real estate sector.

As with Japan, loans that will never be repaid are now piling up in the banking system. This is by no means a new problem. McKinsey & Co., the consulting firm, warned back in 2005 of "the enormous stock of bad loans" in China's banking sector. This past year, the China Banking Regulatory Commission, the country's financial-system regulator, said the bad loans pose a "substantial" risk.

The danger has only grown since then. Japan paid for its sins with a decade of stagnation. China's stagnation is coming, too.

Currency pressure. Following the G20 meeting in Toronto last year, China reluctantly let the yuan rise. This made Chinese goods less competitive, reduced employment, and caused social disorder.

Meanwhile, inflation is on the rise, particularly in food prices. To fight it, China is squeezing the money supply, raising margin requirements, and tightening up lending.

As a result, China's real estate bubble is starting to deflate and many residences stand vacant. Bloomberg News recently reported on the construction boom in Kangbashi, a city in China's Inner Mongolia that was originally designed to accommodate around one million people. It currently has about 30,000 residents.

Legal vacuum. There's no property without property rights. My rule is never to invest in a country where there's no independent judiciary. Some of the latest riots in China erupted because bureaucrats have been confiscating land for projects in which they have a personal stake. Land owners have no recourse except violence.

Hard-line leaders. China's leadership is implicitly admitting things will get tougher. The country's current leader, President Hu Jintao, could afford some openness, but the new leader who is scheduled to take power next year will likely have to clamp down harshly. Xi Jinping, the likely new leader, has a reputation as a hard liner. For me, his continued rise in the political hierarchy is a clear sign that China realizes the future will be grim.

Lack of transparency: China is a dictatorship where analysts find it difficult to perform due diligence on prospective investments - just ask any analyst who has tried to research a Chinese company. What's more, official Chinese statistics are notoriously unreliable, leading some observers, such as Stratfor, a private intelligence consultant, to label the country's economy an unsustainable Ponzi scheme.

Even if China's economic miracle only proves to be overstated, the effects will be wide ranging. Much of the recent rise in commodity prices was the result of Chinese demand. If it tapers off, so will commodity prices. The good news? That will lower costs and liberate cash to start a new bull market.

To my mind, the only question is when the Chinese economy will start to decisively slow down. Brockhouse Cooper, the Montreal investing firm, noted in a recent report that high electricity demand in China indicates the country's economy is still red hot.

The Brockhouse analysts, however, noted that Chinese authorities appear to be losing control over financial stability, with rates in the "repo" market for short-term funds climbing and banks growing increasingly cautious about lending to each other.

Those are telling signs of the growing tension in the Chinese economy. All the more reason for investors to keep away from the country's stock market.

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