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Should You Be Investing in Chinese Companies?

Should You Be Investing in Chinese Companies?

Few can deny that the growth potential of China is vast. The country's success is dazzling, investment inflows are huge, and the society is being transformed in a monumental economic achievement. Because of this, China's potential for investors appears significant, but the market poses a number of unique political and cultural risks.

To better understand the China Machine, let us begin with a passage from the CIA World Fact-Book: ?For centuries China stood as a leading civilization, outpacing the rest of the world in the arts and sciences, but in the 19th and early 20th centuries, the country was beset by civil unrest, major famines, military defeats, and foreign occupation. After World War II, the Communists under MAO Zedong established an autocratic socialist system that, while ensuring China's sovereignty, imposed strict controls over everyday life and cost the lives of tens of millions of people. After 1978, his successor DENG Xiaoping and other leaders focused on market-oriented economic development and by 2000 output had quadrupled. For much of the population, living standards have improved dramatically and the room for personal choice has expanded, yet political controls remain tight?

?Economic development has generally been more rapid in coastal provinces than in the interior, and there are large disparities in per capita income between regions?One demographic consequence of the "one child" policy is that China is now one of the most rapidly aging countries in the world. Another long-term threat to growth is the deterioration in the environment - notably air pollution, soil erosion, and the steady fall of the water table, especially in the north. China continues to lose arable land because of erosion and economic development. China has benefited from a huge expansion in computer Internet use, with more than 100 million users at the end of 2005. Foreign investment remains a strong element in China's remarkable expansion??

In November 2001, with China's entry into the World Trade Organization, the Chinese government made a number of specific commitments to trade and investment liberalization. This began opening the Chinese economy to foreign firms. Yet despite these moves toward privatization, much of China's economy continues to be controlled by large State Owned Enterprises (?SOEs?), many of which are inefficient and unprofitable. Rather than undergo a large scale effort towards privatization, a restructuring of the SOE sector has been a major priority of the government and one of its biggest challenges has been the banking sector. Many Chinese banks have had to write off large amounts of delinquent debts from state-owned enterprises and China's banking sector remains a key concern for the country's economic stability as the ratio of problem loans appears to be rising.

Layoffs have played a large role in the restructuring of the SOEs, as many were severely overstaffed. This has created unemployment, which has been a burden on the government budget due to their providing social benefits which were previously the responsibility of the SOEs. At the same time, the geographic concentration of privately-owned industry in the urban centers along the coast also has created additional social strains.

As a result of its effort, China's real gross domestic product (GDP) grew at a rate of 9.8% in 2005, 9.5% in 2004 and 9.5% in 2003. For 2006, real GDP growth is forecast to drop to 8.9% as a whole. Much of the GDP growth rate appears to have come from excessive spending on capital goods and construction, particularly in the SOE sector.

Given China's booming economy ? if you haven't been scared off ? how does one invest in Chinese companies without risking unacceptable losses?

Aside from trying to acquaint yourself with specific companies or industries, stock shares resemble a veritable alphabet soup. They range from "A," "B," and "C" to signify types of shares traded on the Shanghai and Shenzen exchanges to "H," "N," "L," and "ADR" to denote shares traded on the Hong Kong, New York, and London exchanges and under the American Depository Receipt agreement.

Traditionally, A shares are held only by residents of China and are traded in Yuan. B shares are denominated in Yuan but payable in foreign currency and are designated for foreign investors. C shares are wholly owned by state-owned enterprises and are not publicly traded.

In June 2003, China approved a handful of qualified foreign institutional investors, or QFIIs, to invest in ?A? shares listed in Shanghai and Shenzhen.

To qualify for ?A? shares, a financial institution must have US $10 billion in assets under management in its past fiscal year. Fund management companies must have a minimum of five years of operational experience, while insurance companies and brokerages are required to have at least 30 years experience and paid-in capital of at least US $1 billion. To keep a rein on ?hot money? escaping China and prompting a financial crisis, the QFII scheme also requires funds to be held onshore for at least one year before being repatriated.

Among the ?H? shares, the highest rated are known as "red chips" and they come in two varieties: mainland Chinese companies with Hong Kong subsidiaries and Hong Kong companies that do the bulk of their business with mainland China.

For most investors, the best way to play China is through a mutual fund. And, the number of fund offerings is growing as investor demand for China-related products increases. But remember, it's not like investing in the US markets. China is a volatile economy. Investing in China is very risky, suitable only for long-term investors, and should be limited to a small portion of your portfolio. The things we take for granted, like investor laws, private property, and accounting standards, won't protect your investments there. To some, this may be considered more risky than the US penny-stock market?

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