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Five Reasons You Should Be Scared of China

“China is a political and social time bomb.” So says Karim Rahemtulla in his book Where in the World Should I Invest?

And I believe the time bomb is ticking louder…

Before the financial crisis, no other investment story was more exciting than China. The story seemed to write itself: What happens when you add a billion consumers to an economy? Every day millions move from farms to the cities. And so on.

But the financial crisis and recession in the United States stuck a pin in the China bubble and showed that China’s growth was not as robust as many had thought. In fact, it was fragile – dependent on its exports and government stimulus.

Now, after the Chinese stock markets have been stalled for nearly three years, some wonder if the growth story is ready to resume. So I thought it would be a good time to give you five reasons why I’m scared of Chinese stocks now more than ever…

Reason #1:  No Momentum

A true sign of a healthy market is the ability to heal itself after a big shake-up. For instance, while U.S. markets had rebounded since 2009 before the crisis in Europe led to a pullback, China has seen no such advance. As measured by the Shanghai Composite Index, China’s market peaked in 2008 before falling 72%. Since then, it’s only rallied back to within 34% of its high. Compare that to the S&P 500, which fell 56% and rallied back to within 8% of its high.

If you’re more concerned with GDP numbers than stock returns, China’s GDP growth dropped in 2008 before immediately jumping back up to 11.9%. But since then, it’s seen a nearly straight decline to 8.1%.

Reason #2: Cracks in the Political Façade

China’s human rights record has always been questionable. But thanks to democratized technology and increasing confidence amongst its population, stories of official corruption and mistreatment of dissidents seem to be on the rise and gaining international exposure. Over the last few months, we’ve seen several headlines gaining worldwide attention. Here are just a few…

  • Chen Guangcheng, a blind activist and lawyer, was allowed to move to the United States after he had been under house arrest. He used YouTube to plead for help to escape abusive authorities, leading Secretary of State, Hillary Clinton, to get involved during a diplomatic trip to China.
  • After being confined to Beijing for a year, artist, Ai Wei Wei, was recently released, though he’s still barred from leaving China. Ai first attracted the ire of the Communist Party by investigating the collapse of school buildings after the Sichuan earthquake in 2012. But the Chinese state has been unable to silence him as Ai uses Twitter to get his message out to over 100,000 followers.
  • Then there’s Bo Xilai, who was considered a candidate for the nine-member committee that rules China and a future candidate for President. In March, Bo was dismissed from his post after an investigation began concerning corruption, wire-tapping and the poisoning of a British powerbroker who linked Chinese officials to western companies.

Now, the exposure of this corruption could, in the long term, be a good thing for China. But it caused a lot of unrest as the story broke, since China shut down 16 websites, including popular Chinese versions of Twitter.

Reason #3: What Kind of Government Is This?

Recently, John Hempton, a hedge fund manager who has successfully shorted several fraudulent Chinese companies, wrote a popular diatribe revealing the Chinese government as a giant kleptocracy.

His argument boils down to the following logic. First, the one-child policy leads Chinese citizens to accumulate savings at a high rate, since they won’t have many children or grandchildren to support them. But citizens have extremely limited options for investing those savings. The best option is often savings accounts that pay only 1% (which is a negative return when you consider inflation).

Then all these savings are turned into incredibly cheap financing for State-Owned Enterprises, which are then looted gratuitously by the party elite. (Check out the headquarters of Harbin Pharmaceutical posted by Business Insider to see what I mean.)

It’s worth mentioning that Hempton’s piece reads more like a personal essay than investigative journalism. So he doesn’t quite prove the level of corruption he alleges. But he does lay a framework for just how widespread corruption in the Chinese government might be. Plus, when a major world economy starts being referred to as a “mafia state,” that’s enough to raise serious questions for me.

Reason #4: Corporate Corruption is Just as Bad

I’ve written before about fraudulent Chinese companies that list in the United States and supply fictitious financial statements. The problem is, the executives and party insiders who benefit from these scams get off scot-free, with no investigations or criminal charges. So if you’re a connected Chinese elite, there’s no reason not to dupe gullible U.S. investors.

Reason #5: Qualities Over Quantities

What’s most perplexing about these Chinese risk factors is that they are unquantifiable. There’s no way to measure corruption or political unrest that could give us some sort of mathematical handle on what’s in store for China.

In the end, China’s future will depend on the delicate interplay between the government, dissidents and the actors in the “free” markets.

The only thing we know for sure is that with tensions rising, China’s market is in a state of elevated risk. And as an investor, it’s not a risk worth taking.

Ahead of the tape,

Matthew Weinschenk

Matthew Weinschenk