The Unsustainability of Chinese Investments


America embraces the values of free expression, transparency, and (relatively) free markets. China, on the other hand...not so much. While many cultural differences cannot be deemed right or wrong, when it comes to investing, there are definite benefits to clear reporting and a democratic government. This is why Chinese companies are much less enticing investments than their American counterparts and why they carry more risk than you may realize.

The risks of a cloudy government
With new technology subverting media controls, tyrannical governments have found it difficult to keep power. The Arab Spring changed governments in Egypt, Tunisia, Libya, and Yemen, and it caused a civil war in Syria. Following these Arab protests, a Bloomberg article described how in China, "some Politburo members questioned whether protests might follow against Chinese provincial politicians demanding bribes; local party officials confiscating land; and products and government services rendered shoddy by influence peddling."

But China avoided any major civil unrest, and it now has a new leader, Xi Jinping, who has said, "Reform and opening up is a guiding policy the Communist Party must stick to." Still, even with a new government, a post from Wharton notes: "The new membership of the all-powerful Politburo Standing Committee is quite conservative, in the sense of being averse to meaningful political reform and supportive of a heavy-handed internal security apparatus. As such, longer-term investment risks associated with mounting social pressures and potential instability will remain high."

While all-out revolution is probably only a tiny possibility, based on the historical effectiveness of the government's control, it still exists, and government media regulations can and have affected Chinese businesses. And an even greater risk than social unrest is fuzzy figures from the government, government-controlled firms, and companies. Pollution figures, which the government recently acknowledged might require a finer measure, aren't the only data of which it's difficult to get a clear view.

Social control
Google abandoned China in 2010 when it announced that it wouldn't follow Chinese censorship policies, and now it runs its Chinese website out of Hong Kong. Subsequently, Google's Chinese search market share declined from 36% in 2009 to about 15% today compared to Baidu's 79% share. While both companies earn a majority of revenue from Internet advertising and must learn to make money off an increasingly mobile user, only Baidu must also spend resources to censor results and keep the government happy. And last year three Baidu employees, perhaps influenced by the censoring environment, were arrested for deleting posts for money.

Other government actions include last year's scrubbing of the Internet in a campaign called "spring breeze" that ended with more than 70 companies reprimanded, 200,000 messages deleted, and 1,000 people arrested. Weibo, a Twitter-like service owned by SINA , had to disable comments at the end of March to help stem a rumor of a military coup. According to the Financial Times, this led one user to post, "Did we really need to be reminded that they can shut us up anytime?"

Fuzzy numbers
The greater risk of Chinese investments is iffy accounting. Carson Block of Muddy Waters made his name through research reports that highlighted alleged Chinese frauds, questioning items like revenue reports, equipment purchases, and customer accounts. While it may seem that small investors would be more taken by falsified reports, even global manufacturer Caterpillar was duped by the accounting misconduct of a mining company it acquired for $800 million. In January, Caterpillar wrote off $580 million of the acquisition's value.

If you want to get a macro picture of China, it's just as difficult to be sure of the reported figures. While China's official GDP growth numbers for 2011 and 2012 were 9.3% and 7.3%, respectively, a Standard Chartered analyst estimates that the actual figures were 7.2% and 5.5%. Unfortunately, no matter how much you tell yourself that your portfolio grew 30% larger than it seemed last year, the reality is different.

Supporting questionable behavior
The latest report of an elite Chinese military hacking group that attacked more than 140 U.S. companies over the last seven years should give investors another reason not to take on Chinese risk. In a country where an estimated 80% of software is pirated, China recently said it would do more to protect intellectual property. No matter whether China actually takes on stronger intellectual-property controls or companies continue to pilfer, Chinese companies will need to adapt to achieve stable growth; building off of competitors' designs is not a long-term strategy.

Long-term investing
While you may decide that the risks of government interference, lax accounting, and intellectual-property problems are worth the reward of investing in Chinese firms, I believe there are clearer and more conscientious opportunities. For example, there are plenty of American companies that operate in China but don't carry the same risks.

Learn more about Caterpillar
Caterpillar may have made a misstep with its Chinese acquisition, it's still the market share leader in an industry in which size matters, and its quality products, extensive service network, and unparalleled brand strength combine to give it solid competitive advantages. Read all about Caterpillar's strengths and weaknesses in our brand-new report. Just click here to access it now.

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Fool contributor Dan Newman has no position in any stocks mentioned. The Motley Fool recommends Baidu, Google, and SINA. The Motley Fool owns shares of Baidu and Google. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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