The Dangers of Investing In China

China and other developing nations have been a darling of investment over the past decade.  China has been a diligent exporter and, much like other developing nations like India, has been doing an impressive job of pulling its citizens out of poverty.  While we might be shocked at what a middle class in China looks like, the rate at which it's evolving is cause for celebration among their people.  It's not surprising that Westerners see this growth and want to participate in it.   In these developing nations, we look at what a 2009 "slowdown" will look like (6% growth by many estimates for China) and wish that our slowdown was likely to be comparable.

China in many ways is the model of what we want in a developing nation.  We often look to countries like India and marvel at how they get anything done with their leanings toward bureaucracy and the slow pace at which they move.  Meanwhile China seems ruthlessly efficient despite their penchant for central planning and runs a considerably more profitable government.  What we oftentimes forget in assessing the nature of Chinese growth is:

We Have No Idea How Real Chinese Growth Is

We forget that despite their embracing of freer markets, China is still a closed society.  They do not have a free press; they do not have many of the freedoms that we take for granted in the West.    Given this lack of transparency, it is unclear why investors are so trusting of Chinese growth.  For all of its failings, in the West fraud has a way of coming out because of the interests of so many in finding it.  In China we largely have to take the word of the people who stand to benefit from deceit or exaggeration.

Think of the most recent, obvious parallel.  In the Western financial meltdown that is taking place right now, everyone bemoans the lack of transparency that led to the downfall.  The people who were telling us that certain investments or practices were safe, were the same people who stood to benefit from us believing them.  What makes us think that the Chinese are so much more honorable than our financial pundits?

While there's no reason to believe the Chinese are particularly duplicitous, there is also no way to verify if they are not.  This is one of the reasons that an open, free market society always has a stronger sense of trust to the outside world.  While open societies have their failings, in the long run they are at least auditable.  Chinese investors have considerably more limited capacities in verifying their investments.  While taking the Chinese "word for it" has paid off so far, at some point that kind of power could very likley prove corrupting, if it hasn't already.