Tempted by China? 3 ways to cut risk

By Jim Jubak

The potential rewards from investing in China are enticing, but you certainly don't want to put your portfolio at risk in order to reap those rewards.

China's runaway economic growth rate -- 11.4% in 2007 and a projected 9.6% in 2008 -- has meant huge gains for investors. The FTSE/Xinhua China 25 index is up 600% in five years.

But with China you also get big risk. The market volatility is breathtaking on both the upside and the downside -- Hong Kong's Hang Seng ($HSIX, news, msgs) stock index climbed 40% from July 9 through Oct. 30, 2007, and then fell 28% from Oct. 30 through Feb. 6, 2008.

What do you do if you want the most China profit with the least China risk? You determine the sources of risk and devise strategies for limiting the risk of each source. In this column, I'll suggest three such strategies -- and seven stocks or exchange-traded funds (ETFs) for executing them.

Full-speed economy means inflation

The first source of risk is simply that China's economy is growing too fast. An economy growing at 11% is speeding ahead so fast that when the train goes off the tracks, the result won't be a few derailed cars but a major train wreck. The broadest measure of money supply, M2, grew at an annualized rate of 17% in December. (That's actually down from 18.5% in November 2007). Rule of thumb: If the money supply is growing faster than the economy, the result is likely to be inflation.

And price inflation is exactly what China has got. Prices climbed at an annualized 6.9% in November, driven by soaring food and energy prices that led the government to slap on price controls.

I'd call China's economic risk extreme but not different in kind from what investors deal with in developed financial markets. We're used to dealing with the possibility of corrections (and, to a lesser extent, bear markets and asset bubbles) in the U.S. stock market. We watch valuations and charts and interest rates and economic-growth rates to see when stocks as a whole carry more or less risk.

The same tools can help you deal with risk in China. Right now, for example, we can see that rising inflation and rising interest rates pose a threat to stock-market valuations. The Beijing government's attempts to reduce bank lending in order to control real-estate and stock-market speculation, if successful, would put downward pressure on stocks. A slowdown in economic growth -- albeit from 11.4% in 2007 to 9.6% in 2008 -- also raises the odds that the current correction in stock prices that started in November may run for a while, notwithstanding any short-term rallies.

Using the standard tools that you'd use for any market, we'd say that China's market risk is too high to buy right now, regardless of the potential for profit. If you already own Chinese securities, you might want to hedge some of your risk with one of the short ETFs that aim to profit from any fall in Chinese stocks. For example, ProShares UltraShort China (FXP, news, msgs) is designed to move up twice as fast as the FTSE/Xinhua China 25 Index falls.

Can't count on accounting

There's a second source of risk that's much less familiar to investors in other stock markets. I'd call this China-specific risk because it's a result of the unique characteristics of the Chinese financial and economic systems.

Most discussions of China-specific risk focus on accounting:

• It's even harder than it is in the U.S. market to get numbers on costs, inventory and profit margins that inspire trust.
• It's difficult to figure out who actually owns many Chinese companies given the below-the-radar-screen involvement of government entities ranging from local country councils to the People's Liberation Army. And with that comes uncertainty about how well the self-interest of owners and shareholders align.
• There's a lack of transparency. Deals between companies in China often result in prices that are different from those in the competitive marketplace.

But I think there's another, even more important source of China-specific risk: the role of the Chinese government in picking winners and losers in the economy. This direct interference by the Beijing government is most obvious -- and important to investors -- in what the Chinese government deems the strategic sectors of the economy. Beijing defines "strategic" broadly to include telecom, steel, coal and airlines.

Continued: Beijing bureaucrats decide

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