China's Great Leap Elevates the Risk

It has been, by all accounts, a groundbreaking year for investing in China.

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An Olympic stadium in Shenyang: The 2008 summer games will spotlight China.

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It has been, by all accounts, a groundbreaking year for investing in China. By the end of 2007, a country accustomed to some of the fastest growth in Asia became home to one of the year's best-performing stock markets and even, for a few weeks, the world's largest company. The evolution of China's version of Wall Street is the latest leap forward for an economy that is on its way to becoming a world leader. "It's like their Industrial Revolution," says Donald Straszheim, vice chairman of Roth Capital Partners and a longtime China watcher.

That ascent is set to continue, with China's economy expected to expand around 11 percent both this year and next. The Shanghai stock index rose more than 400 percent over the last two years—a bubble, to be sure, but one with some amazing long-term potential.

So how should average American investors play one of history's great growth stories?

Demographics are a start. China is home to 1.3 billion people who provided its economy a low-cost workforce that is quickly becoming an army of consumers. Specifically, an emerging middle class some 250 million strong is developing a taste for shopping and travel that could mean sustained gains for quality companies in those sectors. Shaun Rein, a managing director at China Market Research Group, says 2008 will be a good year for firms catering to that market. Among firms listed on American markets, he likes online travel superstar Ctrip.com. New Oriental Education & Technology Group, an expanding network of test prep and English-language schools, is another favorite. Ahead of this summer's Olympic Games in Beijing, Focus Media, a digital billboard advertising powerhouse that is pushing heavily into cellphone ads, might also get a boost as multinationals make new overtures to potential Chinese customers, he says.

"Irrational." While the bubble in Chinese stocks has been great for investors, it does create risks. Many Chinese companies, for instance, have reinvested their revenue heavily in the rising stock market and are likely using those gains to prop up profits, analysts say. "There's an irrational exuberance about the future performance of Chinese companies," says Daniel Rosen, founder of China Strategic Advisory, a research firm.

Longer term, China's economy will be forced to contend with its own success. Decades of fast growth will eventually slow as low-cost labor gives way to higher wages and living standards. That will require a transition from low-cost producer to higher-skilled production. China also needs to curb the worst offenses that have accompanied its rise, including environmental damage and a blind eye turned to infringement on patent and intellectual-property rights. Reforming the banking sector is another must, as poor transparency and easy lending remain a possible stumbling block for future stability. Even after raising reserve requirements for banks 11 times in 2007, Chinese officials have roundly failed. Straszheim calls monetary policy "primitive"—a big worry for a country facing rising food prices that have sent inflation to an 11-year high. But for a nation that this year produced the world's first $1 trillion company (PetroChina), the future looks better than the past.