MONEY

Investing in China: Handle with Caution

Beijing-Shanghai High-speed Railway Begins Test Run
SHANGHAI, CHINA - MAY 11: (CHINA OUT) A CRH high-speed train leaves Shanghai Hongqiao Railway Station during its test run on May 11, 2011 in Shanghai, China. After 3 years construction, from April in 2008, with total investment estimated at 220.9 billion yuan (around 32.5 billion U.S. dollars), the Beijing-Shanghai high-speed railway begins a one-month trial operation. It is expected to start operation in June this year, with the travel time between the two cities reducing to five hours from the previous 10. (Photo by ChinaFotoPress/Getty Images) ChinaFotoPress—Getty Images

Wall Street hyper-focuses on how fast China will grow this year or next. As it became clear to me on a recent visit there, my first in five years, that’s the wrong question.

I canceled my flight from Beijing to Shanghai to try out the high-speed train, which covers 811 miles — the distance between New York and Chicago — in less than five hours. Amtrak would take 19.

Five years ago Shanghai was too smoggy and under too much construction for me to understand what China’s urban transformation could mean.

To enter the city today is to be transported to a future of massive skyscrapers connected by superefficient subways. Those buildings are filling up. In 20 years, more than 350 million people will have moved from the countryside to cities.

This first-rate infrastructure now supports the world’s second-biggest economy. The real question to ask about China is whether its leaders will act as if that’s what they’re managing rather than relentlessly pursue export growth on the backs of a cheap labor pool.

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Ann Lee, author of “What the U.S. Can Learn From China,” argues the answer is yes. “They know that they need to put money in people’s pockets,” she says. As evidence, Lee points to China’s 800 million cellphone users and the 6 million students graduating college each year.

Reforms, yes, but…

Financial reform, such as expanding the role of private capital in the banking sector, is slowly taking hold. Michael Hasenstab, of the Franklin Templeton Fixed Income Group, wrote recently that this could “elevate China from a middle-income to a high-income country” over the next decade.

Yet Shanghai’s stock market trades at one-third its 2007 peak. Concerns remain about political reform, rampant bribery, intellectual-property theft, and the opaqueness of government data.

Those issues make the bull case uncertain. As Canadian scholars Alan Huang and Tony Wirjanto have observed, Chinese stocks carry price/earnings ratios similar to U.S. stocks yet with much higher growth potential.

Too bad you can’t trust the numbers and Chinese stocks are so volatile.

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That suggests a conservative approach. A standard diversified portfolio would have about 30% of stocks overseas, and a quarter of that in emerging markets. Your allocation to Chinese stocks would be about 1.4%.

Until China is more transparent, don’t get much more enthusiastic. Still, what can be seen is amazing. Leaving Shanghai, I rode the magnetic levitation train (no wheels or tracks) to the airport. It compresses a 45-minute drive to eight minutes. That’s progress.

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