3 Reasons I'm Avoiding China

The emperor may, in fact, have no clothes.

On the heels of the European debt crisis comes a deepening fear that China's boom is unsustainable. A new report from Bloomberg illustrates just how precarious China's soaring growth may be. According to its study, the debt of China's local government financing companies, used to fund the construction, may total $622 billion. That figure may not be so startling on its own, but this apparent gross underreporting is one of several reasons I'm afraid China's real estate bubble is full of hot air.

1. Ghost cities
The Chinese government has announced plans to build 20 cities a year for the next 20 years, but they seem to be forgetting one thing: people. According to some estimates, there are already 64 million vacant apartments across the country. One recent development, Daya Bay, is designed for 12 million people, but even the state-controlled media admits that 70% of its residential units are unoccupied. China analyst Gillem Tulloch considers it the modern equivalent of building pyramids. "It doesn't really add to the betterment of lives," he said, "but it adds to the growth of GDP."

Residential real estate construction now accounts for a tenth of China's GDP compared to just 6% in the U.S. at the peak of the housing bubble in 2005, and prices have become severely inflated. The average home price in China is about nine times the mean annual income, while the historic average in the U.S. is three, and only reached 5.1 at the peak of the housing bubble. Real estate prices have now started declining, which will have an impact on everything from prices for commodities like iron, copper, cement, and coal to a slowdown in the global credit market. A UBS analyst called the Chinese real estate market "the single most important sector in the entire global economy, in terms of its impact on the rest of the world" because of the materials needed for all that construction.

2. Cooking the books
Those falling real estate prices may cause government authorities to default on their loans. The severity of the debt underreporting uncovered by the Bloomberg report can be seen on the books of the banks financing the construction. For instance, the Industrial and Commercial Bank of China, the largest of the banks, reported loans of 931 billion yuan, but the Bloomberg survey of 2% of its borrowers found totals of about 266 billion yuan. Extrapolating those figures suggests that ICBC could hold debts of over 13 trillion yuan ($2.05 trillion), and ICBC is just one of several banks involved.

China is well known for intellectual property theft -- one consulting group called it the second most common form of fraud in a country -- and without an official governing body or accounting standards, the finance sector has fallen victim to the same kinds of wholesale lies. Activist investors like Andrew Left and Carson Block have taken the place of regulators, and the two men have called bluffs on a number of Chinese companies. Left precipitated a 17.4% drop in China MediaExpress Holdings after calling the company a "phantom" and saying it was "too good to be true." Last year, as my colleague Dan Newman described, Block published a screed against RINO International, asserting that many of its customers were fictional, which led to a total collapse of the stock and its delisting from Nasdaq.

3. Civil unrest
The Chinese government's draconian land-grab policies have become all too real in places like Wukan, in Southern China. Most rural land in China is nominally owned by village collectives, but officials can seize it by paying a (usually undervalued) fee. The townspeople in Wukan responded to the confiscation of a pig farm by destroying police vehicles and government buildings, and the protest turned into a full-on revolt earlier this month as residents set up blockades to keep the police out and armed themselves with homemade weapons. After negotiations last week, the uprising appears to have come to a resolution.

Even if the Wukan uprising turns out to be an isolated incident, it's still evidence of China's growing pains. The Asian power's transformation into a modern economy and its coming-of-age in the information era make for strange bedfellows with the regime's command economy and media and speech controls. This explosive mix can only last so long. At least one Chinese official, Zhu Mingguo, secretary of the southern Guangdong province, believes the Wukan rebellion is a sign of things to come. "In terms of society, the public's awareness of democracy, equality, and rights is constantly strengthening, and their corresponding demands are growing," he said.

Taming the dragon
Investors seem to have already soured on Chinese stocks. One tracking fund, the iShares FTSE China 25 Index Fund (NYS: FXI) has dropped about 20% in a year that has been particularly hard on Asian markets. With the risk of the bubble bursting, I'd avoid any companies that are involved in the Chinese financial mess or supplying resources needed for construction. I'm also particularly wary of companies that benefit from government speech controls, such as the group of Chinese equivalents of American Internet services like Baidu (NAS: BIDU) , China's Google; SINA (NAS: SINA) , which owns China's Twitter; or Renren (NYS: RENN) , China's Facebook. History has shown that regulatory barriers to outside competition are neither good policy nor a sustainable advantage.

Emerging markets continue to provide the most growth for investors, but they come with risks. I still like Starbucks (NAS: SBUX) , Coca-Cola, and Philip Morris in China because they're proven winners that play right into China's newfound love of conspicuous consumption. Even if the bubble pops, a sluggish China should still outgrow a sluggish West. One China bear, Vikram Mansharamani, believes its growth rate will slow to 4% over the next decade, a sharp drop from last decade's 9%-10% but still outpacing the U.S.'s current 1%-2% rate.

China may no longer be the world's hottest growth story, so if you're looking for exposure to a different emerging market, check out this Latin American retailer our experts at the Fool love. In fact, they're calling it their "Top Stock for 2012," and they've published a free report explaining in detail why they think this is such a good buy. The report is yours and it's free. Just click right here.

At the time this article was published Fool contributor Jeremy Bowman does not hold any positions in the companies above. The Motley Fool owns shares of Starbucks, Philip Morris International, and Coca-Cola. Motley Fool newsletter services have recommended buying shares of Philip Morris International, Baidu, Coca-Cola, Starbucks, and SINA. 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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