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As China Stocks Beckon, Beware Of Risks

China's economic growth remains the envy of the world, despite the first quarter's slight slowdown to 7.7%. Yet the Shanghai composite has fallen 4% in 2013 as the S&P 500 and Japan's Nikkei rallied strongly.

A big reason is that China's policymakers have sought to rein in home prices and credit, unlike the easy-money Federal Reserve and Bank of Japan.

So is China worth stock investors' attention? The answer is yes, but with caveats.

Some U.S.- and Hong Kong-listed Chinese stocks still offer opportunities. The Internet software, gaming and other online sectors are performing well.

Chinese Internet users jumped 10% in 2012 to 564 million. Three-quarters surf the Web on mobile phones, the official China Internet Network Information Center says.

Some hot ADR stocks include website/software firm Qihoo 360 Technology (QIHU), job seeker site 51job (JOBS), online real estate listings firm SouFun (SFUN), patient monitor maker Mindray Medical (MR) and plasma-based pharmaceutical producer China Biologic Products (CBPO).

But political leaders have their work cut out for them. China made its once-a-decade power handover in November. The government, headed by President Xi Jinping, is focusing on ways to stem job losses while guiding China to a consumer, rather than export-based, economy.

"There's a bit of relief that a leadership transition has occurred and that a major crisis and slowdown in the economy has been averted," said Gary Kleiman, an emerging-markets expert who runs Kleiman International in Washington, D.C. But he added, "Investors are waiting for a decisive shift and signs that China will tackle its financial issues once and for all.

Here are four Chinese challenges that investors must recognize: Labor pressure. As labor costs rise, incidents such as 2012's worker unrest at Apple (AAPL) contractor Foxconn sow doubts about manufacturing stability.

And talent shortages crimp Chinese corporate expansion.

Such heat is fanned by an aging society where the government's one-child rule is taking a toll on a shrinking labor force. By mid-century, Chinese planners say more than a quarter of the population will be over 65.

Beijing's new leaders have hinted they may ease birth controls in place since 1978. But even if fertility rose, it would take decades to affect the working-age population.

Kleiman notes fewer workers also mean fewer people to pay into a social welfare system increasingly burdened by retirees.

Stanley Chao, a Chinese-American consultant who helps Western firms do business in China, says there are few children to take care of aging parents in a society where kids traditionally divided such duties and costs.

"These parents will only have one adult child to handle their financial needs," said Chao, the author of "Selling to China.

With China moving to a high-tech and consumer-based economy, legions of screwdriver-assembly workers won't be crucial, contends Chao. But in the in terim, he says the 15 million workers who annually flock from the countryside to the cities will be enough to meet future labor needs — screwdriver or not.

Reporting standards. A tussle with Washington might be eroding investor confidence in U.S.-listed Chinese stocks.

As Chinese corporations expand overseas and list on U.S. exchanges, a flap has erupted over differences in Chinese and U.S. data. The past three years, U.S. regulators have delisted over 120 U.S.-listed Chinese firms for accounting and other irregularities.

Reputable American depositary receipt firms like Baidu (BIDU), weren't tarred by the scandal, but the issue undermined the credibility of other Chinese stocks.

The Securities and Exchange Commission is demanding that accounting firms hand over audit data on Chinese firms that trade in the U.S. But their Chinese counterparts have threatened to jail local employees who comply.

Both nations are groping for an agreement that lets U.S. regulators inspect the books of Chinese companies in China. China is hesitant to lift the lid on domestic bookkeeping practices, saying such intrusions violate its sovereignty.

It isn't clear how far Beijing will go to put its accounting on a par with international standards.

"I don't see the U.S. and China resolving accounting differences for another five to seven years," said Chao. "It's part of a culture of corruption that exists in China. Getting delisted isn't good enough. Somebody's going to have to go to jail in China before we see changes.

Performance gap. The disparity between Hong Kong and Shanghai stocks rankles investors.

Shanghai stocks tend to be cheaper than those in Hong Kong. This is partly because the Hong Kong exchange, with its Hong Kong dollar-denominated stocks, is open to foreign investors, while Shanghai is a tightly controlled yuan market where stock market investing is dominated by mainland Chinese funds and local investors who can't invest outside China.

Foreign investors can buy only Shanghai-listed stocks via mutual funds run by approved foreign investment houses.

Chinese regulators hint they will open Shanghai to listings by Western companies and widen access to foreign investors. Meanwhile, IPO activity in Hong Kong and Shanghai has been lackluster.

Kleiman says the problem is deep. Rather than use the ex-British colony with its advanced financial infrastructure as a model for stock and capital market reform throughout China, Chinese regulators are making Hong Kong's capital controls and practices more closely resemble the mainland's.

"China is the biggest market in the world with restricted access," Kleiman said.

Banking time bomb. This problem lurks in a pile of local government debt that might trigger a wave of defaults.

Kleiman notes that borrowing by provincial and municipal governments to fund infrastructure and housing may be much larger than the Chinese government or observers outside China thought.

That involves lots of informal borrowing, including bond issues, that may not show on the books.

Bank lending and government-led investment has supported much of China's recent recovery. A chain of defaults could hit China's banks and overall economy. "The biggest problem with China is the shadow banking issue," said Kleiman. "No one knows the scope of it.

• For more on global investing opportunities, please see IBD's Global Investing special report at investors.com.