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Beware the Dragon's Teeth

Rich Duprey
June 25, 2007

Despite its growing economic power and rising importance in world markets, I'm still leery about investing in China. An increasing number of risk factors should encourage Fools to exercise caution when investing, whether in Chinese companies or domestic firms that rely on China for much of their business.

Political obstacles
For one thing, I'm not sure the government has truly established its willingness to let capitalism thrive in a communist country. This isn't political commentary, just an investment reality, though there are many who disagree. Like Russia before it, the semblance of a market economy can quickly collapse when the state steps in to seize the opportunities whose profits it wants to monopolize.

The state can also suddenly change the rules of any given economic game. That's what happened to Chinese Internet firms TOM Online (Nasdaq: TOMO  ) and Sina (Nasdaq: SINA  ) last year, when the Ministry of Information directed China Mobile (NYSE: CHL  ) to change the imposition and collection of various fees. Both stocks tumbled, suddenly denied large swaths of revenue.

Although the government is permitting certain market reforms, it hasn't much loosened its iron grip. Rather than abandon a potentially lucrative market, Google (Nasdaq: GOOG  ) ultimately kowtowed to the government's mandate to limit searches for subjects the state didn't like. The Chinese video game industry is also learning that it might have to limit the amount of fun it provides players, as the government imposes a moratorium on new Internet cafes.

A toxic revelation
The latest China-related scare revolves around quality control issues. Chemicals used in brake fluid and antifreeze were found in toothpaste made in China. The export companies changed the shipping manifests so that the chemical appeared to be a medicinally approved substance instead of the poisonous coolant. The FDA was concerned enough to urge consumers to throw away any tube of toothpaste that says "Made in China." Chinese-made pet food also has been found to contain dangerous chemical. Manufacturers there added the chemical melamine -- used as a binding agent and flame retardant -- to vegetable proteins, which were then used in feed for pets, hogs, chickens, and fish. Melamine is also used as a fertilizer in some countries, but not here in the U.S.

The latest example of Chinese companies short-circuiting the country's alleged quality control mechanisms involves the use of lead paint on toys sold by RC2 (Nasdaq: RCRC  ) , the maker of the popular Thomas the Tank Engine. Apparently without the company's knowledge, its Chinese manufacturer switched the chemical formulation on the paint the Thomas toys use. After a routine check by RC2 discovered the lead paint, the company notified the Consumer Product Safety Commission and announced a voluntary recall of