Should investors be wary of China?

TIANJIN, China -- Jingjin City is about 120 miles from Beijing, but few people live in the sprawling development. No train or subway goes there. Jingjin City has no hospital. No kindergarten. No supermarket. Grass grows man-high outside the unoccupied villas.

And the developer is still asking too much for the houses. "I think only a rich boss will buy a villa here for his mistress, and even a mistress won't live here because there is no entertainment," says Tian Yongsheng, 47, a private taxi driver.

Ghost developments have grown more in China, making China-watchers uneasy. While all eyes are on Europe's debt woes, economic news out of China is starting to become alarming, too. China's gross domestic product grew at a 7.6% annual pace in the second quarter of 2012, the slowest rate since the first quarter of 2009 and down from a high of more than 14% in 2007.

China cut interest rates twice in June in an effort to boost its slowing economy. But cracks are showing in China's housing market and its banking system. Is China starting to go down the same path as Europe and the U.S.?

Probably not. Even if China's economic growth were to slow from its current pace, the country's economy would still be steaming along much faster than the U.S. and Europe. But in a country as big as China — and with what critics say are such opaque economic statistics — the truth is hard to discover, and investors should be particularly wary.

The Chinese government had been tapping the economic brakes since 2008. In 2007, China's GDP grew at a feverish 14.2%, according to the World Bank. Alarmed by the risk of inflation, which hit 5.9% in 2008, the government slowed down on infrastructure projects and began to slow bank lending.

China's effort to reduce inflation without causing a recession was largely successful. Chinese inflation was just 2.2% in June. But just as the Chinese pulled in the reins, the U.S. budget-ceiling standoff and the European crisis added extra, and unexpected, slowing pressure on its economy. Chinese net exports — exports minus imports — fell from about $300 billion in 2008 to about $150 billion in 2011.

Making matters worse: a possible housing bust. China is a massive country, and all real estate markets are local, so it's hard to get a clear picture of the Chinese housing market. Furthermore, there's widespread distrust of some official Chinese numbers. "It's hard to know what to believe at times," says Michelle Gibley, director of International Market Analysis at Schwab Center for Financial Research on European and Chinese economies.

Soaring home prices

At Moon River Castle Apartments in east Beijing, fewer than 30% of the parking spaces were filled in one building, and only a few apartments appeared occupied. There were no stores on the first floor — only a small supermarket.

But Moon River management says the vacancy rate is low and sales are brisk. "We wish our clients living here have a life like the song Moon River— elegant, high-end, like the American middle class," says Zhou Yun, 31, a manager at the complex's marketing department.

Still, some Chinese are complaining about soaring house prices. At Moon River, apartments cost 3,300 yuan a square foot — equivalent to about $520. "I think the house prices in our county are crazy in recent years," says Ma Fengzhi, 41, who teaches politics in a Shenqiu high school in central Henan province and makes about 1,000 yuan a month, or about $160. She calls that "midlevel."

Nevertheless, many Chinese still want to buy a home. "A lot of people earn less than me, I'm a middle level, but most of us want to buy our own house," Ma says. "Why? Because we think it's a good way to store value. Vegetable and meat prices are rising. The bank cut interest rates. Where should we put our money? Buying a house is the best choice right now."

And even if real estate goes bust in some areas, it may not have the same effect on the Chinese financial system as the housing meltdown did in the U.S. For one thing, there's a vast reservoir of potential buyers. "If you urbanize 1% of the population each year, that's 13 million people," says Henry Zhang, co-manager of the Matthews China fund.

Another reason real estate is different in China: There are no packages of junk mortgages being sold by investment banks. You generally need a 30% down payment on a first home, and a 60% down payment on a second home. Third homes are prohibited. "The other thing to keep in mind is that in China, (there's) no such thing as a non-recourse loan," Zhang says. "Borrowers can't walk away easily. Even during the downturn, you don't see many people default on property."

Rapidly aging population

Other worries for the Chinese economy:

•The labor market. Chinese wages have risen rapidly in the past decade. One reason for higher wages is that as the economy grows, its population is rapidly aging, due to China's one-child policy. "With the population aging and the labor pool limited, we'll see wages continue to grow," says Zhang.

On the one hand, rising wages are a good thing: China wants to transform itself from a manufacturing economy to a consumer economy, and to do that it needs more affluent consumers. The downside is that higher wages make Chinese products more expensive and harder to sell abroad. Already, some Chinese manufacturers are moving plants from the coast, where wages are higher, to China's less-wealthy interior.

•Food prices. The drought in the U.S. will eventually push up grain prices in China, and that could be a big problem, says Mark Mobius, executive chairman of the Templeton Emerging Markets Group. In rural areas of China, food is 30% to 40% of a family's budget. "If China had rapid inflation in food prices, they would have problems," Mobius says.

•Europe. The problems with the euro and European debt could have a big effect on the Chinese economy, says Schwab's Gibley. "Given the slowdown here and in Europe, it's tough to see a big rebound in exports any time soon," she says.

Still a high growth rate

Despite all the worries, few think that China will fall into a recession any time soon. "Even if GDP growth fell to 5%, that's still a very high growth rate," says Mobius.

And China has tools at its disposal that simply aren't available to policymakers in the U.S. and Europe. For example, the Federal Reserve can encourage bankers to lend but can't force them. The Chinese government, however, can use far stronger encouragement than U.S. or European authorities, in part because the government has big stakes in Chinese banks.

China can also reinvigorate its infrastructure projects, which will pump money into the economy and keep employment high. "The command economy can really do a lot to alleviate potential crises," Mobius says.

The biggest danger in China may well be for investors. Although Mobius thinks Chinese stocks are relatively cheap compared with earnings, others are more cautious. Wall Street expects China's GDP to rebound in the third quarter, but Gibley isn't that sure. If China's GDP numbers don't match Wall Street's optimism, stocks could sell off.

For Zhang, the biggest opportunities are in the service sector. "Income is still growing at double-digit rates," he says. "Consumers are more affluent and need more services."

So is the Chinese economy in danger? Probably not now, although it may not be as robust as Wall Street thinks it is. "A lot of the worries is psychological projection — if we're in trouble, they must be in trouble," Mobius says. "But there are tremendous growth opportunities in China. It's the place to be."