I am finally just completely amazed by the blind eye shown towards China by the financial community. Speaking to one of my friends a few months back showed me just how naive smart investors are to China's actual political/business situation.

During our discussion (with someone I consider very intelligent), he was comparing U.S. historical industrial growth to the industrialization ongoing in China. My friend was arguing China's "problems" were that of a developing industrial nation, like many western nations before them.

I responded, "Yes, but China is a communist controlled society where the government directly controls economic policy, enterprise, trade, media, religion, and places restrictions on basic freedoms. China is not a democratic system with a blossoming free-market economy, but a communist system which employs certain aspects of capitalism in their economic policies".

Then he said "it".  "It" through me for a loop, and I realized he just didn't fully understand the situation.

"China is Communist only in name!"

My head sunk! Before you read any further, you must understand and admit China's ruling party, The Peoples Republic of China (PRC), is a communist government, not only in theory, but in practice as well.

In his statement, he was implying that first, the Communist party runs the country, but lets a free-markets based system operate, creating the unprecedented growth we have seen over the last 30 years.

Second, he was arguing the government has grown with the economy of the country, and is becoming increasingly more westernized.  As China increases their wealth production there will be a trickle down effect throughout society on an economic level.

Increased wealth will eventually turn China's government into a quasi-democratic capitalist type nation.

This is, of course, is the best-case scenario for China.

Nevertheless, since our conversation, China's markets have been pummeled. The Shanghai Composite Index fell 1525 points, or 25%, from the October high of 6,124 to 4,599. The Hang Seng Index has fallen 26%, or 8,489, to 23,469 from the October high of 31,958.

Yes, a global economic slowdown has influenced the Chinese markets, but is there more to the story? Are there other reasons to believe that over the long run, China may not be the best place to invest? I believe so, and I will do my best to explain why!

The biggest problem China faces economically resonates with the ruling Communist party.

My friend, like so many, is missing the essence of what the Communist party is based on: control.

As the PRC has created wealth within the party, their grip over China has tightened. Party members, now more then ever, crave the retention of power.

The party has absolute control over the economy and private enterprise. As companies become successful, the party exercises property rights and begins to influence the company by appointing party members to key positions. Every major corporation in China has party members influencing operational decisions.

The situation seems very similar to having a mob member on the board of your company during the 1930's, except this mob is the political party running the country. Maybe the PRC changes, maybe not: think of the Soviet Union's rise and demise.

In a well written book "The Writing on the Wall" by Will Hutton, he explains the west's misconception of China:

"To characterize China as an unstoppable force whose economic model is unbeatable and set to swamp us - the stuff of almost every ministerial and business lobby speech - is to make a first-order mistake... The alpha and omega of China's political economy is that the Communist party remains firmly in the driving seat, not just of government, but of the economy - a control that goes into the very marrow of how ownership rights are conceived and business strategies devised. The western conception of the free exercise of property rights and business autonomy that goes with it, essential to any notion of capitalism, does not exist in China."

Restrictions on media and other public controls limit the free flow of ideas, curtailing innovation. The lack of innovation dictates China rely too heavily on manufacturing exports. Further, China is unable to create innovative products in order to compete on the world stage.

"China spends more than Japan on research and development, but its record of innovation is underwhelming", explains Jim Jubak at MSN Money.

The lack of innovation has created a shortage in Chinese produced patents. China, more often than not, uses foreign patents to manufacture goods. The lack of innovation will limit China's ability to develop past a manufacturing based economy.

These types of shortcomings are always ignored by the west.

Hutton argues, "The west is unforgivably ignorant about China's shortcomings and weaknesses, which leads it vastly to exaggerate the extent of the Chinese "threat". China is certainly emerging as a leading exporter, but essentially it is a sub-contractor to the west."

China's booming economy and stock market of endless opportunities became wildly popular with investors and business media. Sky rocketing IPO's, stock prices, and huge composite gains are inviting to say the least.

Investing in China has become so common, an impression is being created that there is a certain level of security when investing there.

By security, I mean investing in China comes with a certain level of political stability and economic reliability. The investor is lead to believe the possibility of a political or economic collapse is out of the question.

The stability is overestimated, and the chance of an economic collapse caused by political volatility is a real possibility. A severe economic downturn stemming from some form of political turmoil is more likely. Nevertheless, this type of instability should be a concern for investors.

China's supporters argue China's success will thrive on significant GDP growth and 1.3 billion people in the population.

Growth has been explosive in China over the past 25-30 years with 10.6% GDP growth in 2006. Real GDP growth has accelerated to an average annual rate of about 10% between 2002 and 2005. Like I said, their GDP growth is impressive, but does not tell the whole story.

In reference to the population, supporters argue, "China has 1.3 billion people creating a huge consumer base and worker surplus propelling China's economy for years to come."

This might be the case, but it might not. I am sorry, but having the largest population in the world is not an argument for economic success.

China also contains 20% of the world's poor, and a large, poor population could easily present economic concerns.

As far as a huge consumer base, most are too poor to afford domestic goods, and the sale of pirated goods severely hampers already poor domestic consumption.

Of China's billion plus population, estimates range from 150 million to 300 million people live on less then a dollar a day. The population is one of the oldest in the world, and the impact of pollution is creating a sick, old population with rising mortality rates and healthcare costs. This type of population does not spur economic growth.

The problem for China as a thriving nation is they lack the checks and balances over government action in order to mature as previous industrialized nations have before them.

Without the checks and balances, there is no one to force the PRC to deal with major problems such as pollution, corruption, and violations of human rights.

Government: (PRC) Peoples Republic of China

The PRC assumed control in 1949, and in roughly 1978, the party opened up the economy to a quasi-free-market based system. Nevertheless, the party retained absolute control over all political, social, and economic issues.

In order to hide the ill wills of the PRC and control the flow of information, the PRC has enacted several laws aimed at the media, religion, and opposition. Those deemed a threat to public order are punished, jailed, or executed.

Protests and government criticism are considered disturbing the peace. Disturbing the peace laws are used to jail political opponents and journalist at record numbers.

According to The Committee to Protect Journalists, the PRC "issues daily instructions on what may and may not be reported; journalists who digress will be suspended from working or even imprisoned. For the seventh consecutive year, China was the world's leading jailer of journalists, with 32 imprisoned... more than three-quarters of the cases were brought under vague "anti-state" laws."

The People's Daily reports, "During 2004, censorship agencies permanently shut down 338 publications for printing 'internal' information, closed 202 branch offices of newspapers, and punished 73 organizations for illegally 'engaging in news activities'."

Every year, 1000's are allegedly jailed or executed by the PRC. Amnesty International statistics show in 2005, 3400 people were executed, and most considered 3400 a low number. National Peoples Congress argues the number executed is more like 10,000 a year.

Analysts outside China will concede: you cannot rely on anything the PRC reports as truth. Analysts working for the state do not release information not approved by the party, therefore factual numbers are hard to come by on everything from economic to social data.

Government controls over information should be of great concern to investors!

My theme here is that communism is a natural enemy of a free-market system. The political interference with the economic system will eventually make or break the political/economic system.

If we look, we can see the proof throughout history. Can you think of one Communist party that has succeeded either politically or economically over the past 100 years? There is a reason you cannot, and do not tell me Cuba is a Communist success

The bottom line: industrial growth of a democratic-capitalist system cannot be compared to an economic system cloaked in communism. Capitalism is the guiding force behind all the world's economic success, and thrives on freedom of choice and the free flow of ideas; communism is built on control, ideals that contradict one another.

John Micheline

In part 2, I will discuss China's Economy, Corruption, and Pollution. Watch for it!