Editor's note: TheStreet.com's Ronna Abramson takes a look at the risks and rewards of investing in the booming economy of China. She also looks at IBM's venture capital plans and how Microsoft aims to gain a toehold there.

Just say the word "China," and investors and companies seem to start frothing at the mouth these days.

But be careful, because investing in China is not for the faint of heart. While the opportunities in a developing nation of 1.3 billion are undoubtedly mammoth, don't forget this is a Communist country, and consequently it presents some unique risks, seasoned experts caution.

"Investors beware," said Lip-Bu Tan, founder of the venture capital fund Walden International, which has been investing in China since 1994. "I think there is some hype here. People get too overexcited by China."

Start with Baidu.com ( BIDU), a company with operating cash flow of $4.5 million that was quickly crowned the Google ( GOOG) of China. As if living up to its name, Baidu's stock soared to a dizzying $122.54 on the first day of trading -- $95.54 above the price it was sold at by underwriters.

"Clearly there's a lot of hedge funds and retail buyers that get excited about China and a search engine like Google, but this is a very small company," Tan said. Apparently, investors started coming back to their senses, because the stock has recently declined to the $82 range.

Similarly, Tan argued that Yahoo!'s ( YHOO) subsequent $1 billion investment for a 40% stake in Chinese e-commerce company Alibaba was way too high. But that deal may only feed the Chinese frenzy.

As Piper Jaffray senior analyst Safa Rashtchy noted earlier this month: "A major deal like Yahoo!-Alibaba is an endorsement of what otherwise might seem to be risky or unproven areas, and thus, investors are likely to feel more comfortable investing in the Chinese Internet sector."

Economies of Scale

Tan acknowledged the growth potential for Internet companies in China, noting some projections that the Chinese Internet population will surpass that of the U.S. within eight years. But he warns that the risk of government intervention is "very high."

Take Sina ( SINA), for example. Earlier this year, the Chinese State Administration of Radio, Film and Television banned commercials for mobile fortune-telling services on radio and TV stations, causing the company's SMS (short message service) revenue to plummet 30% sequentially. Sina's stock slipped 10% when the company announced the sales decline.

"You really have to work with the government, and they can change the policy very rapidly," Tan said.

Indeed, government crackdowns could certainly go beyond merely filtering content, if history is any precedent, warned Ohio State University Business Professor Oded Shenkar, author of the book of The Chinese Century: The Rising Chinese Economy and Its Impact on the Global Economy, the Balance of Power, and Your Job .

Shenkar said that after the Tiananmen Square protests in 1989, during which students used faxes to marshal support, the Chinese government ordered that all fax machines be placed in public security offices. "What nobody has been talking about is the importance of the Internet as an organizing mechanism," he said.

"Can the government control email?" Shenkar asked. "They're definitely trying." By law, Internet cafes must install special government software that not only filters content but also identifies information flows, he said.

Sound Models

Ninetowns Digital World Trade Holdings ( NINE), which makes software that automates import and export processing in China, is another Chinese tech company that exemplifies the risk of government intervention. The Chinese government's Inspections Administration recently pulled the rug out from under Ninetowns with an unexpected policy change.

The government invited Ninetowns to submit a proposal for development of software similar to its own products as part of an open bid process. The catch, Ninetowns said in its second-quarter results, is that the company "believes the PRC Inspections Administration may distribute the software products ... free of charge to end users."

And there went Ninetowns' business model. Its stock, not surprisingly, quickly sank as much as 33% in intraday trading. In an almost ridiculously understated note, Jefferies analyst Joe Vafi downgraded the company to hold from buy and slashed his 2006 estimates by more than half.

"The company now expects to transition into a services-focused company. However, it's "unclear to us at the moment what services Ninetowns will provide, how quickly the company can develop such services and what level of demand there will be," Vafi wrote in his research note. "Such uncertainty surrounding the company's future, in our view, injects significant risk into the business."

Jefferies was co-manager of Ninetowns' IPO last year. Shares of Ninetowns are now trading at about $5 -- less than half its $11 IPO price.

As a value investor, Ray Mills, manager of the T. Rowe Price International Growth and Income Fund, has largely stayed away from Chinese tech companies like Ninetowns. But he's also very selective about Chinese companies in general.

"I think the fundamental risk, and this could take a long time to play out, is you have a centralized government," he said. "It's not democratically elected. I have a big question as to whether that's compatible over the long term with a market economy."

Mills prefers instead to invest indirectly in China by choosing companies based outside the country that are still poised to benefit from its booming economy. For instance, he has owned some mining companies in Australia such as BHP Billiton ( BHP), energy companies given that China is a source of oil demand, and machinery companies that would contribute to the build-out of the country.

Such investments may not make you froth at the mouth, but they're also less likely to make you lose your stomach.
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