China's shares are finally catching up the economy

The stock market has lagged behind in China - but not for long, says Jenne Mannion

However, until recently Chinese shares have struggled. At the end of 2005, the local Chinese stock markets in Shanghai and Shenzhen (which list A shares and the smaller cap B shares) were trading at seven-year lows amid fears that the economy was overheating and valuations were over-inflated. Foreign investors have also been discouraged by government restrictions on ownership of shares.

The red-chip market of Chinese stocks listed in Hong Kong, has also suffered. Flavia Cheong, a senior fund manager at Aberdeen Asset Management, says that, following strong performance from the MSCI China Index in 2003, this market subsequently declined due to fears that strong domestic growth was not sustainable.

But the tide is turning. The government's assurances that it "will not pursue economic growth at any cost", are important. Shares now look more attractively valued and important reforms are underway.

Since the start of 2006, these local stock market indices in China have posted returns of around 25 per cent, while Chinese shares listed in Hong Kong have also rallied.

Philip Ehrmann ,of Gartmore Investment Managers, says he doesn't believe the Chinese economy will be a boom and bust scenario - it is significant that Hu has said so publicly that he is keen to keep the country's economy in check.

China has already overtaken Britain and France to become the world's fourth largest economy. As a result, it now accounts for 6 per cent of the world's GDP and is expected to overtake that of America in by 2045.

This competitive edge has been possible because Beijing has kept its currency artificially low. Although the authorities in Beijing cut the renminbi's peg to the US dollar last summer, the currency has only appreciated by 1.1 per cent since. Economists say that the renminbi is still 20 to 40 per cent undervalued.

This means that Chinese labour costs can be far more competitive than those in other industrialised nations. Earlier this month, George Bush urged the Chinese to "make a statement" on the currency, amid concerns about the American trade deficit with China, which hit a record high of $201.6bn (£115bn) last year.

The demographics in China are also highly favourable. With around 40 per cent of the population in the high-spending 20 to 44 age group, the rising number of affluent middle-class households is driving up disposable incomes.

But, as Cheong points out, the major concerns over investing in China are not so much about the economy. Rather, the issue is the availability of quality stocks. "There is plenty of scope for disappointment at the corporate level," she says. "There is intense competition and many of the businesses are not necessarily run for shareholders and are still very much part of the old state corporations."

Now, however, changes are afoot that may encourage fund managers to look at the local market. Ehrmann says that after years of decline from over-inflated levels, shares in these markets now represent more attractive valuations relative to their earnings.

Significant reforms are underway. For instance, in the coal sector inefficient companies are being closed, there is consolidation in the aluminum sector and energy companies are moving towards free market pricing. In addition, the ownership of financial companies, previously dominated by provincial governments, is starting to move into private hands.

A further pending development is that, previously, foreign investors were discouraged from investing in locally listed shares because they could be subject to 15 per cent capital gains tax on profits. Ehrmann says: "The government has committed to resolving the issue and we expect that this restriction could be removed in the coming months."

That said, he doesn't anticipate a broad-scale switch from red chip shares into domestic stock. He says that, from the hundreds available on this market, only about 30 display the investment qualities Gartmore seeks, and he would only buy five or six of these at today's prices.

Gavin Haynes, a portfolio manager at Whitechurch Securities in Bristol, says that overall the picture for China is rosy. But he warns investors to be prepared for volatility. "For all but the most adventurous, I would recommend that no more than 5 per cent of a well-balanced portfolio is invested in China funds," he says.

Ben Yearsley, of independent financial advisers Hargreaves Lansdown, also believes that China is a highly volatile market, but likes the long-term growth potential. A good way to smooth out volatility is through regular savings rather than making a lump sum, he says.

Haynes's preferred choices among dedicated Chinese funds include Gartmore China Opportunities and First State Greater China Growth. Yearsley prefers the latter.

Chinese exposure in the mix

* Ben Yearsley of Hargreaves Lansdown says that a more cautious approach to China could be to invest in a broader Far East fund, which will contain some exposure to the country as well as other Asian stocks.

* Both Yearsley and Gavin Haynes of Whitechurch Securities like First State Asia Pacific Leaders. Managed by Angus Tulloch, this fund will provide greater diversification, although China (including Taiwan and Hong Kong) accounts for 35 per cent of the portfolio.

* Aberdeen Far East Emerging Economies, which is managed by Hugh Young and dedicates 28.6 per cent of its portfolio to greater China, is also a good way to access this market, says Yearsley.

* You can also invest in Chinese shares via the UK. Patrick Evershed, manager of the New Star UK Select Opportunities fund, is a fan of China. Sme of his Chinese investments, such as Griffin Mining, are listed on London's Alternative Investment Market (AIM) market.

* Alternatively, Evershed's fund has the option of investing up to 20 per cent of assets in overseas shares, and currently holds 10 per cent of his portfolio in Chinese stocks. In 2003 and 2004, this reached as high as 15 per cent.

* Among Chinese red chip shares, Evershed holds Guangdong Investments, which is a Chinese utility with a very large exposure to water and a smaller exposure to toll roads.

* Evershed says that, with the Chinese market on the rise, there has been a massive demand for some new issues. For instance, excess demand for Nine Dragons Paper, another red chip, was thirtyfold.