Finally time to cash in on the China syndrome?

Investing in the East is risky, but China's flexible currency is a good place to start, says James Daley

China's decision to revalue its currency this month gave economists a rare moment of excitement. However, it is stock-market investors in Asia, from Hong Kong to Thailand, who should benefit over the longer term.

The move means that the Chinese yuan's long-standing tie to the US dollar - for the past 11 years $1 has been worth exactly 8.28 Chinese yuan - will be axed. As its economy has grown over the last few years, China has come under increasing pressure to move towards a flexible exchange rate, with its competitors arguing that its tie to the dollar was giving it an unfair advantage. Although many believed China's currency was undervalued, its fixed rate ensured that its exports remained cheap to the outside world.

When China capitulated last Thursday, Malaysia - one of the other Asian countries to have its currency pegged to the dollar - followed suit, with both now linking their exchange rates to a basket of global currencies. This represents significant progress in the region's development, and a willingness to meet the rest of the world on a level playing field.

Although on the day of the announcement the yuan appreciated by a relatively insignificant 2 per cent and has not moved since, analysts think the currency could rise 5 per cent by the end of the year - and continue to appreciate steadily thereafter.

Although the effect on equities is expected by most fund managers in the region to be broadly positive, the relation between currency and the stock market's performance is not straightforward. Philip Ehrmann, the head of Pacific and Emerging Markets at Gartmore, says the short-term effects will be twofold. "One result is to make imports cheaper," he explains. "This would be of benefit to Chinese consumers, as it would increase their purchasing power."

Ehrmann also points out that some imports, such as those priced in dollars and used to make finished goods, would offset increasing export prices that might otherwise hit Chinese companies. An example of this is the memory chips used in modern technology. "In addition, firms with dollar-denominated debt, such as airlines, could also be expected to benefit from revaluation," he adds.

Growth in the Chinese stock market is certainly overdue. In spite of rapid economic growth over the past decade, China's stock market has not outperformed. Much of this has been down to a difference in mentality from the Western world, with many businesses not comfortable with the pursuit of profit.

This mentality is changing, however, and in the meantime, the potential inflows of money into the region may be enough to continue driving markets upwards. The main attraction of the Asian markets, and of China in particular, is that many industries that are now well developed in the West are just taking off there. Alistair Thompson, the deputy head of Asian and Pacific equities at First State Investments, says, for example, that he is looking to take advantage of the increase in consumer spending. "Longer term, the outlook for the Asian region is really very good," Thompson says. "A lot of the risks that you have in the West - such as property bubbles and credit bubbles - you don't really have in China."

He cautions, however, that although the long-term prospects for the region are excellent, there are several reasons to be wary in the short term.

"We're typically rather cautious and conservative investors," he says. "In the short term, what worries us is that the global appetite for risk is very high at the moment - and so when that cuts back, the more volatile markets such as China are likely to fall."

Simon Somerville, the head of Japan and Asia at Jupiter Asset Management, adds that another short-term concern is the sharp rise in oil prices. With Asian countries tending to import much more oil than they export, they are badly affected by the recent price hikes. "High oil prices impact consumption much more than they do in the Western world," he says.

Such uncertainties continue to make China, and Asia as a whole, a relatively risky area in which to put your money. However, if you have a high appetite for risk, the returns from the region certainly have the potential to be spectacular.

Few funds invest purely in China, though they have been increasing in number over the past few years. Gartmore, JP Morgan Fleming, First State and Invesco Perpetual are a handful of the larger fund managers that offer China investment funds.

In spite of the relatively unexciting equity market performance as a whole, Gartmore's China Opportunities fund has more than doubled investors' money over the past three years.

For those who prefer to spread their risk, there are many more funds that invest in stocks across the Far East - some of which have also produced returns almost as good as Gartmore's China fund.

To compare performance of funds in the sector, visit www.trustnet.com or www.morningstar.co.uk.

A bull in a China shop

* Ernest Liu, a fund manager at JP Morgan Fleming Chinese Investment Trust, says the Chinese revaluation will encourage investment to flow into Hong Kong and China, so the currency's 2 per cent rise is the first step towards further gradual appreciation. China's and Hong Kong's equity markets should do well, he says.

* A gradual appreciation would help to rebalance China's growth, helping it shift from an economy that relies on exports to one focused more on internal demand, as it would increase the buying power of the Chinese population.

* Moderate appreciation should help address China's potential inflation problems by lowering the cost of imports to China priced in US dollars.

* The appreciation reduces the need for a rise in domestic interest rates to curb inflation .

* The revaluation is positive for companies with significant assets and revenue in the Chinese currency. The decision to let the currency rise could lower the threat of future trade frictions.

A bear in a China shop

* Paul Niven, head of strategy at Foreign & Colonial, says the yuan revaluation is marginally positive for the global economy. It is also an important but small first step in the adjustment required to cure global imbalances. But there are minority views on why the yuan revaluation could prove negative, he warns.

* The bear scenario points to a widespread expectation that China will engineer further revaluations.

* If the market continues to speculate that currency revaluation is imminent, further intervention will be required by Asian central banks, if they don't want to lose competitiveness. This would result in more buying of US Treasuries (government bonds) - which could reignite US and global growth.

* If the market does not speculate on further yuan revaluation, and Asian central banks undertake less intervention, this would have a bearish impact on US Treasuries. Yields would rise, stifling domestic growth and impacting negatively on the global economy.

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