Where next for China's economy?

China has been the growth story of the 21st century so far, taking the rest of the world by surprise with its ability to combine economic growth with social change. Investment has poured into infrastructure and industry through the stockmarket.

But now the word bubble is increasingly being used, as concern mounts that China's growth is out of control.

Evidence of this is building. Growth in the fourth quarter of 2010 was a racy 9.8%, confounding expectations that the pace would slow and pushing the total for the year to 10.3%. Inflation may have eased slightly, but at 4.6% it is still way ahead of government targets, and most commentators warn it will accelerate again.

So is it time to quit China, or does it still represent one of the most exciting investment opportunities in the world?

For more on China and the other BRIC economies, read our Guide to BRIC.

There is little doubt that China is well on the way to becoming the new superpower; its economy has just overtaken Japan's to become the world's second-largest and it has the US firmly in its sights.

It will surely not be too long before the renminbi joins the dollar as one of the world's reserve currencies. And the potential for dramatic consumer growth as its 1.3 billion population gets richer remains intact.

In the short term, however, there could be turbulence. The stimulus package used by the government to ensure the economy did not suffer from the impact of the Western financial crisis has, if anything, proved too strong. The challenge now is to slow the economy down.

Philip Ehrmann, manager of the Jupiter China fund, is confident the authorities will achieve the slowing required. He thinks talk of a bubble is "completely misplaced".

"Talk of bubbles comes from stockmarkets that are trading at 40 or 50 times earnings and property markets rising by around 40 or 50%. That is not happening in China," he says.

Much of the spike in inflation is down to food prices, which are rising at around double the overall inflation rate. New sources of supply can be brought in relatively quickly, however, and inflation is expected to start falling later this year.

Stuart Parks, head of Asian equities at Invesco Perpetual, agrees: "Loose monetary policy has certainly enabled inflationary pressures to build across Asia," he says.

"What we have seen recently, though, is primarily food price inflation and there's been a quick policy response in China, which demonstrates the government's desire to keep it under control. Given that China's population is migrating to cities and high levels of savings make home purchases generally affordable, there are solid long-term fundamentals underpinning prices."

China is forecasting a moderation in growth to around 8%, compared with 10.3% last year, although China sceptics point out that growth was supposed to moderate last year too but accelerated instead.

Andrew Gillan, manager of Edinburgh Dragon Trust at Aberdeen Asset Managers, says: "Having turned on the stimulus taps in 2008, China is now having to rein in an overheating economy. Real consumer price inflation is probably close to 10% and the government has committed to addressing this problem.

"We expect interest rate hikes, which will likely weigh on the market for the foreseeable future."

Interest rates have already been increased three times, in October and December 2010, and again in February. Ehrmann predicts they may have to rise by another 0.5%. But, with borrowing by companies and consumers at low levels, at least by Western standards, Ehrmann thinks the economy should easily be able to withstand this.

Inflation, interest rates and accelerating growth were already weighing on the Chinese stockmarket last year. The Shanghai index fell around 10% in 2010, while Western indices rose by around 15%. That underperformance is likely to continue until it is clear that the authorities have managed to engineer a gradual slowdown and that inflation is being brought under control.

Some fund managers think that, despite last year's lacklustre performance, Chinese shares still look expensive. First State Investments, among the most experienced of managers in this area, is concerned quantitative easing in the US and Europe is sending asset prices soaring across emerging markets.

First State has warned that policymakers appear to be recreating the conditions of 1999 and 2007, when dramatic growth ended in painful busts, and it fears the outcome this time could be worse.

Seck Yee Hou, senior analyst with the Asia Pacific/global emerging markets team, says: "The lofty earnings expectations built into Chinese stocks, particularly in the consumer sector, mean we are likely to continue to err on the side of caution by focusing on quality companies."

Chinese banks are falling over themselves to lend money for commercial and residential property investments. That is pushing up property prices, and some investors warn that the rises are unsustainable.

The Chinese authorities are working to control this by increasing the capital banks are required to hold against their lending and forcing them to take some loans back onto their balance sheets.

First State is more enthusiastic about the banking sector. "Although headwinds may materialise, we have regained a degree of interest in the Chinese banking sector, as we believe credit quality and capital-raising concerns have been largely priced in, thus reducing downside risks," says Seck Yee.

Ehrmann, by contrast, is shunning the banks in favour of the seven emerging strategic industries to be highlighted in the 12th Five-Year Plan due to be presented later this month.

The plan will aim to increase the efficiency of manufacturing, reduce its environmental impact and improve healthcare. Ehrmann likes technology, healthcare, logistics and transport shares.

Invesco's Parks says: "Stock selection is paramount and there are compelling opportunities for investors in 2011. Retail sales in China are growing at 15% per year, which in this vast market is a clear signal that domestic demand is still in rude health, and will continue to be the most important long-term determinant of growth."

But Gillan warns corporate governance remains an issue for investors. "While top-line growth at many companies has been strong over the years, this has not always been reflected at the bottom line. It is often hard for investors to assess how they - as minority shareholders - will be rewarded, particularly since many industries are heavily regulated. Banking is a prime example."

Advisers say: take the regional route

Tim Cockerill, head of fund research at Ashcourt Rowan, says his "instinct is to be cautious towards China" because of fears about its rampant economy and inflation.

"Additionally, the Chinese authorities have pumped huge sums of money into the economy, just as they have in the West - 13% of GDP," he adds. "The money has been used primarily for infrastructure projects, but there is a limit to how many of these can be built.

"There is also a sense of déjà vu. Japan was considered to be all-conquering in the late 1980s; nothing could stand in the way of it becoming the dominant economy. Then it had a financial crisis."

Long-term investors should, however, have some exposure to China - after all, it is on track to become the world's largest economy. But it would be wise to not rush in until it becomes clear whether the authorities will succeed in dampening economic growth or whether the economy will land with a bump.

It is also prudent to reduce the risk of a severe correction by investing through a regional or global emerging markets fund rather than a China fund.

Cockerill's preference is for the First State range of funds, as First State is one of the longest-serving and best-performing managers in emerging markets. First State Asia Pacific has around 37% of its assets in Greater China, while its Global Emerging Markets fund has more than half its assets in Asia.

Templeton Emerging Markets investment trust has over a fifth of its assets in China and Hong Kong.

Investors wanting a dedicated China fund should consider Neptune China or First State Greater China Growth.

This article was taken from the March 2011 issue of Money Observer.