Is China's economy too hot to handle?

People throughout the world will be cracking open their fortune cookies on 9 February to celebrate the Chinese New Year. But, as the Year of the Rooster begins, this is as good a time as any to question whether China's own fortunes can be sustained.

People throughout the world will be cracking open their fortune cookies on 9 February to celebrate the Chinese New Year. But, as the Year of the Rooster begins, this is as good a time as any to question whether China's own fortunes can be sustained.

Certainly, with its 1.3 billion population and rapid economic growth, China has been a success story in recent years. GDP growth in 2004 is thought to have been 9.5 per cent, and has averaged 8 per cent per annum over the past two decades. Beijing has claimed success in its war on inflation, and this impressive rate of growth looks set to continue in 2005.

Although there is political pressure from the US government for China to revalue its currency, the renminbi, analysts say that this has to be put into context. Kathryn Langridge, the head of international equities at Invesco Perpetual, says that any revaluation is unlikely to be significant and that upward revaluation might be beneficial for China.

In recent years, the Chinese stock market has started to reap the benefits of the strong growth. Over the three years to the end of 2004, the MSCI China Index posted a 23 per cent gain in sterling terms, comfortably oustripping the FTSE All Share index and FTSE World index.

The big concern, however, is that amid such strong growth an asset bubble is developing in China, and that it will eventually burst. If the global macroeconomic picture becomes grim, or if people start considering the market to be overly inflated, foreign investors could turn their backs on China, leading to a collapse. There are also destabilising regional political isues, notably concerning North Korea and Taiwan.

Most investment professionals say there's no need to panic, provided investors are prepared to stomach short-term volatility and be patient in pursuit of longer-term gains. On the whole, they are cautiously optimistic. Martin Lau, the manager of the First State Greater China Growth fund, does not expect a serious setback in the market, and says that an increase in interest rates (the first in nine years was implemented in October) is having the desired effect. "We expect there is a reasonable chance that China will engineer a soft landing. As investment slows, it is likely that consumption will take over as the driver for the economy. We are already seeing retail sales accelerating in China as people feel more confident about spending," Lau says.

Hilary Cook, director of investment strategy at Barclays Stockbrokers, says: "Provided reforms continue, China should be able to keep growing at a rapid pace for another decade. And, although in the short term the risk of a hard landing is increasing, the potential for rapid growth over the medium term outweighs the near-term risks for investing." Langridge says her company has trimmed back exposure to China recently, but does not expect a hard landing.

China, increasingly integrated into the world economy, is also exposed to the sorts of problems other trading countries grapple with, such as the rise in raw materials prices and the weak dollar.

One special concern is the lack of transparency. This was highlighted recently with the China Aviation Oil fiasco. The Singapore-listed company reported previously hidden losses of £290m in oil derivatives, in the biggest scandal in the region since the Barings Bank collapse in 1995. Petty corruption is a perennial problem.

Patrick Lo, the manager of Fidelity's China Focus fund, says China is a highly influential driver of global economies, not only because of its factory status, but also, and quite importantly, because of its position as a global consumer and investor. He says that, as a result of its rapid growth compared with all other main markets, the Chinese market has become increasingly diversified. "As economic growth indeed translates into better earnings growth, we'll continue to see a benefit from the significant increase in available investment opportunities," Lo says.

The growth in China is also having an indirect impact on shares closer to home. Nigel Thomas, the manager of the Framlington UK Select Opportunities fund, is playing the growth of China as a prominent theme in his fund, which holds several UK-based shares that will benefit from exposure to this market. One example is the British engineering firm Rotork, which has won a contract to supply equipment for China's massive west-to-east natural gas pipeline.

Peter Jarvis, the deputy manager of the F&C European fund, is taking a similar view, saying that some continental stocks feature a Chinese dimension, such as French-listed Danone - which has a significant share of the soft-drinks market in China - and the Dutch-listed P&O Nedlloyd, supplying commodities to mainland China.

There are other proxies for the Chinese market that can be easily bought. Oil and commodities feature strongly. At Barclays Stockbrokers, Hilary Cook says one of the best ways to tap into Chinese economic growth is through the mining sector, as China is one of the world's largest consumers of copper and other metals. Rio Tinto is her preferred diversified mining stock. Rob Stewart, co-manager of Newton Managed Fund, suggests that BHP Billiton is benefiting from urbanisation across Asia (specifically China), and he feels that at current levels, this stock is still reasonably priced. He also rates Shell. HSBC - with Standard Chartered - is among the best-of-breed in the banking sector, he says.

"HSBC is continuing to grow in China, where it can take risks that smaller financial companies may not be willing to take," he adds. Standard Chartered, meanwhile, has more than 70 per cent earnings exposure in Asia, including in China. Both have quality management and are benefiting from strong loan growth.

Stewart also mentions Intertek, which makes equipment that tests textiles and electronic goods, and says that Chinese quotas for textiles exports are due to be removed shortly. Ted Scott, manager of the F&C Stewardship funds, says that Clarksons, a shipping broker, is also benefiting from the demand for commodities.

For private investors, it can be difficult to invest directly in shares listed on the Chinese market. Registration and custodial issues mean that there is a lot of red tape and expense.

Some Chinese companies, however, are listed in Hong Kong and Singapore. Because listing requirements are much more stringent in these markets, Chinese shares listed in Hong Kong tend to be of higher quality than companies that are available directly through the Chinese market. Many advisers would suggest, however, that given the higher risk nature of this market, you are better off investing in a diversified portfolio via a fund.

Hilary Cook says that a cheap way to gain diversified access to China is by investing in an exchange traded fund (ETF) of Chinese shares. The FTSE Xinhua China 25 iShare is listed on the London Stock Exchange, and will reflect the performance of China's 25 largest companies, including China Mobile, PetroChina, BOC Hong Kong, CNOOC and China Telecom. Her other main recommendations are the Aberdeen IF China Opportunities fund and Fidelity's Greater China fund.

Tim Cockerill, an independent financial adviser at Rowan & Co, warns that, because of the inevitable high volatility of the Chinese market, investors should hold no more than 5 per cent of a diversified portfolio in this area. Gavin Haynes, an independent financial adviser at Whitechurch, suggests that regular savings are a good way to invest in China, so pound cost averaging smoothes volatility. He recommends the First State Asia Pacific Leaders.

There are only a handful of direct China specialist funds available to British investors. Cockerill's and Haynes's preferred option among such offerings is the Gartmore China Opportunities fund. Another fund with quality management is the JPMF Chinese investment trust. However, because this investment trust is not trading at the usual discount to net asset value, it cannot be considered cheap, Cockerill says.

More than anything, though, investment professionals stress caution, diversification of risk and research for anyone wanting exposure to the exciting, but risky, Chinese growth story.