China: Is the Reward Worth the Risk?

Some market pros remain optimistic about Chinese stocks, despite interest rate-hike jitters and periodic bouts of volatility.

Any lingering doubts about China's global clout were laid to rest when fears that the government would have to raise interest rates caused a brief panic on Apr. 19 in Asian and European markets. News that China's economy had grown at an annualized rate of 11.1% surpassed expectations, and investors feared China would have to hike rates to stave off inflation and rein in overheated growth. But analysts remain sanguine despite the Middle Kingdom's periodic bouts of volatility, good news for investors in Europe and the U.S.

Though it's far more volatile than markets in the U.S. and Europe, the Chinese stock market has also displayed impressive resilience. After the Shanghai composite index plunged more than 9% on Feb. 27, it quickly rebounded to new highs. Likewise, on Apr. 19, when the market benchmark saw a large slump on interest-rate worries, it recovered most of the losses by the next day.

Some equity players in China and elsewhere appear to be rethinking their initial rate-hike worries. Peter Cardillo, chief market economist at investment firm Avalon Partners, says that even if China does raise rates, "I'm not sure how hard they're going to hit those brakes." Cardillo figures policymakers would be cautious because tightening would hit development in the country's rural interior, which has seen fewer benefits from China's rise than glittering cities such as Shanghai and Beijing. The prospect of rate hikes, he believes, was mainly a catalyst for high-priced stocks to pull back a bit.

Exporting Deflation

China will raise rates if central bankers become concerned about inflation, says Shigeki Makino, managing director at Putnam Investments' global core equities unit. But that may not be as much of a threat as investors think. Sure, overheating remains a concern in rapidly expanding countries like Brazil, Russia, India, and China—a quartet sometimes called "BRIC"—but Makino says China has a built-in venting system.

How so? Makino says that as the country begins to depend on more sophisticated businesses instead of the mass manufacturing of inexpensive goods, it is able to export deflation to smaller up-and-coming economies like Vietnam and Bangladesh that are inheriting China's manufacturing base.

Markets appear to have some confidence in Beijing's ability to keep things on an even keel despite the occasional dustup. Year to date, the Chinese benchmark is up about a third. This is even more remarkable considering that last year it more than doubled, ending the year at an all-time high.

Hike Fears Factored In

Apprehension that China would raise rates had a greater effect on markets in Europe than in the U.S. But after declines Apr. 19, continental indexes seemed to shake off their concern, paring losses before gains on Apr. 20. Their stateside counterparts likewise appeared to brush off the news: The Dow Jones industrial average approached 13,000 for the first time on Apr. 20.

Todd Salamone, senior vice-president at Schaeffer's Research, says the prospect of China raising interest rates is "one more worry built in" to market conditions. But taken as a whole, he sees that fear actually being a positive for investors, especially with strong performances from U.S. markets. "From a contrarian perspective, it's bullish when prices contradict worries," he says. "You'd rather have a market that has low expectations because it makes it easier to surprise on the upside."

This is good news for U.S. investors looking to latch onto the China story, and they have several options. Among several China-oriented exchange-traded funds, iShares offers one that tracks the FTSE/Xinhua China 25 index (FXI), a basket heavily weighted to large companies especially in the financial and utilities sectors. It includes many of the individual stocks available to U.S. investors as American depositary receipts like well-established outfits China Mobile (CHL), PetroChina ( PTR), CNOOC (CEO), and China Life Insurance ( LFC). None of these are startups. In fact, they are among the largest and most liquid Chinese outfits. Still, Salamone holds that because of the high risks, U.S. stocks are a stronger bet than emerging markets including China.

Nonetheless, the ability of Chinese equities to withstand the occasional storm—and of the Middle Kingdom's economy to sustain its rapid pace of growth—offers encouragement to those investors brave enough to play the emerging-market stalwart.

Halperin is a reporter for BusinessWeek.com in New York.