China’s economic pot continues to bubble at a full boil, recording strong economic growth and stock market activity for 2007. And it looks like more of the same for 2008.

Despite various government efforts to reduce the heat by raising interest rates and increasing bank reserve ratios several times, the Chinese economy registered year-over-year growth of 11.5% at the end of the third quarter of 2007, beating the previous year’s pace of 11.1% and allowing China to hold its position as the fastest-growing economy in the world.

Although China’s growth has so far been unimpeded by signs of an economic slowdown in the U.S. and global financial liquidity problems, most managers of Asian funds expect there will be some impact in 2008 as U.S. growth slows. But the damage will be minimal. China is firing on all cylinders with a maturing domestic economy and massive inflows of foreign capital.

The upcoming Beijing Olympic Games, urbanization, the development of inland China and growing relationships with non-U.S. trade partners are providing additional stimulus. Europe has surpassed the U.S. as the largest destination for Chinese exports, and Europe’s economy is growing faster than that of the U.S. for the first time in a decade.

“China is decoupling from the U.S. and is exporting more to Europe and other Asian countries,” says Nina Wu, senior fund manager at Hamon Asset Management Ltd. in Hong Kong and manager of Excel China Fund, sponsored by Mississauga, Ont.-based Excel Funds Management Inc. “In addition, the structure of exports has changed. It’s not just cheap clothing and low-end exports. China has moved up the export value chain, and higher value-added items such as machinery and equipment now make up half the value of exports. Overall, exports may be a little less in 2008, but they will still be strong.”

Wu is forecasting economic growth of 10% for China in 2008. The government continues to spend heavily on infrastructure such as roads, railways and ports, and a growing middle class is spending its rising wages, creating opportunities for domestic businesses. Attractive investment opportunities include China-based producers of everyday items such as cellphones, food, wine, liquor and shoes, as well as resources producers and real-estate developers.

Domestic consumers, who previously did not spend money unless they actually had it in their pockets, are discovering the benefits of loans and credit cards. The growing acceptance of borrowing will further drive consumption in China, says David Harding, managing director of San Francisco-based Matthews International Capital Management LLC and manager of GGOF Asian Growth and Income Fund, sponsored by Guardian Group of Funds Ltd. of Toronto. In addition, a growing number of citizens now have the means to own their own homes, a trend that will add further stimulus to consumer-based industries.

“The story of consumer spending growth is broadening,” Harding says. “Investors have traditionally viewed consumption trends in Asia as narrow, focusing on things such as cars and cellphones. Those tend to be the first ‘aspirational goods’ as a society gets wealthier. But as the middle class evolves, the Chinese economy will become more structurally similar to North America, and there will be opportunities in areas such as private health care, banking services, insurance and the media.”

K.C. Lee, portfolio manager with Fidelity International Ltd. in Hong Kong and manager of Fidelity AsiaStar Fund, sponsored by Toronto-based Fidelity Investments Canada ULC, believes that problems in the U.S. housing market will affect U.S. consumption of Chinese goods to some degree. But, he says, the Chinese economy will remain “somewhere between extremely buoyant and buoyant” — and a slight slackening in demand could be a “blessing in disguise, as it will help the Chinese government cool things down.”

However, if the U.S. slowdown turns into a recession, the implications for China and the rest of the world will be more negative. “In the five years from 1998 to 2003, the Hong Kong property market went through a prolonged adjustment after a huge boom, and there were widespread effects on the rest of the economy, including consumption,” Lee says. “It’s fair to assume that if a similar real estate collapse occurs in the U.S., exports to the U.S. will be affected.”

Although China’s government has been attempting to put the brakes on domestic economic growth, the unprecedented inflows of foreign capital have been so large that its fiscal and monetary policies have been rendered ineffective, Lee adds. Beijing’s foreign-exchange reserves stand at a colossal US$1.5 trillion; the tidal wave of Chinese exports washing over the rest of the world have widened China’s trade surplus to US$240 billion for the first 11 months of 2007, up by more than 50% from a year earlier.

@page_break@Rampant growth in money supply and the economy, combined with expectations that the pace will continue, have sent stocks in Chinese companies soaring, particularly the A-class shares, which trade in mainland China and are restricted to domestic investors. Hong Kong-listed Chinese companies have also risen strongly, although to a lesser degree.

Until recently, Chinese investors have been prevented from investing outside of China, which has fuelled the formation of a bubble in the A-class shares. Oil company PetroChina Co. Ltd., which listed its shares this past November on the Shanghai Stock Exchange while continuing to trade in Hong Kong, saw its share price soar following its China listing. It has become the largest company in the world, with a market capitalization of more than US$1 trillion.

Although nobody is calling for the bubble to burst, observers expect some of the pressure to be relieved as the Chinese government gradually introduces measures that allow its citizens to invest outside the country. The process has begun with the approval of funds called “qualified domestic institutional investors” (QDII), enabling Chinese investors to venture offshore. The first port of call for Chinese money is the Hong Kong stock market, on which many Chinese companies are listed. These shares could receive an extra boost in 2008 from money coming in from the mainland, managers say.

Money managers mainly buy Chinese shares in Hong Kong, and they are extremely selective about the companies they buy because valuations are quite high.

“Stocks in Hong Kong are reflecting the opportunities in China. But many are stretched, in terms of valuation,” says Justin Nightingale, assistant vice president of global equities for Montreal-based Natcan Investment Management Inc. and co-manager of Altamira Asia Pacific Fund, sponsored by Altamira Investment Services Inc. of Toronto. The fund contains some Hong Kong-listed China plays that are still attractively priced, including Hengan International Group, a company producing disposable paper products such as diapers and tissues; and Lenovo Group Ltd., the largest personal computer manufacturer in China.

While job creation for China’s population of 1.4 billion is driving the massive development schemes being masterminded by the centralist government, the result of rapid growth has been a pickup in inflation. Chinese inflation has soared to 6.9% annually year-over-year as of November 2007, the highest level in 11 years, driven largely by rising food costs. As the Chinese people become wealthier, their diet includes more protein, which increases demand for meat as well as the crops that are used for animal feed.

A slight drop next year in China’s frenetic growth rate may be just the dose of cold water the country needs to quell inflation. Another tool the government could try is to allow the tightly controlled renminbi to appreciate at a faster pace, increasing Chinese purchasing power and effectively reducing the cost of imports. Since 2005, the renminbi has appreciated slowly against the U.S. dollar, rising by about 9%.

“The undervaluation of the currency is still significant,” says Pablo Salas, managing director of Trilogy Global Advisors LLC in Orlando, Fla., and manager of CI Emerging Markets Fund, sponsored by CI Investments Inc. of Toronto. “It would take a lot more appreciation for it to put a drag on Chinese exports.” IE