Investing in China has proved to be a risky, but richly rewarding strategy say TD Bank economists Craig Alexander and Parhat Zunun, in a recent topic paper.

While the pair admits that the region is volatile, the firm suggests that the long-run opportunities are hard to ignore.

“The combination of rapid economic growth and political change allowing increased foreign access has created golden opportunities for investment in China,” Alexander and Zunun say. “Indeed, foreign direct investment has boomed, with foreign companies either setting up operations in China or purchasing significant ownership in existing Chinese companies. Portfolio investment in Chinese equities has also heated up. And, many investors have taken an indirect approach to profiting from China’s rapid expansion by investing in foreign companies that have close business ties with China.”

Since the start of 2000, Chinese equities have delivered a total return of 218%, contrasting with the roughly 20% losses recorded by U.S. equities (as represented by the S&P500) and international equities (as proxied by the Morgan Stanley EAFE index), the two economists report. “However, investors have had to ride out quite a storm, as Chinese equities delivered greater than 100% annual returns in 2000 and 2001, but dropped by 44% in 2002 and a further 8% in 2003 before rebounding 8% so far in 2004.”

“Looking ahead, the volatility in Chinese equities is likely to persist,” the pair warns. “Regardless, there is one potentially positive development on the horizon. There is considerable speculation that China will allow its currency to appreciate by close to 10% relative to the U.S. dollar at some point in the near future. For holders of Chinese equities, this would provide a windfall currency gain on the value of shares held.”

If the volatility and risks related to holding Chinese securities directly are too great for some investors, there are alternative ways of profiting from China’s booming economy. “An effective strategy is to invest in equities of non-Chinese companies that are well positioned to profit from the Chinese economy. For example, many multinational companies have operations based in China. Other companies are located outside of China, but have export strategies that target the Chinese market. Indeed, China’s explosive growth, and its beneficial impact on the rest of Asia, is likely one key factor contributing to the double-digit gains recorded in non-Chinese Asian stock markets since the end of 2002,” the duo says. Also, China’s economic performance will boost earnings of commodity-related companies.

“Cheap and abundant labour will continue to attract strong foreign direct investment. So too will any further loosening of restrictions on foreign ownership. And, rising income will create profit opportunities from the growth in Chinese domestic demand. As a result, earnings and profit growth will continue to attract foreign capital into China,” Alexander and Zunun say.

The pair says the long-term outlook remains extremely positive. “While China faces several major hurdles, including managing widening regional income disparities and the need for improved capitalization of the banking system, there is every reason to believe that the government will prevail. If it does, look for China to remain one of good-news investment stories for both companies and private investors in the coming decade.”