The frantic pace of this year's recovery has provoked concerns that the momentum is too strong to prove sustainable. Investors are entitled to view the Chinese economic rebound with a degree of suspicion - a potent mix of abundant liquidity and an undervalued market has driven the Shanghai index up by 80 per cent in the first seven months of the year, doubling the book value per share to over 3.8 times. The remarkable strength of the rally has left Chinese stocks trading at a premium to both emerging and developed stocks.

Yet there are precious few signs that business conditions in China are drastically improving - a miserable stream of company reports posting earnings and profits declines has continued largely unabated. Investors are understandably jittery and volatility remains exceptionally high - the index fell by 7.6 per cent in one day alone in late July this year as panic over a potential tightening of lending conditions set in. Subsequent statements made shortly after by the central bank that the loose monetary environment would continue soothed investors, successfully averting a market free-fall.

Fears are exaggerated

We think that fears of an old-fashioned asset bubble are overblown, not least because the extent to which the state's fiscal injection fuelled the resurgence of Chinese growth remains ambiguous. Though significant, amounting to 12.5 per cent of GDP, it is unclear even now just how much of the package was new spending and how much had already been earmarked for previously announced projects.

Claims about the scale and impact of so-called “risky” lending on the Chinese stock exchange are also exaggerated. It is true that government-directed bank lending has been fiercely aggressive in the first six months of year at RMB7 trillion (around $1.3 billion), contrasting against RMB4.9 trillion for the whole of 2008. However, as The Economist comments, only a fraction of new inflows into the stock market could have been financed by borrowing – UBS research shows that net inflows into Chinese stocks amounted to less than 10 per cent of total new lending over the first half of the year.

Detractors are quick to point out that the Chinese government itself was responsible for slowing Chinese growth even before the full force of the global economic crisis hit export demand. They remark that the current loose fiscal and monetary stance is by no means guaranteed to persist.

Although the Chinese authorities, worrying over an overheating of the economy, did rein-in credit and constrain demand during 2007, the risk of a reversion to these policies seems distinctly remote. The government is keenly aware that Chinese exports remain weak and they are particularly sensitive to employment trends, which show little sign of real improvement. Inflationary pressure is also unlikely to materialise in the near term, with wages still depressed by excess manufacturing capacity. The short to medium term policy environment is therefore likely to be supportive.

An engine for global growth

In the longer term, China appears poised to be the new locomotive of future global growth. The country’s underlying population structure can be described as being in a "demographic sweet spot", with the working population expanding and the dependent population decreasing. The research house Gavekal argues that this steady decline in the dependency ratio will continue until at least 2015, creating a colossal source of long run productivity gain for the Chinese economy. 

Domestic demand growth is also set to underpin economic expansion in the coming years. Although decreasing as a share of total GDP, the absolute increase in domestic consumption - at 8 per cent per annum in real terms - makes China one of the fastest growing markets in the world.

We believe that China is embarking on a period of sustainable growth, irrespective of the vagaries of global demand. Our portfolios are therefore strategically overweight in China. Since we expect global activity to recover rather feebly in the short term, tactically we favour those sectors that profit more from domestic demand growth than export growth. We therefore see the most immediate opportunities coming from financial, property, and consumer cyclical stocks.