Is China finally cooling off?

Chinese equity funds recently had their worst week in a long time. What's causing the blip?

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NEW YORK (Fortune) -- Investors have piled $3.24 billion into China equity funds since the start of the year, taking advantage of the MSCI China's 54% year-to-date returns. The S&P 500, meanwhile is up about 18%.

But since the end of July the MSCI has returned less than 1% to the S&P's 6%. During the third week in August, China equity funds had their worst week on record since early in the first quarter of 2008 with investors pulling out $603 million, according to fund flow tracker EPFR. (In the subsequent two weeks they have committed $609 million.)

So what caused the blip?

"China's resilient growth has been a key driver of flows into emerging markets equity funds in recent months," EPFR reported, but now "doubts about the quality of the loans doled out at breakneck speed by Chinese banks during 1H09 prompted investors to book profits and take some of their recent gains off the table."

This growth in loans came after a period when Chinese banks had been under-lending to the market due to restrictions from the central government, says Frederick Jiang, portfolio manager for Waddell & Reed. The loan growth rate had been lower than nominal GDP growth rate, and for every $100 in deposits banks could only lend $60 due to the government's fears that greater lending would lead to an overheating of the economy. In response to the financial crisis the government abolished the quota to stimulate the economy.

Normally with this kind of explosive growth in lending comes an increase in non-performing loans, Jiang says. And while investors may have pulled out because of these concerns, he doesn't expect the non-performing loans to grow substantially.

Many of the loans actually went into the large government-sponsored infrastructure projects, so they have a reliable backer -- the Chinese government.

Toward the end of the second quarter and the beginning of the third, Jiang says he did trim some of his China shares. They were not cheap anymore, he says. He was waiting for a correction, which he says happened in July and August so he's back in the market.

The best move for investors is to buy and hold China and other emerging markets, he says, noting "they are long-term growth stories." The two themes that he plays: Chinese consumption buoyed by the increase in household income, and infrastructure development like high-speed railways.

Since the explosion of loans, Barclays head of international research Christian Broda says that China has relatively tightened its monetary policy. Lending in August subsequently dropped to a third of June levels. China is one of the first country's to start tightening its monetary policy, partly because it has been recovering since November of last year in terms of growth.

"It does confirm that growth is healthy in the eyes of the people who have the best data for the Chinese economy, that is the Chinese government," Broda says.

Another positive for China, says Broda, is that the rest of the world is recovering and hence will provide further support for export growth.

Along with doubts about loans, Arijit Dutta, a fund analyst at Morningstar covering international investing, says that the government's massive stimulus package also may have given investors cold feet. The stimulus reportedly led to excessive investment in infrastructure and property, he says. As a result, all kinds of prices in China went up, possibly causing several bubbles.

All of this liquidity that the government had been pumping into the system was being channeled to the stock market, he says. At some point authorities are going to take steps to prevent this and tighten up.

"If that worked as planned, it would take away a big source of funds into the stock market and would take away its momentum," he says. Hearing that, investors may have pulled out.

Dutta says that this kind of volatility comes with the territory of investing in a narrowly focused China fund. While there's still a lot of growth taking place in China, a better option may be to invest through a broader emerging market funds.

But Robert Horrocks, chief investment officer at Matthews Asia, says that investors are overly worried and don't have enough in China to begin with.

"Getting people to pull money out of China is like telling a starving man to not eat too much rich food," he says. "They have 5% or less in China but it will contribute a third of global growth over next five years."

He says that while China may seem a "shade" expensive, what's really happening is that it's not trading at the bargain basement prices it was a few months ago. Looking ahead, investors should benefit from an increase in domestic consumption as the Chinese household starts owning a home or a car, and traveling on vacation. To top of page

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